Will the Real Alphas Stand Up?
Just the mention of Alpha gets neurons firing in the investment world, conjuring up the following synonyms:
“Winner – Outperformer – Dominance”
This post is not all about Alpha synonyms, though.
It is a follow-up to a piece we wrote a few years ago, which encouraged more of us to admit that, “even though we throw around language like we grew up in Athens” it can be All Greek to Us.
To hopefully help bring transparency into how some of the Greek terms we use are defined, we are diving deeper into what investment Alpha is, is not, and some issues for investors and the industry to consider.
First, repeat after us…
Alpha Is Not Outperformance
We can already hear some bristling at this, but we think it is important to mention, especially related to how investment Alpha can be presented and the calls to action it can invoke.
As an example of why we put our statement above in bold, and how talk about Alpha can be more than it may seem to some, below is a recreation of a chart we received not long ago from a fund company. It was sent with this anchoring marketing line:
“A compelling record of consistent Alpha generation.”
In fact checking the manager’s presentation using analysis software from MPI, and what the manager stated was their best fit benchmark (more on this later), we found their Alpha claims to be accurate.
We also found this chart to be correct, however, which the manager didn’t include in their marketing materials.
The same manager that promoted consistent Alpha generation, consistently underperformed their stated benchmark, the S&P 500, over the past 3, 5, 7 and 10 years for the period ending June 30, 2023.
How these two charts can be accurate, brings us to this…
What Alpha Is
We are going to spare you more Greek in the form of a quantitative asset-pricing model but, in short, Alpha is a relative risk-adjusted measurement of performance, not pure outperformance.
The reason why Alpha can be positive in the first chart while Excess Returns are negative in the second one lies in the complexities of formulas that can be used to calculate Alpha (yes, more than one calculation method exists and it is worth asking which is being used, as they can produce different results).
What one might call the “Underperforming Alpha” we have illustrated can also be the result of Bungled Benchmarking (the selection of a “best fit” benchmark or factor that is not a good representation of the manager’s investment style) or due to other measurement issues we touched on when we previously asked this question – Are We Baking With Bad Ingredients?
Back to the original pitch we started with, if an investor understood all of what we’ve mentioned when receiving the manager’s “consistent Alpha generation” call to action and invested based on this knowledge, all good – maybe the manager was the correct fit based on their objectives.
If they didn’t, though, might the call to Alpha have driven an untended action – an investment in a manager that had consistently underperformed their stated benchmark?
What Could Improve
In writing this piece, we are not suggesting that the manager we highlighted above did anything that was non-compliant (detailed disclosures and definitions of various terms existed in fine print at the back of the presentation).
In addition, we’re not making any statements about Alpha’s usefulness. It’s a helpful metric and manager evaluation tool.
What we are touching on is something we think can improve not only investor outcomes but also improve the industry – plain language.
Our hope is that this post will spark a little more debate about all the Greek we speak and encourage everyone to be more focused on educating investors using more easily understandable terms.
Along the lines of the title of this piece, we’ll simply end with this question:
Will more of the Alphas in the investment world stand up and spend more of their alpha energy focusing on transparency and simple language?
We hope so.
Related Reading:
A Five-Factor Asset Pricing Model – Journal of Financial Economics – Fama and French
How to Calculate Three-Factor Alpha – Alpha Architect – Wes Gray
Bungled Benchmarking – Fiduciary Wealth Partners – Preston McSwain
What’s It All About – Alpha? – Oaktree – Howard Marks
Are We Baking With Bad Ingredients? – Fiduciary Wealth Partners – Tommi Johnsen, PhD
Transparency – Do We Protest It Too Much? – CFA Institute – Preston McSwain
The Road Less Traveled – Simple Alternatives 
Beware of Sharpe Objects