Sunday, May 24, 2015

We are condemned to earn alpha

For me beta is a synonym to the state of choicelessness. To earn a true beta you have invest proportionally in all investable assets without discriminating any of them. Any choice, voluntary or forced, to deviate from this pure theoretical set of all investible assets is an exposure to alpha.

As investing proportionally in truly all investable assets is not possible nor desirable, each investor is always exposed to at least few choices in building her portfolio and therefore is condemned to earn alpha (not necessarily positive).

Passive vs. active investing debaters often use beta and alpha as synonyms to corresponding strategies. While they are definitely overlapped, there are some differences between being passive and being "beta investor".

Further down is an attempt to clarify these two overlapping ideas of earning alpha vs. beta and passive vs. active investing:

Theoretical concept (impossible to invest)

  • True beta is earned by owning equal share of all investable assets. It is a purely theoretical concept.

Passive investing

For me, passive investing is holding a group of funds tracking some wide market capitalisation weighted indices. Therefore passivity refers not to absence but rather low frequency of choices. Passive investor makes choices only when she creates a portfolio. This kind of investment process however exposes portfolio to a bit of alpha.

  • Strategic allocation alpha is earned by choosing weights of investable asset classes different than the market. The most famous 60/40 portfolio allocation could be a great example of a portfolio that is very different from "having market exposure" and therefore earning very different results;
  • Index (instrument) alpha - is earned by investing in instruments . We often talk of some index tracking ETFs as representing wide asset classes, however they are selective portfolios. There are two levels of choices included here. First, there is someone who chooses which securities are included in the index. Second, ETF company chooses portfolio for tracking the index (they rarely invest in all the securities in the index). Each of these choices effect performance of the portfolio.

Operational alpha

Investment returns are generally discussed on before expenses basis, mostly because post expense returns are very different for different investors. Each investor, however, should independently judge his unique circumstances and seek returns on a net basis. Successful effort to maximize net results is the source of what I call an operational alpha with too best examples being:

  • Tax alpha - which is earned by choosing investments to reach best after tax rather than before tax returns;
  • Investment cost alpha - earned by making investment cost related decisions.

Active investing

Step into the active investing territory exposes investor to a variety of choices. Whether you limit yourself to tactical asset allocation, let an algorithm to define your portfolio or actively involve in stock picking, you definitely earn alpha (once again, not necessary positive).

There are many alternative approaches investors and scientists take to classify active alpha. For me, as before, the type of choices made is the core criteria (even if sometimes it is hard to identify what are the actual choices made).

Conclusion

Passive investing is often misdefined by using theoretical concepts of alpha and beta. Even if you are a passive investor, you do make or have made decisions that effect performance of your portfolio.

Thanks Christopher Schelling for inspiration.

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