The allure of alpha

May 7, 2011

keeping up with the joneses

“Alpha”, most commonly known as beating the market on a risk-adjusted basis, in laymans terms means doing better than a passive strategy, better than most other dollars or pounds in the market. While obviously alpha is a good thing, there is no guarantee of achieving it – it is a risky prospect itself, but the fees associated with active management are a sure thing. So taking on manager risk as well as market risk implies that there is significant value to active management. Regardless of whether or not managers can achieve it in a pure economic or returns sense, we might also make sense of it in terms of the satisfaction it gives investors to achieve it. So I’d like to reflect more on the demand for alpha - our desire to achieve it. There sometimes appears to be so much more demand for alpha than ability to actually provide it, that many funds exist purely to fulfil our desire to achieve outperformance. The vast majority of assets in markets are “actively” traded – average holding period for a stock has dropped to well below a year. However, everyone can obviously not be above average, so why do we invest so much time/effort pursuing a slightly higher return? The desire to be better than our peers is one of the most ubiquitous facets of human nature. What is amazing is how much absolute performance we are willing to forego to achieve this. In one classic study, people were asked to choose between a job which paid $70,000 per year, which would require moving to a neighbourhood where the average salary was $80,000 per year, or one which would pay $60,000 per year, in a neighbourhood with an average salary of $50,000. The majority decided they’d rather be above average, than actually better off. This preference to beat the neighbours also shows up in how people experience outcomes. Someone who has achieved a good return, once they know that others did better, will rate the return flat or not positively. As a result, there is substantial demand for managers who can beat the market, not simply on an accounting basis – that they can achieve the returns – but more in terms of the additional happiness beating the market implies. There are a few psychologically tricky ways to achieve this effect. Imagine that a manager has exactly the same average return as the market, but can shift some of their returns across months statements. If the manager outperforms for 11 months by a small amount, and takes a large loss in one month, they have still given the client 11 months of alpha – something the client will likely remember, more than 12 months of the same returns. The question for financial advisors is whether the desire for relative outcomes should play a role in the advice they give. Some individuals might be much more concerned about relative outcomes than others, and they might take action (churning their portfolios or managers) on the basis of perceived under-performance. Others might be fine to ignore what markets are done. However, most likely is the worst case scenario – investors are relative in gains (“why am I up only 10% when the market is up 15%?”), and absolute in losses (“I don’t care that markets are down 15%, why are you down 10%”). References Alpizar, F., F. Carlsson, et al. (2005). “How much do we care about absolute versus relative income and consumption?” Journal of Economic Behavior & Organization 56: 405-421. Miles, D. and R. Maximo (2007). “Learning about one’s relative position and subjective well-being.” Applied Economics 39: 1711-1718. Iluka Hedge Fund Consulting (2006). The Tao of Alpha.