The Quest for “Alpha”

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A New Book Review

By Peter Benedek PhD CFA

In “The Quest for Alpha” Larry Swedroe systematically dismantles the theory that active money management (defined by him as stock selection and market timing) can lead to alpha (returns above risk-adjusted benchmark) after fees. He argues that “if markets are highly efficient, efforts to outperform are unlikely to prove productive after the expense of the efforts.

If that’s true, the winning strategy is to focus on the following: asset allocation, fund construction, costs, tax efficiency, and the building of globally diversified portfolios that minimize, if not eliminate, the taking of idiosyncratic, and therefore uncompensated, risks.”

He also argues that “In order to show that markets are inefficient, we need to see evidence of persistent outperformance beyond the randomly expected. Otherwise, we cannot differentiate skill from luck.”

Swedroe then ploughs through the available evidence on: mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors and behavioral finance, to conclude that the evidence does not support the pursuit of active management in the quest for persistent alpha after costs.

Some messages [for doctors] and us all

  • “all activity is counterproductive” or “please don’t do something, just stand there”
  • attempts to generate alpha by the various means mentioned above are thwarted by: (1) highly efficient markets, (2) “the costs of exploiting any inefficiencies are sufficiently great to make it difficult to generate persistent alpha sufficient to overcome the costs of the effort, and (3) “if there are inefficiencies, the competition to exploit them causes them to disappear rapidly”
  • “since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do economists” (and he equates economists forecasting skill level equivalent to guessing)
  • described “the winning investment strategy” involves a globally diversified portfolio of passively managed funds (such as index funds and exchange traded funds) tailored to an individual’s unique ability, willingness and need to take risk….(as well as) integrating an investment plan into a well-developed estate, tax, and risk management (insurance  of all types) plan.”
  • referring to the futility of active management and getting its practitioners to recognize that, he quotes Sinclair “It is difficult to get a man to understand something when his salary depends on his not understanding it”
  • William Sharpe is quoted as explaining the active vs. passive debate as: “If “active” and “passive” management styles are defined in sensible ways, it must be the case that: (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar, and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”…so “active management is a negative sum game, also known as the loser’s game…(and) the quest for the Holy Grail of alpha is the triumph of hope, hype, and marketing over wisdom and experience.
  • Swedroe explains how one might improve portfolio performance relative to S&P500 alone by increasing its diversification across asset classes


To paraphrase the message of the book, you have to be lucky, not smart, to generate after costs, alpha on a risk-adjusted basis with active management. And there are very many smart [physician] investors competing, but very few will end up being lucky.

So doctors, you’ll want to read this book, and then re-read it every time you get the urge to be active.


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One Response

  1. Buffett’s Defense No Match For S&P 500’s Flat Line In 2011

    Warren Buffett, the billionaire investor who has highlighted his record of beating the market when stocks languish, oversaw a decline last year as the Standard & Poor’s 500 Index ended unchanged.

    Did you beat Warren, last year, doctor?



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