Alpha investing: Super geeks

Why are so many money managers talking about their alpha?

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From the December/January 2008 issue of the magazine.

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If you’re in the market for investment advice, you’ll hear a lot about “alpha.” It’s a trendy term. Money managers brag about their ability to churn out alpha, a magazine called Alpha caters to hedge fund executives, and the Financial Times of London calls its investing blog Alphaville.

So what is alpha? The term comes from the geeky realm of financial theory—more specifically, from what’s known as the Capital Asset Pricing Model, or CAPM (pronounced cap-em) for short. The fi- nance professors who invented CAPM were looking for a unified theory to explain what makes the market tick. They argued that in a logical universe any investment’s expected return should be in line with its risk. Rational investors should demand a higher payoff from investing in dicey assets such as gold mining stocks than they do from holding boring, safe investments such as government bonds. On average, high risk should be reflected in high returns.

That’s the theory anyway. Problem is, you often see cases in which a safe, steady portfolio produces results that are much better than a risky, volatile portfolio. While this reversal of performance might seem to call into question the whole tidy structure of CAPM, the finance professors have an alternative explanation for why safe sometimes beats risky. They say that the reversal occurs because of a manager’s skill. They call this skill alpha. In plain English, alpha is supposed to be the dash of extra return that a truly outstanding manager can add to the risk-adjusted performance of a portfolio.

Now you understand why every money manager likes to think that he or she has alpha. If he or she didn’t have alpha, you would be just as well off investing in an index fund. But if he or she does have alpha, you and other clients should pay big fees to get yourself some of it.

The problem is that genuine alpha is rare—75% of mutual funds don’t keep pace with the market. Even in cases where a manager does beat the market, you can’t be sure that his success is because of alpha. Anybody can get lucky and beat the market for a year or two. For that matter, anybody can look back and check what strategy would have performed superbly over the past decade, then announce that, golly, he’s discovered the secret to generating alpha for years to come.

Unfortunately, hot streaks don’t always last and a strategy that beat the market in the past doesn’t always continue to beat the market. In fact, high-flying strategies often come crashing down to earth. While alpha sounds scientific, the term doesn’t refer to any specific approach to investing. It’s really just another way for a money manager to beat his chest and boast, “I can beat the market.”

So what should you do if a money manager tells you he can generate alpha? Ask to see a long-term track record of his results. Ask him to explain precisely how he is able to generate alpha. Ask how much borrowed money is involved and be leery of strategies that involve borrowing more than half again your original stake.

You should inquire what risks are involved. (There are always some.) Also, ask how much of the manager’s own money is invested in his fund. If he’s not putting all his own wealth into his strategy, maybe his alpha isn’t quite so sure after all.

In no case should you put all your money into any one alpha-generating scheme. Wide diversification is still smart, no matter what alpha bettors say.

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