Treading Where Alpha Does NOT Sum to Zero
Oct 1st, 2006 | Filed under: CAPM / Alpha TheoryBy: Max Darnell, First Quadrant LP
Published: May 2006, Eurekahedge
“Most readily accept the notion that any alpha captured corresponds to alpha that someone else has lost…Some, on the other hand, take the view that for all practical purposes, it is a zero-sum game, but admit that there is legitimacy, at a conceptual level, in the case that can be made opposing the zero-sum assumption.”
Max Darnell, CIO at First Quadrant makes a number of interesting observations about the nature of alpha. In particular, he suggests that alpha is only a zero-sum game if investor’s utility curves are assumed to be totally homogenous. Where investors have different utility curves (i.e. different time horizons, non-economic motivations, different risk aversions etc.), positive net aggregate alpha can be created. Essentially, he is saying that it all depends on how you define success.
“It is, we believe, the distinct minority who hold as a core belief the notion that alpha does not always sum to zero, that opportunities to create net positive alpha across investors exist, and who actively seek out such alpha. The most conventional sources of alpha do, we believe, tend to sum to zero, so looking for constructive alpha opportunities – those transactions that lead to net positive aggregate alpha – typically means looking for alpha in places other than where most active managers tread.”
“Endowments and corporate defined benefit plans, for example, have materially different investment objectives and different appetites for risk. As a result, what may be a prize to one investor may not be so to another. This allows us to consider the possibility that investors may, in fact, be able to trade with each other with the result that both are better off!”
Darnell argues that small pockets of the market may be able to produce a non-zero aggregate alpha due to non-identical utility curves.
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[…] But more importantly, Hill argues that alpha is not actually a “zero-sum game”. Like Max Darnell of First Quadrant, she argues that the heterogeneity of investor utility functions mean that everyone’s a winner! (Well, if not everyone, at least more than half of all investors.) […]
[…] But how can this be?  Intuition suggests that more assets chasing the same inefficiency will eventually arbitrage- (”iron”) out that inefficiency. As Alexander Ineichen says in his new book, the market “learns” or “becomes immune” to the arbitrageur (although he does say that markets cannot be perfectly efficient). But according to Beltratti and Morana, market participants have heterogeneous utility functions (a notion also argued by Max Darnell, Joanne Hill, and William Sharpe): “The wide variety of real world investors, including noise traders and investors with heterogeneous time horizons and objectives, seems to provide plenty of opportunities for hedge funds managers to exploit: the limits of arbitrage do not seem to have been met yet.” […]