Swedroe: Alpha’s Persistence Always At Risk

June 23, 2017

The quest for performance predictability has been as unsuccessful as the quest by King Arthur’s knights for their own Holy Grail, the cup from Christ’s Last Supper.

The bottom line is that investors are not well-served by selecting mutual funds based on past performance, whether in the form of alpha or absolute returns.

Instead, investors should focus on other characteristics, such as the fund’s underlying market philosophy, portfolio construction rules, exposure to (or loading on) well-documented factors, trading strategy, total costs (not just expense ratio) and, for taxable investors, tax management strategies—all of which are important to providing investors with the best odds of achieving their financial goals.

Alpha vs. Actual Returns

There’s one more important point we need to cover. When it comes to picking mutual funds, investors should care less about alpha (by whatever measure) than about actual returns. I want to own a fund that provides me with exposure to factors I care about, such as market beta, size, value and momentum. I’m then happy to have minimal alpha, so long as I get the beta (loading on a factor) I am seeking, which leads to higher returns.

In other words, I would rather own a low-cost, passively managed small value fund that provides me with high loadings on those factors, and minimizes or even eliminates the negative exposure to momentum that is typical of value funds and has no alpha, than an active fund with less exposure to those factors, even if it generates a positive alpha, because that positive alpha would have to be great enough to overcome the loss of returns due to its lower loading on the factors.

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


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