By: Max Darnell, First Quadrant
Published: April 2004

First Quadrant was a pioneer in Alpha/Beta bifurcation and were even advocating portable alpha back in the late 90’s (when, to its chagrin, beta was producing double digit returns and no one cared about alpha).  So they’ve developed a very acute “sense of alpha” over the years.  This article, written by the firm’s CIO, Max Darnell, summarizes their unique alpha-centric view on investing (even if it is a little self-congratulatory).

Darnell starts by highlighting a common misunderstanding about alpha – that it is simply out-perforance of a benchmark.

“What is this alpha really? Is it value added relative to a benchmark? If I build a high beta portfolio of stocks from the S&P 500 and beat the S&P 500 over the course of a bull market, have I delivered alpha? I’ve certainly beaten the benchmark.”

He points out the arguments made my many of the papers and articles at AllAboutAlpha: that alpha is often just “exotic beta”, that numerous systematic risk factors exist beside the market, and that any one of them can produce “market-beating” returns. 

“Most would agree that the small cap bet is a bias, which somehow means that it isn’t alpha either. So what’s the difference between screening on market capitalization – or price/book for that matter – and screening on discretionary accruals? Nothing other than the fact that small cap stocks have been identified in the literature as a style that has had a long-term payoff and therefore has been officially recognized. We would say that there isn’t a difference between them. They both represent a systematic risk that can be easily produced by screening the stock universe for some objective characteristics of stocks.”

Darnell calls the generation of skill-based returns as a ”craft” business.  To underscore this point, he draws on a useful analogy of two cooks in a kitchen using the same ingredients, but producing very different culinary creations.  

“Put two chefs in the same kitchen – one who flips burgers at McDonalds and the other a sous chef from the best restaurant in town – and give them each the same ingredients to work with. When you compare the quality of what each of them produces with these ingredients, you’ll likely taste a difference. The difference is the result of craftsmanship.”

But here’s where Darnell takes an interesting detour…

“A logical extension of this argument might be to say that pretty much any objective, systematic approach to selecting assets might never amount to anything we’d call true alpha. Such approaches might be accused of doing nothing more than bundling together a set of what are ultimately some form of systematic risks. We can imagine the traditional fundamental stock pickers saying that it’s the subjective decisions that come after their stock screens that are the real alpha. If these decisions are disciplined (read: systematic), however, then they may boil down to just another screening process, even if the judgments are based less on objective facts. And what if the judgments aren’t systematic, what are they then? In the spirit of Bill Clinton, we might then ask, Is it an it? At any rate, we’ll leave the matter of traditional, subjective approaches and their relation to alpha to others to meditate on.”

Okay, let’s take Darnell’s suggestion and “meditate” on this question for a moment.

The hedge fund world can be roughly bifurcated into two groups: those managers that repute to rely on “skill” and those that repute to rely on systematic, quantitative techniques.  “Skill-based” managers will often say their edge is experience & wisdom.   On the other hand, the systematic managers allege that they are exploiting unique market inefficiencies – gleaned through quantitative analysis and an understanding of market dynamics.  These “arbitrageurs” are currently de rigor among the global fund of hedge funds community since trust and previous experience with a manager is not as important when making an investment.

But in a way, skill-based managers also argue that they exploit market inefficiencies.  They argue that specific equities are over- (or under-) valued when compared to their proprietary bottom-up analysis and chalk this up to an “informational inefficiency” in the market that they have managed to exploit.  

Which brings us back to Darnell’s highly “disciplined” fundamental stock-pickers.  It seems that fundamental bottom-up managers can’t win.  If they allege to generate returns by summonsing up the alpha-spirits in a shaman-like display of wisdom and skill, then investors find them hard to take seriously.  But if they espouse a highly structured research and analysis process, then investors (and particularly academics) argue they are merely purveyors of over-priced beta.

At the end of the day, Alpha Male argues that there is no “pure” alpha or “pure” beta.  Rather there is a continuum with mystical, skill-based ”alpha” at one end and the S&P500 at the other.  What lies in between should be priced according to the cost of passive substitutes.

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