Investors Are Still Chasing Alpha Despite Clear Evidence This Chase Is ‘Brainless’

Friday, November 08, 2013 09:46
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Investors Are Still Chasing Alpha Despite Clear Evidence This Chase Is ‘Brainless’

Tags: active management | investor behavior | portfolio construction | value investing

Despite the data showing active managers fail to beat their passive index alternatives, investors have not given up on alpha – they still want to beat the market. Many have embraced passive strategies such as smart beta, fundamental indexing, and advantageous factor investing, while others pursue the active strategy known as “Active Share.” My term for each of these strategies is “Brainless Alpha.”

 

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Brainless Alphas are mechanical approaches to investing, and their appeal is obvious – someone has already done all the thinking so finding alpha is easy!
 
Dimensional Fund Advisors (DFA) has attracted billions of investment dollars with its factor investing approach, and Research Affiliates (RAFI) has attracted more than $100 billion into its fundamental indexes. Smart beta investing is a tilt toward smaller companies and toward value, primarily because history shows that this tilt would have beaten the market. But history doesn’t necessarily have to repeat itself; smart beta will work until it doesn’t.
 
The active flavor of Brainless Alpha is also attracting assets. Active Share is the percentage of portfolio holdings that do not match the benchmark’s allocations, and big bets are a necessary condition for alpha. It is mathematically necessary to deviate from the benchmark in order to produce an alpha, but big bets are not a sufficient condition for success because the bets can be wrong.
 

Brainless Alphas go too far in their simplicity. Beating the market is much more complicated than tilts or big bets. If we really want alpha someone will have to think. For a more detailed analysis of these issues, as well as links to relevant scholarly articles, go to “Searching for Brainless Alpha: The Streetlight Approach.”

 

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