Why Long-Term Alpha Is Avoided
Bottom line: Pro investors avoid long-term alpha opportunities when their investors are focused on short-term relative performance.
And can you blame them? Asset managers are compared with a benchmark every month, quarter, year or even three years, and short-run relative performance has serious consequences. Whether the asset manager is proactively protecting his/her job, or the client is actively driving the conversation around near-sighted metrics, the end result is the same—few pros want to engage in active investing, and prefer a closet-indexing approach, since it is safer from a career perspective.
We’ve outlined a few elements of the marketplace. First, prices aren’t always efficient, and second, exploiting inefficient prices is difficult, because professional investors rationally prefer employment versus unemployment. We encapsulate these simple ideas in Figure 3.
Figure 3: The Long-Term Performance Equation
The long-term performance equation has two core elements that help us identify a true “alpha” opportunity. First, sustainable alpha. By sustainable alpha, we mean a process that systematically exploits mispricings caused by behavioral bias in the marketplace (i.e., find the worst poker players).
Next, sustainable clients—which are important, because many of the best poker players in the game (think large asset managers with a majority of the capital)—are unable to pursue long-term opportunities because their client base is too focused on the short term (i.e., understand the best poker players). Without sustainable clients, there is no opportunity to pursue sustainable long-term performance.
Based on the equation, if one could identify processes with an edge (e.g., sustainable alpha) that require long-term discipline to exploit (e.g., sustainable clients), it is likely that this process will serve as a promising long-term strategy.
Of course, identifying a reasonable process is not too challenging, but identifying sustainable clients with long-term focus is almost impossible.
Hence, sustainable active investing is almost impossible.