Swedroe: All Those Factors Shrink Alpha

June 28, 2017

Alpha historically has been thought of as the return from active management (that is, from stock picking and market timing). However, it’s also possible alpha can come from a source (common characteristic) that isn’t associated with any known investment factor, possibly one that is yet to be discovered.

For example, prior to the 1992 publication of the paper “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French, excess returns (above-market) generated by managers/funds that had exposure to value stocks were considered alpha.

Since their paper’s publication, a manager’s/fund’s holdings are adjusted for exposure not only to the market factor (beta), but also to the value and the size factors. The result was that the alphas of many active managers disappeared.

Alpha Increasingly Explainable

Today almost all studies on the performance of actively managed funds incorporate the use of a multifactor model. These models generally will include some combination of common factors, such as beta, size, value, momentum and, most recently, profitability (or quality).

As my co-author Andrew Berkin and I explain in our book, “The Incredible Shrinking Alpha,” finance has moved from a one-factor world to a multifactor world.

With that, alphas have shrunk as they are reclassified and no longer are attributed to active management. Instead, they are attributed to exposure to common factors. (Andrew Berkin and I explore which of these common factors are worthy of investment in our latest book, “Your Complete Guide to Factor-Based Investing.”)

As financial theory continues to evolve, what once was considered alpha becomes explainable by relatively understandable and easily accessed factors. The result is that, as new factors are discovered, alpha continues to shrink as it is turned into beta (exposure to common factors).

That said, this understanding doesn’t detract in any way from the performance of the active managers who exploited those factors before the academics “discovered” them and reported their findings.

Positive Development For Investors

This incredibly shrinking alpha is a positive development for investors, because these factors can now be accessed without incurring the high costs of actively managed mutual funds, the much higher costs of hedge funds or the risk of style drift that comes with active strategies. Instead, they can now be accessed through low-cost strategies (such as index funds and ETFs) that can be considered to fall within a broad definition of passive strategies.

Having access to lower-cost, structured portfolios that capture or harvest return premiums means that a shrinking alpha doesn’t necessarily have to suggest lower returns, just lower costs for investors seeking exposure to these strategies. Investors benefit from being able to diversify their portfolios across more low-correlating sources of returns without the high costs that can more than offset the benefits.


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