Book Review: “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches” by David Schawel, Economic Musings
I have to be honest, I find many investment books incredibly boring & so much so that I sometimes don’t even finish reading. My friend Eric Freedman, CIO of Captrust, recently sent me a copy of “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches” by Larry Swedroe and Andrew Berkin. While there wasn’t anything earth shattering in the book, it was a thought provoking read that emphasized that while alpha does exist, it is more difficult to find in today’s environment. I will share some interesting tidbits from the book and leave you with some closing thoughts:
- “A study by Wermers found that on a risk adjusted basis active equity mutual fund managers outperformed their benchmark by 0.7% per year on a gross basis. But after total expenses, the investors were left with negative net alpha. “economic rent” is going to the scare resource (ability to generate alpha), not to the plentiful resource (investor capital)”
- This has been repeated in the media often lately, but individual ownership of equities directly has plummeted. At the end of WWII, households held more than 90% of US corporate equity. Fell to 48% by 1980 and 20% by 2008. The authors contend this trend has made markets more efficient.
- The outperformance in Yale’s endowment fund was attributable to factor exposure and not skill in security selection The author says, “The Yale endowment fund’s returns can be explained by consistent exposure to diversified, risk-tilted, equity oriented assets and extraordinary outperformed in PE and VC. The public equity returns are fully explained by exposure to factors (small cap & value), not skill in security selection.”
- A simple factor model can explain nearly 100% of endowment returns: The authors tell of a 2013 study on university endowments by Barber and Wang which said that “a simple factor model shows that a 59% exposure to stocks and 41% exposure to the Barclays Agg explains 99% of returns” The authors conclude that “Despite taking on more risks such as opaque investments and illiquidity, there’s no evidence that the average endowment delivers alpha relative to public bond or stock benchmarks.”
- The paradox of skill: The authors use a sports analogy and remind readers of how rare it is in professional baseball for a hitter to hit for a .400 average. They correctly state that athletes are bigger, stronger, and faster today than at any other time in history, yet it is more difficult to hit .400 than it was 70 years ago. They conclude that the paradox of skill says that the average investor/athlete is better today, so outlier results are much more unlikely.
- Younger funds outperform older ones: Funds aged up to 3 years outperformed those aged more than 10 years by a statistically significant 0.9% per year. The point of this is that younger funds lack a track record and are typically much smaller, so the majority of investors are not around in the early days of the fund to benefit from the higher returns.
- Results of investing are more about relative skill than absolute skill. Again, the authors use a sports analogy about tennis to describe what market participants are going up against. This is the difference between Roger Federer playing a specific opponent or playing someone with Andy Roddick’s serve, Andy Murray’s backhand, and Rafael Nadal’s baseline game. The market’s collective wisdom is tough to beat.
- Market impact costs eat into fund returns: The authors cited a MSCI Barra study that said, “A typical small cap or mid cap stock with 500mil in assets and an annual turnover rate of 80-100% could lose 3-5% per year due to market impact costs.”
- From 2004-2013 the HFRX Global Hedge Fund Index return was 1% yr, lower than every major asset class including 1 year treasuries.
- Be careful investing in popular strategies or stocks which are HF favorites: “The lesson here is that whenever an investment strategy that is supposedly exploiting some market mid pricing has become popular, it may already be too late to join the party. And when a strategy becomes popular, not only will it have low expected returns due to crowding but the assets in it are weak hands that will panic at the first sign of trouble”
The authors conclude with a list of things that investors can do to combat this environment of ever shrinking alpha. I won’t post the list but will say that the book is a very easy read that is thought provoking and should only take an hour or two. To me, this book isn’t so much about the efficiency of markets as it is the change in market efficiency over the last few decades. Going forward it seems like a foregone conclusion that lower cost alternatives such as ETFs will increase in popularity. Will this make extracting alpha even more difficult? Conversely, will it cause a large shakeup among investors whenever the market has another a prolonged period of losses and volatility?
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