Looking For "Alpha" In All The Wrong Places

Looking For "Alpha" In All The Wrong Places
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If I had to select one factor that causes investors to underperform market returns (that anyone could easily obtain), it would be the quest for “alpha.” As indicated in this excellent white paper from Vanguard, most investors define “alpha” as the ability to outperform a designated benchmark, like the S&P 500 index. However, this definition doesn’t account for the amount of risk the fund manager is taking.

However you define “alpha, the underlying assumption of many investors — and the primary reason they rely on brokers — is the lure of earning outsized returns. The securities industry preys on the greed of investors and entices them with misleading claims about its ability to “guide” them in accomplishing this goal. The end result is often a combination of low returns, high fees and the transfer of wealth from investors to those who “manage” their money.

Poor returns

One study looked at 10-year annualized returns of mutual fund investors in actively managed funds for the period 2004-2013. During that time, the S&P 500 index had an annualized return of 7.4 percent. While you can’t buy the index, you can purchase an index fund that tracks the index for a cost as low as 0.05 percent.

The average investor in a blended portfolio of stocks and fixed-income actively managed mutual funds had a net average return of only 2.6 percent during that period. The results over longer terms were even more dismal. The 20-year annualized return was a puny 2.5 percent. The 30-year annualized return was even worse, coming in at 1.9 percent.

For these investors, the quest for alpha generated “negative alpha.”

Metrics that matter

This data should discourage you from succumbing to the allure of capturing “alpha”. Unfortunately, the reality is that the combination of massive advertising by the securities industry and a stream of misleading financial news is likely to continue to tempt the majority of investors to engage is this high risk strategy.

If you must pursue this rocky road, you should be aware of the metrics that matter and those that don’t.

The Vanguard study found the expense ratio of actively managed funds (the amount the fund charges as a management fee) was the most significant factor by far in trying to predict which actively managed mutual funds are likely to outperform. The lower the cost, the more likely the fund was to outperform.

A cautionary note

Although buying low management fee actively managed funds increases the likelihood of outperformance, let’s put this in context. Lower cost funds don’t always generate higher returns. In addition, the majority of actively managed funds don’t generate “alpha”, even when low cost is taken into consideration. Over the 20 year period ended Decemnber 31, 2013, only 35 percent of actively managed stock funds in the least expense quartile outperformed, compared to 17 percent of funds in the most expensive quartile.

A better way

Fortunately, there’s a better, more responsible way to invest. Fire your broker. If you need an advisor, use a registered investment advisor who focuses on putting together a globally diversified portfolio of low management fee index funds, passively managed funds or exchange-traded-funds in an asset allocation suitable for you. If you don’t need an advisor, you can purchase these funds directly from low cost fund families like Vanguard, Fidelity or Schwab.

If you can’t resist seeking alpha, recognize the fact that the odds are against you. You can increase those odds by purchasing the lowest cost actively managed funds.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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