Active versus Passive Investing: The “Alpha” Bet

What is “Alpha”?

In investment terminology, “alpha” refers to the level of outperformance of a portfolio relative to an appropriate benchmark. Of course, everyone would like to achieve returns in excess of their benchmark. But you’re advised to have a good grasp of the cost and chance of achieving alpha before you decide to chase it.

There are two broad approaches to investment management: active and passive. An active approach seeks to add value, or alpha, by over weighting exposure to securities that are believed to be undervalued and under weighting those believed to be overvalued. The obvious aim is to perform better than a strategy that simply holds all securities according to their market weight (i.e. benchmark portfolio).

Passive investment managers believe that it’s highly improbable that you’ll be able to reliably outperform the benchmark over the long term (without taking more risk). Their focus is therefore not on beating the benchmark but replicating it as cheaply as possible. Their value add is in providing a diversified portfolio with minimal trading and management costs.

Shouldn’t everyone go for “Alpha”?

If you knew that your additional return would more than offset your additional costs, it would always make sense to try to outperform your relevant investment benchmark. However, the difficulty is that while you know the quest for alpha will increase your costs you don’t know for certain that your return will increase. You could end up with the additional costs and worse than benchmark performance (i.e. negative alpha).

In fact, it’s impossible for all active investors to achieve positive alpha. Let’s have a look at an example that illustrates this for the two investment approaches described above.

The small, mythical country of Tinyville has only 4 companies on its stock exchange: Beta, Delta, Gamma and Omega. The values of the companies and their market weightings are shown below for “yesterday” and “today”:

Also, there are only six investors in Tinyville: Mr Blue, Mr White, Mr Black, Mr Brown, Mr Pink and Mr Orange. Pink and Orange are passive investors and, therefore, their portfolios will reflect market weightings. The other four are active investors, so their portfolios will differ from the market weightings.

The investors’ portfolios for “yesterday” and “today”, consistent with the total market experience shown above, are detailed below:

Investor Portfolios – Yesterday

Investor Portfolios – Today

Based on the the market movements and starting portfolios, each investor’s investment return is recorded below:

Points to note include:

• The total value of the portfolios for all six investors equals (and must always equal) the value of the overall market;

• The weighted average return of all investors equals (and must always equal) the market’s total return;

• The passive investors earned the market’s return;

• The overall weighted average return of the active investors equals the market’s return; and

• Black’s outperformance is offset by the underperformance of the other three active investors.

The “Alpha” bet may not be the smartest

The findings from our mythical market apply to real share markets. An active approach is not synonymous with outperformance. In fact, any outperformance by some active investors must be matched by the underperformance of all other active investors.

Many active investors are of the opinion that it’s naïve not to try and “beat the market”. They either don’t understand that active management is a zero sum game or, unrealistically, all believe they are better than average investors!

And let’s not forget the certain losses you will incur as a result of the additional costs of being an active investor. Generally, compared with passive investment, they include higher transaction and management costs, early crystallisation of capital gains tax and reduced diversification benefits.

What level of outperformance is required to justify this ongoing drag? Over a 30 year period of share market investment, our estimate is that you would have to generate an additional (risk-adjusted) return of at least 2% p.a. just to breakeven with a passive investment approach. You need to be pretty confident (perhaps, overconfident) of your investment abilities to take this “Alpha” bet!

Acknowledgements: We wish to acknowledge “The Inconvenient Truth about Active Investing” by Steven C Merrell of Willow Ridge Capital Advisors in the preparation of this article.