Investing Myths: Alpha and Beta

[Sand]

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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?). Any decent papers that talk about low return averages for distressed stocks?

[ArturiusX]

A good poem:

Remember but a few weeks past
When your holdings took a blast
The Dow was down four-hundred plus
Don’t tell me you didn’t cuss

You prayed, “Give me once last chance–
To hedge, to trim, to reduce my stance.”
Recall when the bear seemed near
How your heart filled with ugly fear

The chance you asked for has been gifted
The Dow since then has been quite lifted
So let’s now see if you’ll stay true
To all that selling you swore you’ll do

[DespotInExile]

Naj,

I essentially agree with your post, even though I am a strong advocate for indexing. The reality is that most investors lack: (a) the ability to evaluate whether a manager is likely to be capable of generating alpha; or (b) access to the alpha-generating strategies employed by SAC, Caxton, wherever.

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. And if you dont believe this, then you should be hoarding bullets and food.

Ironically, I speak from the perspective of a high net worth individual whose single largest investment exposures are in actively managed hedge fund strategies (plus cash). Our own indexed investments are less than 10% of our total net worth.

[hawk59]

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risk has decreased and rewards increased?

holla if i go on to become a good investor.

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you are well on your way, just be patient!

[Thremp]

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risk has decreased and rewards increased?

holla if i go on to become a good investor.

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you are well on your way, just be patient!

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I'm not following so much. Rephrase this in moran terms. Today it seemed an investment is -EV while tomorrow after the price moves to 5.50 its +EV.

[hawk59]

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risk has decreased and rewards increased?

holla if i go on to become a good investor.

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you are well on your way, just be patient!

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I'm not following so much. Rephrase this in moran terms. Today it seemed an investment is -EV while tomorrow after the price moves to 5.50 its +EV.

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1) Figure out what you think something is worth. Estimate conservatively. It should preferably be something easy to figure out. You won't come up with an exact number.

2) See what the stock is trading for.

3) Compare the price of the stock to what you have estimated as it's worth. If the price is a lot less than the value then you buy it. As the price falls your potential reward goes up, and your potential risk goes down. As najdorf said, a large number of people who outperform are value investors, and this is what drives their investments. Low risk = high reward.

When you estimate what it is worth you need to have a solid reason behind it. You can't do what most people do and worry about what EPS they report next quarter or anything like that. Just figure out what it is worth, if you don't think you can figure it out then that is fine, you just move on.

[NajdorfDefense]

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Interesting stuff, Naj, I might tried to read some of this closer later on. I sort of agree with what you are saying in theory, but I'm not sure if it applies to ... Sure, that's exploitable in theory in either direction, but not in practice by your average investor.

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It would equally be a myth to say 'Every investor can capture alpha' or 'all managers generate positive alpha,' like a poker game, Alpha is zero-sum, not everyone can create/retail positive alpha, I totally agree.

However, plenty of public managers/investors generate alpha, and have been doing so for 2-5 decades.

[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.

[Joey Joe Joe]

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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.

[stoxtrader]

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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 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.

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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.