Investing Myths: Alpha and Beta

[Thremp]

hawk,

Okay I think I got it more now. The 5/7 are the collars of it and you're sliding in between makes more sense.

[Jeff W]

Before anyone jumps on the active management train, remember to look at ER and Tax Efficiency(in taxable accounts). Active funds tend to have high turnover relative to passive funds, which leads to tax inefficiency.

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They seek to buy undervalued, out-of-favor stocks with high cash flows, low book values, often low debt, that generally pay some sort of dividend. A simple example would be Neff’s purchase of Ford in 1984 when it carried a PE of 2.5x. In less than 3 years it climbed 350%. Strong-form says the market is 100% rational, 100% of the time when evaluating every single security in the marketplace -- this is clearly false.

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This strategy is replicable with Rydex Pure Value ETFs -- RPV, RFV, RZV. 0.35 Expense Ratio, very deep value orientation. Again, it net of taxes it can be difficult to reproduce the value premium in taxable.

[Jeff W]

[ QUOTE ]
Myth #2 – You can’t predict which managers will outperform.

They insist you buy your equity exposure via a relatively passive index, pay Vanguard’s moderately expensive indexing fees [when compared to BGI or SSgA] to purchase a market-weighted index, and guarantee that you underperform the SPX or Wilshire 5000. You guarantee yourself sub-market returns in perpetuity, but at least you’ll get a relative return that is close to ‘the market.’

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First of all, Vanguard ETFs are the cheapest ER in the business for every asset class they cover AFAIK.

Second, Vanguard has positive tracking error because of advanced management/transaction skill. For example, Vanguard's index funds outperformed their index by .9% after fees from 1996-2000. I wish I had more data, but I'm not that motivated.

[john kane]

great post, thank you hugely for this, something ill put into my favourites to ensure i read it a few times.

i can't comment much due to my lack of knowledge, however, fwiw I received an email from an IFA yesterday who said when investing in funds, it was crucial to invest in the best managers.

[gull]

I agree, but I'm still in index funds.

[ QUOTE ]
Burton Malkiel says that mutual funds regularly underperform by 2% on an annual basis. Since the average mutual fund costs about 1.3%, that means that most funds are losing 70bps per year in alpha. Index funds are losing 15-20bps per year in alpha.
However, this also means that other players in the market, by definition, are generating significantly positive alpha. After all, if 70% of funds have negative alpha the other 30% are gaining all of that alpha,

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The underperformance of mutual funds isn't completely due to negative alpha and fees.

[UCLAseetoK]

Favorited to be re-read when I'm more investing knowledgable.

<===== Index fund.

[matt holland]

Thanks for the effort you put into the post, I don't have anywhere near the knowledge to understand all this, but it was very interesting.

If the shorting hedge funds idea works like I imagine it, it appears to be a great argument. Could a similar thing be done with mutual funds?

Something I was thinking about beta, if the market actually did reward this extra "risk," wouldn't an index fund of the stocks with the highest betas be expected to drastically outperform the S&P in the long run?

"Vanguard’s moderately expensive indexing fees [when compared to BGI or SSgA]" Could you expand upon this?

Lastly, if the avg. investor in this forum was interested in alpha from hedge funds, how would they go about it? what would they look for? I imagine these questions are too detailed to answer here, but if you could recommend a resource or starting point to answer these questions it would be really appreciated.

Naj, thanks again for your time. Responses from anyone would be greatly appreciated.

[stoxtrader]

[ QUOTE ]
[ QUOTE ]
Myth #2 – You can’t predict which managers will outperform.

They insist you buy your equity exposure via a relatively passive index, pay Vanguard’s moderately expensive indexing fees [when compared to BGI or SSgA] to purchase a market-weighted index, and guarantee that you underperform the SPX or Wilshire 5000. You guarantee yourself sub-market returns in perpetuity, but at least you’ll get a relative return that is close to ‘the market.’

[/ QUOTE ]

First of all, Vanguard ETFs are the cheapest ER in the business for every asset class they cover AFAIK.

Second, Vanguard has positive tracking error because of advanced management/transaction skill. For example, Vanguard's index funds outperformed their index by .9% after fees from 1996-2000. I wish I had more data, but I'm not that motivated.

[/ QUOTE ]

this is actually something I can chime in on. Generally large indexers will get a rebate on their business because depending on how it is done, it can be lucrative for the executing broker.

It is not uncommon at all for a broker to make a risk bid of close +/- 10,20,30 bps to the principal in their favor as a way to lockup the business. This will have market impact most likely but it will help the indexer beat it's index.

[rsliu]

"Thus, for investors who are neither high net worth nor financially sophisticated, index investing with periodic rebalancing of a sensibly diversified portfolio w/ minimized internal correlations, is clearly the best long term strategy if you believe that US and global asset classes will continue their inexorable climb as they have for the past 100 years."

This is wrong. Let's say you follow Vanguard's standard advice and get a 70/30 stock bond allocation mix, and then just buy their index funds. First of all, even though you've 'diversified', your risk exposure still primarily comes from equities. This stems from the fact that equities are more volatile than bonds, which, when combined with the fact that most of your exposure is in equities, leads your portfolio to be highly correlated with the stock market. You can mitigate this problem by changing your allocation in favor of bonds, but that reduces your returns.

So how do you solve this problem? Leverage. To really capture the benefit of diversification, you'd want to lever up the risk share of your bond allocation until you have the same risk from bonds as you do from stock (assuming that asset classes have similar sharpe ratios, this should mean you've levered the returns of your bond allocation up to equities returs as well). So now, instead of buying 70/30, you're buying something like 50/100. With this allocation, you'd expect roughly the same returns as if you were just 100% invested in equities, but with a significant reduction in risk because bonds and stocks aren't 100% correlated.

Unfortunately you can't do this because our government doesn't allow you to lever your portfolio.

[stoxtrader]

you should be able to lever the traditional accounts portion of the portfolio, but you would pay a price for it. I'm not really sure I've ever heard this strategy before...