Alpha wolves. Alpha apes. Alpha outperformance on your investments. The idea that being at the top of the pack has significant advantages for canines, primates and investment managers is pervasive. In the first two cases, its benefit is access to resources and therefore survival. Oddly enough, it has pretty much the same benefit in the third case.

That is because alpha is the key performance metric that allows the clients of investment managers to differentiate their performance and evaluate their fees. As alpha has proven extremely hard to secure, and as low-cost market benchmark index products like exchange-traded funds have proliferated, capturing alpha and delivering it to clients truly has become a matter of survival.

What Is Alpha?

It is useful to understand just what is meant by alpha.

The term “alpha” is often used in a colloquial way to refer to an investment’s performance in excess of its market benchmark. Using this definition, a large cap U.S. equities manager that returns 11% in a year when its benchmark, the S&P 500, returned 10% is delivering 1 percentage point of alpha.

That is a bit misleading, though. Alpha (α) and its related measure, beta (β), are part of the capital asset pricing model (CAPM). This is an equation devised by Bill Sharpe and his colleagues in the early 1960s to determine if an investment’s returns are worth its risk. It shows whether the outperformance of a manager was just due to taking on additional risk or due to actual skill in selecting securities.

A portfolio’s beta is a measure of how much it moves relative to the market overall. A portfolio with a beta of 1.5 would gain 15 percentage points when the market rose 10, and lose 15 when the market fell 10.

This is key because the benchmark’s beta is, by definition, 1, so if the manager just piles on securities with higher betas, it will distort the picture and make the investment manager appear more successful than they really are.

Why Is Alpha So Important?

Alpha is key to evaluating performance across investment managers so that clients can choose the best manager. Since some investment managers charge high fees, it is also crucial to determine returns net of fees. Clients had better understand whether their alpha—and importantly, their alpha adjusted for the fund’s beta—is large enough to make the fund’s performance positive on a fee-adjusted basis.

The truth is, alpha in most cases does not even come into this conversation because most asset managers underperform their benchmarks. Standard & Poor’s Dow Jones Indexes keeps track of these performance shortfalls. It issues a SPIVA Scorecard (SPIVA stands for “S&P Indexes Versus Active”) twice a year. The reports make for grim reading.

The June 2023 S&P SPIVA Scorecard showed that about 90% of U.S. large-, mid- and small-cap funds underperformed their benchmarks over 15 years. Bond funds have done almost as poorly.

It is important to note that while nearly 75% of small-cap funds beat their benchmarks over one year, that number falls off to just about 10% over 15 years. SPIVA data show that more than half of actively managed large-cap funds have only beaten their benchmarks three times in the 21st century.

It should be noted, too, that the benchmarks are changing, and not always for the better. Morningstar, in a recent report (Mining for Alpha with Index FundsJuly 2023), noted that there are now more than 1,600 equity index tracking funds and 400 fixed-income funds. However, the nature of the underlying indexes has changed.

First, the number of stocks held in these indexes has declined, from an average of 500 in 1998 to less than 150 in 2022. Second, weighting schemes have changed in recent decades. In 1998, 85% of index funds weighted their holdings by market capitalization. That has fallen to 42% by 2022.

“Fewer holdings and a wider variety of weighting schemes increase active risk,” Morningstar analysts wrote. They added that new index funds launch against benchmarks that have only been around, on average, for four months, meaning their historical performance through business cycles, crises and other events is not well understood.

More risk in the index throws suspicion on its value as a representative benchmark for the active fund that is using it as a point of reference. If the index behaves erratically due to too few component securities, or because it has not been adequately back-tested, the CAPM and similar tools will be of little value to investors seeking insight into the investment manager’s performance.

Alpha’s Key Role

Apart from these issues, alpha remains a key metric for investment managers.

Capturing alpha is essential for the preservation and growth of capital. Investment managers who consistently outperform the market can better protect their clients’ capital during bearish phases, mitigating losses.

There is a debate among some asset managers as to whether alpha is a zero-sum game. They believe it cannot be generated but that the limited amount of alpha in the markets must be divided through competition among managers.

Bill Sharpe was supportive of this view. In his famous 1991 paper The Arithmetic of Active Management, Sharpe noted the challenge active managers have when attempting to provide alpha net of fees:

“If ‘active’ and ‘passive’ management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”

This sounds like unwelcome news for managers hoping to consistently identify and capture alpha for their clients, thereby allowing themselves to charge a reasonable fee. In fact, it simply shows the importance of the concept of alpha as a metric, without which asset managers would be flying blind.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?

Paul Daneshrad is CEO of StarPoint Properties, a real estate & investment firm, and author of the Amazon BestSeller ‘Money and Morons’. Read Paul Daneshrad’s full executive profile here.

Link to Forbes article HERE

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