Alpha Hunters and Beta Grazers

Abstract

The search for incremental returns—“alphas” in current parlance—has become the holy grail of active investment. This article begins by drawing a distinction between two broad classes of alphas: (1) “allocation alphas” that are broadly available, on a non-zero-sum basis, by moving the strategic portfolio toward a more balanced return–risk structure and (2) truly active-skill-based return enhancements derived from opportunistic inefficiencies. Inefficiencies can be hard to discern and even harder to exploit, which may help explain both why some investors are able to consistently produce positive alpha and also why they are so few in number.

The search for incremental returns—“alphas” in current parlance—has become the holy grail of active investment. This article begins by drawing a distinction between two broad classes of alphas: (1) “allocation alphas” that are widely available, on a non-zero-sum basis, by moving the strategic portfolio toward a balanced return-risk structure and (2) truly active-skill-based return enhancements derived from opportunistic inefficiencies. A number of potential sources of such inefficiencies are discussed, including an excessive focus on outcomes versus process, “convoy” or herding behavior, concentration on either very short term or annual evaluation periods, Bayesian rigidity, price-target revisionism, highly channeled investment flows, implicitly inconsistent rebalancing procedures, clustering in portfolio volatilities, risk structures that are overwhelmingly dominated by the home-equity exposure, and an overly compulsive focus on maintaining a pre-established policy portfolio.

One source of market inefficiencies is the rebalancing behavior of four typical categories of investors: holders, rebalancers, valuators, and shifters. Holders are individuals who tend to leave their positions unchanged as markets deteriorate. In contrast, institutions tend to be formulaic rebalancers; when the market pushes an institutional fund away from the policy portfolio allocation, they usually quickly rebalance back to the original percentage weights. Valuators take positions based on the belief that the market is either cheap or rich or based on the belief that it will continue or reverse its recent direction. Valuators can thus be contrarians or momentum followers. Shifting occurs when a fundamental change in asset allocation is required because of a fund's or an individual's situation rather than because of an assessment of the market. At times, these behaviors may overly exacerbate or overly moderate market movements, thereby creating some level of market inefficiency.

Moreover, one can argue that the standard practice of rapid rebalancing back to a preset policy portfolio is theoretically inconsistent with either a purely efficient market or a (discernibly) inefficient market. One can also speculate whether the remarkable clustering of U.S. institutional portfolios on volatility in the 10–11 percent range reflects a concern with avoiding a potential triggering event so adverse that it could force a fundamental downshift in the policy portfolio.

Behavioral biases of individuals and institutions create opportunities and, at the same time, stand in the way of their successful exploitation, which may help explain both why most investors fail to bring home a steady supply of positive alphas and why some few great investors do seem to develop winning records over a span of many years.