ALPHA vs. BETA (Round 2)

The impact of the 2008 financial crisis on the whole financial industry was so brutal that ramifications will be felt for at least another decade; none more so than our friends in the asset management industry. Today the asset management landscape remains enormously challenging. But along with great challenges come great opportunities. Clients are even more demanding, product trends continue to shift, the regulatory climate is tightening further, and competition is intensifying – with different markets posing different challenges. In addition, with an investment backdrop defined by chronically low interest rates, inevitable inflation, potential market bubbles, and lingering market volatility, the business climate remains truly unsettling.

The debate on active versus passive management is hardly new. It was eloquently raised above the parapet again by my dear friend at Blackrock, James Charrington (Alpha may be reborn – with a difference, 26.09.2011 FTfm), where he stated “ultimately, the swing towards beta may paradoxically lead to a revival of alpha”. Or to put it another way, stop selling us dressed-up beta and charging alpha prices; alas I am not known for dancing around subjects. The revival is in fact long overdue and those investment managers able to deliver alpha will likely come through as winners over the next decade.

The crunch is that most managers will deliver positive alpha from time-to-time, however very few are able to deliver consistent positive alpha i.e. a gestimate would be about 1 in 20. Alpha is a ratio which expresses the so-called risk-adjusted performance of an investment strategy. If the average return on a portfolio is larger than its expected return, the alpha is positive. If the average return is smaller than expected, the alpha is negative. On the other hand beta is the measure of the sensitivity of an investment portfolio to the overall market. A beta of >1 indicates that the relevant share or portfolio is subject to larger fluctuations and thus carries a larger systematic risk than the overall market.

Despite numerous studies (including Jensen: 1968, Blake, Elton Gruber: 1993, Mark Carhart: 1997, and James Davis: 2000) that indicate lackluster performance of active portfolio management, the industry maintains growth, albeit more slowly. One such study, “The Arithmetic of Active Management”, written by William F. Sharpe (1991), makes the case that “(1) before fund costs, the return on the average actively managed dollar will be equal the return on the average passively managed dollar and, (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” In summary, Sharpe asserts that active managers in aggregate effectively hold securities representing the index and therefore cannot outperform a passive strategy after costs. Whilst the conclusion is certainly damning, the word “aggregate” is in fact much more telling and should be read as some active managers do well and others do not.

Given all the anomalies and variables within the industry, performance analysis remains difficult and inconclusive (e.g. aligned benchmarks, adjusting for survivor bias, and using a time period spanning complete market cycles), therefore in relation to active versus passive debate – independent advice and much greater due diligence is necessary to identify talented investment managers and if in doubt use well-structured passive investments with sensible pricing.

However the debate on asset allocation is a whole new chapter; clearly blunt exposure to active or passive managers without careful thought on diversification, investment weight and timing can be equally damaging.

By Louay AL-Doory