ELITE ADVISOR BEST PRACTICES
The Incredible Shrinking Alpha
And what you can do to escape its clutches
By Andrew Berkin
- With so many well-armed competitors in the markets, focus on the things you can control and discover what investing and life have to offer beyond the quest for alpha.
- With more risk factors and a smaller pool of easy “victims,” alpha is getting increasingly scarce.
- You can’t really combat shrinking alpha, but you can set realistic expectations. Have clients diversify their asset classes, watch their costs and use smart passive investing, but not just indexing.
In their new book, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches,Larry Swedroe, director of research for the BAM Alliance, and Andrew Berkin, director of research for Bridgeway Capital Management and an Elite Advisor Report contributor, offer a fresh take on the power of evidence-based investing and why beating the market is the stuff of science fiction.
ELITE ADVISOR REPORT: Andy, that’s a pretty unusual title for a book based on financial research and investing. Where did the title come from?
ANDREW BERKIN: We’re both big fans of science fiction. We saw similarities between Richard Matheson’s Incredible Shrinking Man and every individual investor futilely trying to beat the market. We’ve tried to take all this quantitative academic research and explain it in simple terms to help investors of all types understand why it’s tougher and tougher to achieve risk-adjusted above-market returns.
EAR: The term “evidence-based investing” gets tossed around a lot. What does it really mean?
AB: It refers to using research to back up your decisions. It’s about applying the scientific method from hard science to investing. You want to use both qualitative and quantitative data to prove your hypothesis. You want to filter out as much noise, hype and emotion as possible in order to make reasoned investment decisions.
EAR: So you’re saying it’s not worth the time and effort to beat the market? We should just all tell our clients to take the passive route?
AB: Not exactly. We’re saying that it’s not worth the time or effort spent battling to win those few extra cake crumbs. Instead, focus on the things you can control and discover what life has to offer beyond the quest for alpha.
EAR: Can you be a little more specific?
AB: Sure. Alpha is getting mighty scarce and there are four big reasons for that:
- People are finding more (risk) factors, so in a sense alpha is being transformed into beta.
- The pool of easy victims is shrinking. For instance, back in 1945, about 90 percent of American households held stocks. Now it’s only about 20 percent. You’re no longer investing against Mom and Pop, and other less sophisticated investors.
- The competition is tougher. There are a lot more people with professional training, reams of data, powerful computers and other tools. They all have the same tools, information and resources, and that makes it tougher to gain an edge.
- A lot more money managers and money are chasing the same alpha.
EAR: Let’s go back to your first point about more risk factors to contend with.
AB: Sure. There used to be one big factor—beta—the basis of the CAPM model. Then Fama and French came along with their three-factor model (market, value and size). Now we have four-factor, even five-factor models, if you ascribe to “momentum” and “profitability.”
EAR: So, money managers aren’t necessarily less effective than they used to be?
AB: Right. It’s like saying Major League Baseball players aren’t as good as they used to be because no one has hit over .400 since Ted Williams did it in 1941. Today’s pitchers throw much harder and have a lot more access to hitter tendencies. There are more relief specialists. Defenses are better and play shifts. And training has improved. It’s simply much harder to stand out than it used to be.
EAR: So, what should advisors and their clients do?
AB: You can’t really combat the problem, but you can set realistic expectations. Know what risks you and your clients can take and how much of them. Diversify your asset classes to minimize risk. Watch your costs, both taxes and fees. Use smart passive investing, not just indexing.