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Where did all the alpha go? [video]

The investing industry often talks about alpha, but what is it?

    The evidence shows that fund managers are finding it increasingly difficult to generate alpha

    In simple terms, alpha is a measure of outperformance compared to the market. The evidence shows that fund managers are finding it increasingly difficult to generate alpha, especially when you take into account their fees and charges.

    Andrew Berkin explains the four main reasons why it’s becoming more and more difficult to outperform

    RP: The investing industry often talks about alpha. In simple terms, alpha is a measure of outperformance compared to the market. The evidence shows that fund managers are finding it increasingly difficult to generate alpha, especially when you take into account their fees and charges.

    This phenomenon is explored in a book by Larry Swedroe and Andrew Berkin called "The Incredible Shrinking Alpha". The authors suggest four main reasons why it’s becoming more and more difficult to outperform.

    AB: One is the conversion from alpha to beta. So, explaining the outperformance because of factors that people are investing in, which can be achieved without all the hoopla, often at a very much lower cost.

    Another is, that the pool of victims is shrinking. A lot of money used to be held by “mum and pop” retail investors. That’s come way down.

    Third thing is that the competition has become tougher. You get a lot of very smart people with access to a lot of data, a lot of mathematical and statical tools, a lot of computing power. The tougher the competition, the harder it is to outperform. The last thing is, that with all this competition you’ve got a lot more money chasing what is perhaps a very limited and fixed set of investment opportunities.

    RP: So, it’s not that fund managers are becoming less skillful. On the contrary, absolute skill in asset management is arguably higher than it’s ever been. But relative skill has decreased; in other words, the gap between the best and worst performers has narrowed. The same thing is happening in the sporting world. Take baseball, for example.

    AB: In baseball, batting 400 - that is when you go up to bat, getting on base over 40% of the time - that is an incredible feat. Only a very small number of people have done it. But nobody has done it for well over half a century - I forgot the exact number. One way people may think about this is, “Well, baseball players just aren’t as good as they used to be”, perhaps. But all the intuitive evidence would argue otherwise. In the old days, people in the off-season had to work jobs. Nowadays, they can train year round. They’ve got access to much better training, techniques, etc. The upshot of all that is, that with the increase of general skill level, it makes it that much harder of anyone to outperform because your pitchers are getting better, the defences are getting better and that’s why it makes it so much harder for people to outperform.

    RP: There is, in short, a finite amount of alpha, and it’s now very difficult to find. And remember, trying to find it costs time and, potentially, substantial sums of money. It really is best, for ordinary investors, to abandon the search for alpha altogether.

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