WARNING: The linked articles are NOT for the faint of heart. They’re very dry and highly technical for those who don’t deal with investing in mutual funds on a professional – or at least regular – basis. That being said, it’s great support for the methodology we use in our practice. If you want to dig in and learn more about the stock market and how mutual funds are managed you may enjoy it!
THERE’S NO SUCH THING AS ALPHA OUTSIDE OF DECONSTRUCTING ASPECTS OF MARKET BETA
The article linked here by Michael Kitces offers a GREAT explanation and thorough analysis with many links on how mutual funds perform in the real world. Alpha in short, is a fancy industry term for the value that a manager adds to improve their mutual fund returns. Beta on the other hand, is a term for the risk of investing in an asset class as a whole.
A mutual fund investor would expect their mutual fund manager to add Alpha in terms of extra returns over the return of the general market. The with this happening however is noted here in The Arithmetic of Active Management, by Bill Sharpe.
There are factors which have implied Alpha, but they’re really Beta factors. Meaning, a mutual fund manager (such as Dimensional Fund Advisors) which can decipher factors of the overall market which produce higher returns over long periods of time is perceived to be adding Alpha (manager added value), when in reality they’re adding that Alpha because they’ve deconstructed aspects of Beta, then tilted their portfolios towards those aspects of Beta which deliver higher returns over long periods of time.
Probably the most interesting aspect of this article is Mr. Sharpe’s paper The Arithmetic of Active Management. He notes that trading stocks is a zero sum game. For every seller there’s a buyer and vice versa. As such, there’s no way to really “win” by trading stocks because the weighted average returns of the stock market as a whole must add up to the market itself.
Interesting stuff! I hope you enjoyed it as much as I did!