Book Review: The Incredible Shrinking Alpha

The Zero-Sum Alpha Game is Getting Harder to Win

In Berkshire Hathaway’s 2016 annual shareholder letter, Warren Buffett estimates that active investors have wasted over $100 billion seeking to beat the market over the past decade. Buffett would find kindred spirits in Larry Swedroe and Andrew Berkin, collaborators on the recently published book The Incredible Shrinking Alpha. The thrust of this work is that active management is a loser’s game, which will only get tougher to win going forward. The basis for this assertion is that the pool of alpha available to investors is both shrinking and getting more crowded with skilled competition. This matters because active managers must prove the ability to generate alpha in order to justify charging higher fees than an index alternative.

Alpha is the Return from Skill, Beta is the Return from Risk

Swedroe and Berkin define alpha, or investing skill, as “returns above the appropriate risk-adjusted benchmark.” Put another way, alpha is the portion of an investor’s return that is not explained by the level of risk in his portfolio.

Thus, the key to accurately estimating an investor’s alpha is properly assessing the amount and type of risk, or beta, in his portfolio. Take for example a US equity manager who outperforms the Russell 1000 index, but “cheats” by adding highly volatile microcap stocks to his portfolio. Over a meaningful investment horizon, this manager should earn a higher return than a benchmark comprised of large-cap equities, because he is invested in smaller, riskier companies. In this case, he did not generate any alpha because his excess return can be explained by the elevated risk, or beta, of his portfolio.

The Pool of Alpha is Shrinking as Alpha Becomes Beta

Naturally then, as our understanding of risk matures, the amount of unexplained return, or alpha, decreases. Swedroe and Berkin refer to this phenomenon as the “shrinking pool of alpha.”Somewhat controversially, the book applies this concept to Warren Buffett’s market trouncing track record, claiming that Berkshire Hathaway has generated a “statistically insignificant” amount of alpha. To support this position, the authors reference academic research which finds that Buffett’s outperformance can be explained by his exposure to risk factors like size, value, and leverage, not his stock-picking skills. But the authors don’t take all the credit away from Buffett, acknowledging that it took skill to identify those risk factors and invest in them before they became popular.

Alpha, the Product of a Zero-Sum Game, is a Finite Resource

After taking down the Oracle of Omaha, Swedroe and Berkin shift their focus to another legendary investor, David Swensen, the Chief Investment Officer of Yale’s Endowment Fund. Although Swensen has outpaced industry benchmarks and his endowment peers over the course of his tenure, the authors argue that a high-risk investor could match Yale’s performance with passive index funds and a little leverage. They cite academic studies which indicate that – aside from private equity – Yale hasn’t generated any alpha.

In their view, Yale’s inability to generate alpha is a result of the high degree of competition in modern securities markets. After all, if the market return is simply the weighted average performance of all market participants, then for each participant who makes a winning investment choice there must be a loser who has made a bad decision. Therefore, the pool of alpha available to active managers is limited to the sum of mistakes made by uninformed and undisciplined investors. Or, as Nobel Laureate Bill Sharpe put it, the quest for alpha is a zero-sum game.

The Number of Bad Decision Makers is Shrinking, Tightening the Competition

Swedroe and Berkin point to research which illustrates that the losers of the zero-sum game tend to be non-professional, individual investors. Unfortunately for active managers, this “pool of victims”, or investors who make bad choices, is shrinking. According to the Investment Company Institute, over the past decade, US households have shifted trillions of dollars from direct equity ownership (i.e., stock picking) into passively managed ETFs and mutual funds.

As the amateurs exit the game, opting to accept the market average offered by passive funds and ETFs, the professionals are forced to make their living off the mistakes of other institutional investors. The problem is that those other institutional investors aren’t as prone to making mistakes.

Ultimately, this means active investors must compete for a smaller pool of alpha with an increasingly sophisticated set of competitors. This does not bode well for the future of active management.

It’s Not All Bad News: Passive Investors Have More Attractive Options Than Ever

Swedroe and Berkin conclude The Incredible Shrinking Alpha on a positive note, suggesting that the very same developments that have made the alpha game more difficult for active managers – improved understanding of risk factors, massive flows into passive investments, and the increased competition among managers – have delivered an unprecedented array of options to passive investors. Never before have investors been able to achieve such targeted risk exposures across as wide an array of asset classes at such a low cost.

And your team at Kings Path Partners thinks that is a wonderful development.

For those investors interested in a relatively easy-to-read book about factor investing, we think The Incredible Shrinking Alpha is a good place to start.