Does Your Mutual Fund Have Risk Disguised As Alpha?

If alpha is not consistent, perhaps it’s an outcome of the fund manager’s luck, not skill. And that luck could very well run dry.

A sign that reads Caution is kept on a  washed sidewalk in Los Angeles, California. (Photographer: Kevork Djansezian/Bloomberg)
A sign that reads Caution is kept on a washed sidewalk in Los Angeles, California. (Photographer: Kevork Djansezian/Bloomberg)

Larry Swedroe and Andrew Berkin’s ‘The Incredible Shrinking Alpha’, is a slim, 87-page roller-coaster ride that took the investing world by storm when first published in 2015. After being quite influenced by it, I later learned from industry colleagues and friends that the book had a profound impact on advisors and clients all over the world. It was a peek into the fascinating world of what is popularly known today as ‘evidence-based’ or ‘factor-based’ investing.

I remember the most profound takeaway that the authors eased into the minds of readers pretty early on into the book – alpha is actually beta!

I know that statement can be unnerving – allow me to explain. Alpha is not just outperformance, it is defined as outperformance over the right risk-adjusted benchmark. If you bought a credit risk fund and it happened to beat the G-Sec, you don’t say you generated alpha. You know you have taken on credit risk and that is beta – which happened to pay off. By that logic, almost all of the inconsistent outperformance of active fund managers could be attributed to some additional risk that they had taken in the first place, tilting the portfolio away from the benchmark.

Outperformance may happen in equity funds when, say, the fund manager loads up on ‘factors’ such as low market capitalisation (small caps), low price-earnings ratio (value stocks), or high profitability but then, by doing that, she/he has exposed you to beta. The point that the authors make is that beta should be available cheaply to you.

One can create an index fund of stocks that have the same traits and reduce the costs of investing significantly – as opposed to paying a fund manager high fees for claiming to identify which of the stocks exhibiting the same traits will outperform the others.

Academic inquiry has made it clear, that by tilting towards one or more of these factors – active fund managers alter the risk profile of the fund and deviate from the benchmark. Hence, calling it alpha over that benchmark is erroneous and can be explained away. If the portfolio were compared with a benchmark that had a similar risk profile and factor exposure, one would find that the portfolio had actually underperformed the new appropriate benchmark.

This is gradually becoming clear to Indian investors as well. After the recent SEBI reclassification, Indian fund managers who were loading midcaps in funds labelled as large caps and delivering outperformance, have more or less disappeared.

Fun Fact: The book explains Warren Buffet’s alpha without discrediting him in any way – just breaks down his legendary skill and shares some interesting less-known stories.

I write about this now because the authors have just launched a second edition it is even more enthralling than the first. If the first edition was guilty of being a tad academic, although highly enjoyable to finance geeks, the second edition seems like a soft-voiced, guided tour to understanding some monumentally important concepts.

It starts with a little foreword by Gus Sauter – the first and now retired chief investment officer of Vanguard. One cannot help but smile through those pages as he speaks of how active fund managers—now more than ever—are harping on the same old elusive ability to pick through the ‘minefield’ of stocks when many will declare bankruptcy due to Covid-19. Have we not heard managers point to how indices will continue to hold on to those poor-quality stocks, dragging the index performance?

Here is a glimpse of the provocative index which is bound to pique your interest.

Chapter 1. The Quest For The Holy Grail: What Was Once Alpha Becomes Beta   
Chapter 2. The Pool Of Victims Is Shrinking   
Chapter 3. The Competition Is Getting Tougher
Chapter 4. Is The Market For Alpha Overgrazed?   
Chapter 5. Why Do Investors Ignore The Evidence On Actively Managed Funds?
Chapter 6. What You Can Do
Chapter 7. Asset Allocation

The central theme of the book revolves around advocating passive investments because the size and availability of alpha are shrinking. It educates investors with evidence, practical solutions, and not theoretical possibilities, that they do not need to take excessive risks, pay higher costs, or trade heavily to earn strong returns. The negligible alpha, if available at all, is only factor-based, risk-adjusted beta. The charade of heavy trading and stock selection only generates a high pay-off for the wealth management industry and not investors.

Most importantly, if alpha is not consistent, perhaps it is an outcome of the fund manager’s luck and not skill. And that luck could very well, as it often does, run dry.

Here is a little excerpt: “Passive investing doesn’t win because active managers are dumb. And as John Bogle points out with his ‘Costs Matters’ Hypothesis, you don’t need the markets to be efficient for passive investing to be the winning strategy. It is simple math. It is the greater costs of active managers that are the cause of their underperformance”.

Remember, no one is wishing away active fund managers. Their competition for information helps in making markets efficient both in terms of information and capital allocation. In fact, their collective actions give passive investors a free ride – all the benefits of making the markets efficient, while paying smaller costs.

The overarching theme that the book propounds is that while indexing is preferred to active investing, factor-based passive investing to achieve ‘Smart Beta’ returns is the way forward. Indian index makers have work to do in this space, but the passive, indexing movement is well underway in our country as well.

The book ends with some specific advice for investors. It has a glossary of technical terms, improved appendices clarifying important topics. It also includes a chapter discussing why, even now, a large number of investors continue to embrace active styles, despite the overwhelming evidence against their performance. Overconfidence, the illusion of control, hard work, and others form misplaced beliefs that the field of behavioural sciences has explored. The role and motives of wealth managers in influencing investor decisions have been discussed as well.

Since this debate is just picking up in India, we may at best have encountered some eloquent, seemingly erudite criticism of passive strategies so far. However, in the developed world where massive shifts have happened in favour of passive investing recently, vicious attacks have been made. 'Death knells' on indexing have been announced – understandably so, after all, livelihoods are at stake. We should be prepared for backlash in India as well but continue to read and put forward, evidence to support the supremacy of passives. Do grab your copy of the second edition of ‘The Incredible Shrinking Alpha’ to prepare yourself for tomorrow.

Abaneeta Chakraborty has close to two decades of experience in managing money for ultra-HNI families, and founded Abanwill Consultants LLP in 2017 to provide independent views on investing. She is also Visiting Faculty at Praxis Business School.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.