Investing Myths: Alpha and Beta

[NajdorfDefense]

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Beta is a measure of the "riskiness" of a particular portfolio's asset allocation. You claim that it is a myth that riskiness and earnings are even correlated.

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I don't think I even mentioned earnings.

Most HF are, in fact, low beta, or less volatile. Virtually all of them, but of course not 100%.

[spider]

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 90% of the population (and hence the popularity of index funds). I'll just use a couple of examples.

Take Jon Corzine. I assume he doesn't manage his own money now (at least at the level of details) now that his is governor (and for the moment, in the hospital). But I think what you are saying would certainly apply to him. He knows who to give his money to (who has talent and can be trusted) and he has enough money that he should get a good deal -- he won't pay $1 for $1 of alpha, he'll pay 30 cents.

But take somebody with out Corzine's knowledge of Wall Street and with a mere 200k of assets. Can they really get any sort of alpha? Problem #1 for them is going to be how they figure out who can make the alpha in the future given they don't know much about the market. Problem #2 is what they are going to pay for that alpha. Assuming they aren't going to give more than 25% of their money to a hedge fund, what kind of hedge fund is really going to be interested in 50k? I'm mean sure, someone will take it but after 2 and 20, what is left?

And sure some of this you can do yourself, but you have to be smart, knowledgeable, and spend the time. Yeah, you can go long this and short that on the basis of high beta/low beta, but how do you know which is which?

I mean, take what you are saying about the corporate spreads. I think it's fairly accepted that spreads aren't big enough now but maybe in two years the opposite will be true. Sure, that's exploitable in theory in either direction, but not in practice by your average investor.

[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]

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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.

[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.

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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.

[hawk59]

Constantine,

Think of this simple scenario, and try not to confuse it by putting it in terms of greek letters. A company is liquidating, they've stated the total liquidation proceeds to shareholders will be in the range of $5 on the low end and $7 on the high end. The stock closes today at $6.50. Tomorrow morning a manager that has a big position in this stock is taking big losses in his other positions and gets irrational and decides to sell out his position in this company ASAP. During the day tomorrow the stock is trading at $5.50, down $1 from the close today.

What has happened to your risk, what has happened to your reward? If you can understand and believe this simple example, then that is all you need to be a good investor. Everything follows from the one fundamental concept.

[john kane]

risk has decreased and rewards increased?

holla if i go on to become a good investor.