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The Alpha Paradox

Here are a few things we know about the financial markets:

  1. Beating the market or obtaining “alpha” (excess return) is extremely difficult as evidenced by the annual SPIVA Scorecards.
  2. Alpha doesn’t exist in the aggregate because we all hold what sums to one portfolio wherein we earn the after tax and after fee return of the global financial asset portfolio (GFAP).
  3. In order to be properly diversified to reduce single entity risk we must hold a portfolio that increasingly correlates to the total market portfolio.
  4. Since we are likely to deviate from the global financial asset portfolio for various reasons (usually due to risk tolerance) we all implicitly engage in the pursuit of alpha, however, we must accept the fact that we are engaging in an arithmetically difficult pursuit in which the further we reach for alpha the more risk we are likely to take and the higher taxes and fees we are likely to incur.

This creates a paradox for all asset allocators – we are all implicitly chasing alpha by deviating from the GFAP, but alpha is elusive in the aggregate because we all generate the post-tax and post-fee return of the GFAP. Should we decide to engage in the only free lunch in asset allocation (diversification) then we must choose to accept the reduced odds of generating high amounts of excess return. On the other hand, the asset allocator who chooses to pursue alpha aggressively must recognize the likelihood of higher risk, higher fees and higher taxes.

When one understands these points it becomes clear why point number 1 is so pervasive among high fee active managers. They must either choose to be substantially more risky than the markets they engage in (which churning up higher taxes and fees) or they necessarily correlate to the market they’re engaged in. This also explains why closet indexing is so pervasive – active managers can’t, in the aggregate, be uncorrelated to the market portfolio because they manage assets that represent such a substantial portion of the market portfolio.

Further, the alpha paradox explains the conflict of interest that so many advisors and portfolio managers are encountered with. The portfolio manager whose portfolio goal is alpha is creating a conflict of interest in the way he/she perceives risk and the way the client perceives risk. After all, the real risk for the manager is underperforming while the client likely views risk as the potential for permanent loss. If the manager achieves alpha by taking more risk then they are exposing the client to greater risk of permanent loss.

And this doesn’t even touch on the most problematic factor in trying to achieve alpha – the fact that alpha is not a financial goal for the average asset allocator. “Beating the market” is not a requirement for financial success. In fact, aggressively engaging in the pursuit of alpha tends to result in worse performance, higher risk, higher fees and higher taxes. As it turns out, alpha is a HOPE that is sold to the average asset allocator in exchange for the GUARANTEE of higher fees.

What the alpha paradox teaches us is that it’s okay to pursue alpha even if done so only implicitly. However, the most important lesson is that we must be realistic in our pursuit of alpha recognizing that market beating returns are very difficult to achieve and that the more aggressive we are in this pursuit the more likely we are to create the frictions (mainly taxes and fees) that could reduce our odds of financial success.