There are two sides to every story, and in investment, 'alpha' is just the same. It represents above market performance, or outperformance. If the market goes up by 10 percent in a year, everything above 10 percent is outperformance and that is what investment professionals and money managers refer to as 'skill'.
It is this skill that helps to justify the massive incomes and bonus payments to investment bankers and hedge fund managers.
Alpha is risk adjusted. It's coefficient is one of the parameters of the capital asset pricing model and can be used to calculate whether an investment manager has added value - or created economic value - as an economist would say.
An average investor cannot outperform the stock market say the theorists, because an average investor cannot know
as much - or more - than the market itself. This plays into the hands of
those who prefer to track an index rather than to actively invest.
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Are Markets Efficient?
This is the realm of the Efficient Market Hypothesis. Efficient market hypothesis, a theory first developed by Eugene Fama, informs us that market prices take into account all available information at the time. Clearly this is more information than any individual investor could hope to take into account.
In the modern world, all information relating to an investment is expected to be in the public domain as soon as possible and that no investor should have an unfair advantage.
However, no system is perfect and clearly a director or employee of a company is likely to know more than the most astute active investor about the current trading performance of the firm. This advantage is why acting upon it is generally termed as insider trading and is illegal in much of the developed world.
The theory presumes that any extra value an investor sees in a share is incorrect when compared to the price actually set by the market. Therefore, EMH tells us that it is impossible to outperform the market. Just ask Warren Buffett or Peter Lynch their thoughts about that...
There have actually been a large number of traders and investors that have consistently outperfomed the stock market. In fact, a whole new secretive industry has grown since the mid 1990's to take advantage of this fact. These folks are known as 'quants' and use sophisticated mathematics in computer algorithms to trade automatically. These speedy trades gobble up price inefficiencies in much the same way as the 'pirhanas' that Fama wrote about.
It is widely believed that these mathematicians, programmers and traders view the search for alpha as a search for the truth.
Despite the difficulty in generating alpha
the financial services and investment industries make it appear as
though you almost can’t help beating the stock market. Key features
documents will explain how an investment can 'go down as well as up' but
the rest of the glossy brochure collection is usually committed to
explaining just how fast an investment has risen.
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This plays on human nature rather than an investment theory. Sales copy
for an investment fund rarely covers investment theories which by nature
can put most people to sleep. Despite this, a mutual funds alpha is clearly an important element to consider when choosing between products.
Earning Their Money
The rather sad reality is that the majority of fund managers do not beat their index very often. On one level, this is obvious - we cannot all be 'above average' can we?
It also highlights just why some fund managers earn the huge bonuses that make front page news. In a very competitive environment, with some of the hardest working and smartest minds in the economy, if you consistently outperfom your peers, you would expect and demand a very large salary or bonus.
This helps to justify some of the large salaries earned by hedge fund managers, but it does not help to explain why poor fund managers - those who underperform their benchmark most years - also earn well above average salaries. Those managers that do incredibly well will be the names many of us have heard of and see in the Wall Street Journal or Financial Times, but the rest are doing quite well, thank you very much!
Given that some index tracking funds can mimic their main index - such as NASDAQ or the Dow Jones - for very low annual fees, the entire concept of a managed fund can be argued over.
A very real problem that is part of the divide in modern society, is that of fund managers. Those that really do have bags of alpha and can beat the NYSE year in and year out will be flooded with money soon enough. Good for them. But before long, only the mega wealthy can really have access to this level of money management. The majority of investors - you and I - are left to choose between funds that underperform most years, while the minority are able to effortlessly grow their wealth. As the saying goes, "The rich get richer".
It was this phenomenon that swindler Bernie Madoff played to. Many of his clients were very wealthy and since his annual returns (whatever that meant under the circumstances) were so consistent, he had more people wanting to invest than was perhaps rational. As such, his private fund became exclusive and people waited for years to get in. By turning people away he had all the investment money he could ever need!
To read more about risk analysis techniques and measures, please use the following links:
How To Use Risk Analysis To Make You A Better Investor
Some Investment Definitions Explained
Learn How Beta And Volatility Impact Your Investment Portfolio
How Does Volatility, Standard Deviation and Beta Impact An Investment Portfolio?
How Do Different Types Of Risk Influence A Portfolio?
Does Correlation Influence Portfolio Diversification?
Understanding Gearing And Borrowed Money
Understanding A P/E Ratio (Price To Earnings Ratio)
Why Selling Investments Is THE Most Important Skill You Can Learn In Investing