Seeking Alpha – what is it and why is it so elusive?
Alpha is the term used to describe the return of an investment measured against an appropriate benchmark market index. In other words, it measures the performance or movement of a stock that is not related to the performance of the market as a whole. When used in the context of a fund, the excess return of a fund relative to the return of a benchmark index is the fund’s alpha. Very simplistically, if a fund has negative alpha, it means that it has underperformed the benchmark. The converse, positive alpha, indicates the fund has done better than the market.
What do fund managers mean when they say “seeking alpha”?
Active fund managers of a mutual fund pick stocks which they forecast will do better than the overall market. So they are seeking alpha in their portfolio through a strategy of stock selection. Some do this using traditional fundamental research and analysis. Others do this using computer models.
Whatever method or combination of methods the managers employ, the aim is the same; to get the fund to generate returns that over the longer term will outpace the market.
Why is it so difficult to generate alpha?
It is simply a statistical fact that most active fund managers do worse, or underperform the market as time passes. Their ultimate quest for alpha is unsuccessful. Moreover, producing alpha appears to have become even more difficult over the last 20 years.
In 2015, data indicates that only 2% of fund managers in the US produced alpha!
During market crashes or severe downturns, active managers generally do a good job of protecting a portfolio – and they nearly always perform much better than an index tracker or exchange tradeable fund (ETF). They do this by implementing various strategies ranging from increasing cash exposure, to buying defensive names, and reducing high risk names. With an ETF, this does not happen. A holder of an index ETF will be fully exposed to any market downturn*. However, too often they fail to spot the bottom, or turning point in the market, and lag any market recovery.
The situation is further complicated by an increasing volume of professional managers competing against each other for a limited pool of available alpha, at the same time as having to deal with a totally new post-financial-crisis investment environment. Because fund management is a zero sum game, and transaction and management costs drag the return down, the after-expenses sum of active management will tend to be negative. The majority cannot perform better than an index tracker or exchange tradeable fund (ETF).
Is alpha worth it?
Whether trying to generate alpha through your own stock picking, or through finding a mutual fund which has consistently generated alpha over the years, the process takes time and a lot of effort. Moreover, there is an entire industry of consultants and financial planners who are paid to do this. As a retail investor, you will need to spend a lot of time doing research if you want to find a good mutual fund. Of course if you have a good financial planner helping you, they should be able to find you a good fund.
Clearly over the decades there have been a number of famous high alpha producers (Warren Buffett and Peter Lynch immediately comes to mind!). But if you do not like the odds stacked against active management, you should just stick to an ETF.