Swedroe: All Those Factors Shrink Alpha

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.

Examples Of Wider Access

For example, investors now have access to low-cost, structured funds that not only provide exposure to small-cap stocks and value stocks, but to the momentum factor as well. And there are also low-cost, structured funds that provide investors access to securities and strategies that were once considered the sole realm of hedge funds, such as commodities, the carry trade, shifting maturity bond strategies, low-beta stocks, low liquidity stocks, and merger and convertible bond arbitrage.

As an example of how a “hedge fund strategy” like merger arbitrage can be implemented in a passive—and therefore a relatively low-cost—manner, consider that merger arbitrage involves both offering a form of insurance against the deal not closing, as well as providing liquidity to shareholders who want to sell immediately. Arbitrageurs who buy the target company and sell short the acquiring company capture a systematic risk premium.

Another example that was once the domain of hedge funds is managed futures. Managed futures are basically momentum strategies that can be accessed with passive strategies. Equity-market-neutral strategies are another example of a hedge fund strategy that can be replicated by going long value stocks and short growth stocks, or long positive momentum stocks and short negative momentum stocks, and done in a relatively low-cost, passive manner.

'Cancer On Institutional Fund World'

The preceding examples are all strategies that have provided positive long-term returns while also exhibiting low correlation with more traditional stock and bond investments. And you no longer need to employ a hedge fund and pay 2/20 to incorporate any of these strategies into an investment plan. What’s more, you certainly don’t need to hire what David Swensen (Yale’s chief investment officer) called a cancer on the institutional fund world: a fund of hedge funds (and pay an additional 1/10).

Finally, it’s interesting to note that among the leaders of bringing lower-cost structured strategies to individual investors is hedge fund manager AQR Capital Management. (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Before closing, I’ll offer the following words of caution. Investment strategies often appear appealing on paper, but once implementation costs are considered, the real-world returns don’t look as good. This is especially true of those that have high turnover (such as momentum strategies).

Thus, it’s important to be sure that the fund manager you employ to implement the strategy has strong skills in terms of fund construction rules and in terms of controlling trading costs and operational risks.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.