The Elusive Pursuit of Alpha: Balancing Returns and Costs in Modern Investing
In 1688, Joseph de la Vega penned his thoughts on the trading of shares on the Amsterdam Stock Exchange, likening profits to elusive treasures that shift like shadows. Today, investors chase a similar phantom — alpha, that extra portion of return that seems just out of reach. Academics struggle to define alpha, and even empirical evidence is elusive, with many investors convinced they can predict and capture it in advance.
Alpha is a slippery beast. Michael Jensen, who coined the term in 1967, observed the mutual fund industry’s struggle to forecast security prices. The S&P Global Persistence Scorecard shows that 88% of large-cap mutual funds underperformed the S&P 500 for 15 years. In my research on institutional portfolios, no public pension fund has significantly outperformed market benchmarks since the Global Financial Crisis of 2008.
Furthermore, the quest for alpha is fleeting. As investors flock to exploit it, alpha begins to vanish. Yet, the real sticking point lies in the cost of active investing — a topic often overlooked. Investment expenses, from management fees to carry costs, are concrete and measurable, but many institutional investors are opaque about revealing them.
An NBER study found that balanced mutual funds underperform market benchmarks by an amount equal to their cost. I discovered similar patterns in public pension funds and endowments, where expenses often surpass returns. For example, Harvard University spends an immense sum on money managers but struggles to match market performance.
As markets grow more efficient, finding alpha becomes increasingly challenging, emphasizing the importance of managing costs for active investors. To strike a balance between elusive alpha and corrosive costs, consider these strategies:
- Transparently track all investment costs, fostering a culture of cost-awareness within your organization.
- Rethink portfolio design by trimming costly investments that offer little diversification, favoring passive investments with low fees.
- Establish an expense budget alongside a risk budget to control active investing costs.
- Measure performance against a simple passive benchmark to reveal the true value added by active strategies.
Ultimately, the choice lies between a complex, underperforming portfolio laden with high fees or a streamlined approach with carefully selected active strategies that outperform. By reducing costs and embracing transparency, investors can give alpha a fighting chance in today’s challenging landscape.
