Investing Myths: Alpha and Beta

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"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...

[pig4bill]

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

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There are lots of ways to leverage, from simply buying on margin to using futures.

[NajdorfDefense]

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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 ... asset class they cover AFAIK.

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You can get Beta exposure cheaper than ETFs, not however for $2500. [BTW, the info on the VG site about their competition's fees are overstated by 25% or more in the few examples I examined. Caveat Emptor.

[NajdorfDefense]

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We're invested with a manager who's beaten the SPX by 40bps a year after fees for 15 years...with 65-75% less volatility.

Think about that...that should be impossible! Better market performance and alpha generation with a vol 3-4x less and no correlation -- I can't even think of a metaphor describing how insanely difficult that is, but it obliterates the notion of 'luck.'


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It comes a lot closer to proving the notion of luck than obliterating it.

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You are completely wrong, as anyone could have guessed by your brainless, uneducated one-liner.

Gross, he's beaten the index by 390bps per year, for 15-20 years, with 70% less vol.

Now, there are less than 100-200 professional, active [as opposed to passive indexers like VG] money managers with a track record that long, who manage over, say, $200mm.

This manager would be about 10-12+ std devs out in the positive tail. He's way past 95% stat sig, past 99% [~3 sd], etc.
So's John Neff who did it for 32 years. So is WEB - 50 years of data. So's Simons. So's SAC. So's Lynch. So's Marcus. That's 4% of the group we sampled. Richie Freeman has more than doubled the SPX over 23 years, an outperformance of several hundred percent -- all these guys managed hundreds of millions/several billion $$ which meant they had enormous fees and costs to overcome, just to start, plus paying the bid/offer spread on every holding.

So, either come back with an actual statistical study proving that 5% of managers who manage over $200mm for multiple decades are *randomly* going to beat the market by several hundred-thousands of % points, [i.e. proving a random distribution will show this result] with less risk, or stop 'tarding up the thread.

But we all know you can't. 95% of academics don't even believe the market is Efficient anymore. The far majority of the EMH guys admitted they were wrong years ago.

[NajdorfDefense]

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Several firms have used models and bond agency ratings to predict defaults to evaluate the equity performance of various ‘risk’ classes. Generally speaking, they find distressed stocks have abnormally low returns, inconsistent with return/risk assumptions. These firms have higher volatility, betas, and market cap-factors than stocks with a low risk of failure.
Studies have shown that stocks with low risk factors such as lower beta, leverage, higher profits and dividends outperform the market, consistent with the research on distressed firms. O'Shaughnessy shows similar results.


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I could have sworn I have read that distressed firms on the whole do very well (maybe Siegel?).

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Perhaps you are thinking of Milken's dissertation showing that 'fallen angels [junk bonds]' outperformed portfolios of high quality bonds from 1950-mid 70s. He was very right, hence his/Drexel's creation of the junk bond market.

As shown in OP and many places, this is no longer the case [which will change again at some point in the future.]
Would love to see add'tl studies on this thread or a new one, either about stox/bonds, either way.

[spider]

Naj, I doubt many here would say that if you are both financially savvy and wealthy you should end up beating the market by a bit.

But what exactly are you suggesting for someone who is not financially savvy and has something like 200k in assets? Put it in some PIMCO fund rather than AGG and put it in Berkshire rather than SPY or VFINX?

[NajdorfDefense]

Spider, this was not intended to be another thread on fund-picking, merely my thoughts on differentiating btw alpha and beta for 2p2ers.
Uneducated consumers who wish to remain uneducated should hire a talented, fee-only fin'l planner, akin to the way one searches for a lawyer, tax acc't, or doctor/specialist.

FTR, Vanguard today announced they will start offering actively managed funds. Someone should probably start a thread on that.

[Perplexity]

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FTR, Vanguard today announced they will start offering actively managed funds. Someone should probably start a thread on that.

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Vanguard has had actively managed funds since at least 1958 (when the Windsor Fund was launched).

Not sure what you are talking about here, but curious. I googled around a bit but couldn't find anything (some video game called Vanguard is cluttering the results).

[spider]

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Spider, this was not intended to be another thread on fund-picking, merely my thoughts on differentiating btw alpha and beta for 2p2ers.

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Yeah, I get that part, and I'm not trying to hijack the thread, it's just that I think for many people the second stage here is ultimately more relevant (i.e. first stage is generating the alpha (Buffet, Gross, etc., the second stage is who shares in the alpha they generate). It seems like an open (and interesting) question to me as to whether someone with around 200k of assets should really buy anything besides index funds. Or maybe put it like this: if you are trying to find an alpha generating manager, are you yourself generating alpha?

Or to be anecdotal about it: If your aunt asks what to do with her 200k, what do you tell her? Assuming you want to minimize your "responsibility" for whatever happens. IOW, you aren't going to give her your 5 stock picks b/c no matter how great they are that would be bad on at least a couple levels. So do you tell her VFINX or Berkshire?

Anyway, not asking for an answer on that, just clarifying. Though of course, if you have any thoughts on that I'd be curious to hear them.