Some time ago, I was contacted to see if I had any interest in writing for the site Seeking Alpha. Alpha is a term that quantifies beating the market. While there are many interesting articles on the site, I politely declined, noting that I’m all about avoiding alpha. In fact, I registered the domain name AvoidingAlpha.com.
Here’s why I think you should avoid alpha.
The Argument For Alpha
First, let me say that I wish I had owned the right active ETFs from last year. The list below shows the best-performing ETFs of 2020. ARK ETFs dominated, and CIO Catherine Wood took in $36.5 billion in fund flows in the 12 months ending Feb. 28, according to Morningstar.
The flagship ARK Innovation ETF (ARKK) returned 122.4% in the year ending March 8, 2021, and 46.4% annually in the five-year period ending March 8, 2021. By comparison, my Vanguard Total Stock Market ETF (VTI) earned only 16.7% annually over the same five-year period.
No matter what the proper benchmark is, ARKK delivered on alpha. Furthermore, both Fox and Motley Fool predict ARKK should make you rich over the next 10 years.
The Argument Against Alpha
So, yes, I wish I had owned ARK ETFs, as I’d be a lot richer. But let me clue you in on a secret: The total alpha ever delivered in the stock market since inception is zero. To make matters worse, that zero is before costs.
It’s actually impossible for the overall market to beat the market. Some money (like ARK funds) trounced the market last year, and some badly underperformed (smart beta ETFs). On average, active investing earns the market, before costs.
Though it’s not certain whether ARK funds will continue to produce alpha, the odds are at least as much against it as they were against smart beta several years ago. Owning the market according to market cap back then seemed downright dumb, and I embraced dumb beta, merely accepting the return of the stock market.
Alpha is a Wall Street invention to convert your money into my industry’s money; that is to say, in the aggregate, alpha is zero before costs. This means the following formula must be true:
Investor return = market return - fees
This formula must be true as described simply by William Sharpe’s Arithmetic of Active Management. It has nothing to do with the efficient market hypothesis; only the simple laws of arithmetic.
So, the more you pay in fees, the lower your expected return. Active funds (ARK, smart beta, and the like) have higher fees and, on average, will produce lower returns.
Active picks part of the market to overweight and outperform. Cathie Wood overweighted growth companies with disruptive technologies while smart beta overweighted value, or old-economy companies.
Wood is winning this round, as ARK funds took in billions in asset flows, while value shops like Dimensional Fund Advisors saw billions in outflows as value badly underperformed.
Morningstar 2020 Equity Performance
I don’t know if growth or value will win out for the rest of the year, so I’m avoiding alpha and owning growth and value according to market size. I’m doing the same for tech versus energy and every sector. I will get the market return, also known as beta.
There are now 308 alpha-seeking ETFs on the market now, with an average expense ratio of 0.73% annually. I predict two things:
- Many will become extinct in a few years
- On average, they will underperform the low-cost beta-seeking ETFs in their respective asset classes
Active ETFs may be the craze now, but most investors are still avoiding alpha. The largest ETFs are mostly beta-seeking funds with low expense ratios. But I praise those investing in alpha-seeking ETFs, as they serve a critical role in keeping markets efficient, and give those of us avoiding alpha a free lunch.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.