“Peak Alpha” Theory: Perspectives from Around the Blogosphere
Oct 7th, 2006 | Filed under: CAPM / Alpha TheoryThe past week has served up a good helping of blog chatter on the topic of alpha finiteness, both in response to and coincident with Alpha Male’s recent posting Peak Alpha Theory?
In response to Peak Alpha Theory? Steve LeCompte at CXO Advisory says:
I think I might compare alpha sources more broadly to energy (low entropy) sources rather than just oil. Peak man-labor gives way to peak horse-labor to peak wood-burning to peak oil-burning to… We are always looking for the best return on energy investments.
Entropy may provide an even better analogy, because of its direct link to information theory. Private information is a low entropy source. Alpha comes from early exploitation of the release and diffusion of private information throughout the investing environment. Maintaining a high alpha means continually locating sources of significantly private and investing-exploitable information. Are a growing number of information exploiters exhausting the supply of private information sources? Do better information drilling tools make more sources of private information exploitable? Do more and more people participating in a global networked economy create an ever-increasing supply of private information sources?”
Steve has written several postings about alpha. In his October 5 posting Diminishing Returns from Hedge Funds? Or Not? he references a new white paper by Andrea Beltratti of the Universita Bocconi and Claudio Morana of the International Centre of Economic Research that suggests Alpha is not being exhausted by the growth of hedge funds.
The quantitative trader behind CASTrader.com takes the “Peak Alpha” debate in some intellectually acrobatic directions (“CAS” stands for “complex adaptive systems”). He wonders if alpha is infinite and that the discovery of market inefficiencies will accelerate thanks to explosive technological progress (often referred to by futurists as “The Singularity”).
If alpha is not a zero or finite-sum game, then it is extractable in ever-increasing quantities, perhaps fueled by what others claim is the coming technological singularity.
CASTrader.com also does a good job of tying together alpha-threads in various blogs (AllAboutAlpha, CXOAdvisory, HedgeFund.blogspot).
HedgeFund.blogspot.com contains a great posting called How much alpha is available? that reminds us that theoretical discussion of alpha is fun, but does not have an impact on day-to-day investing:
“When a new fund sets up I regard it as neither a threat nor a competitor. They do what they do, I do what I do. They are not going to affect my alpha generation and assuming they are competent, I am not going to affect theirs’.”
Finally, Richard Kang, an ETF columnist at SeekingAlpha and long-time reader of AllAboutAlpha, touches on this debate in his recent posting Quasi-index and Quantitative Model ETFs: It’s Beta, Not Alpha. Kang suggests that market inefficiencies might be finite, but that the number of people search for them is growing.
“Perhaps there’s no change in the amount of alpha out there, but because of so many participants, especially hedge funds, there’s simply less to go around per capita.”
By revisiting the definition of alpha, Kang throws water on the idea that ETFs could deliver alpha. He discusses the notion of market beta being a type of commoditized beta and alpha being simply non-commoditized beta.
Non-commoditized beta is like your parents telling you as a child that strangers were just friends you haven’t met yet. They were suggesting to you that all strangers were destined to become friends. Similarly, Kang suggests that all alpha is destined to become beta. In other words, all alpha will eventually be commoditized and therefore, by definition, disappear. (This argument is reminiscent of Max Darnell’s musing that disciplined & systematic alpha generation could almost be considered an oxymoron.)
A fellow Torontonian, Kang has much in common with Alpha Male. Both agree that active management can be disintermediated with a combination of ETFs and market neutral hedge funds. Still, Alpha Male is a little more bullish on the future of active management and proposes an important clarification: while all alpha sources may eventually become beta, new sources of alpha will always come online to replace them (emerging markets, new financial instruments etc.). This, after all, is the central rebuttal to Peak Alpha Theory.
- Alpha Male
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Alpha Male
Your comments are great; the blogsite is totally unique. Kudos on your work.
Some clarification on your conclusion to the above piece. Whether you or I are more bullish on the future of active management, that is debatable but overall not of any significance. I think what we can agree on is that the art/science of active management is tough. The game is the ongoing search for new sources of alpha (your comparison to oil is spot on) as alpha becomes “betaed”. You say “new sources of alpha will always come online to replace them” however I don’t think we’re in a Soros/Trout/Robertson world anymore. The environment is so different (number of participants, speed of capital movement, etc.) that although new sources of alpha may be available, the opportunity for investors to fully participate in its exploitation is unclear. In my opinion, the issue is not the aggregate size of alpha but the actual true alpha realized by each participant. Didn’t our parents always say nothing worthwhile was ever easy?
Point well taken. More participants mean less alpha per participant. I wonder if more participants also lead to more aggregate alpha in the long run? Intuition would say “no” because increasing liquidity should reduce inefficiency. But not necessarily when there are commensurately more niche and emerging markets to play in.
In any event, you’re absolutely right that all the important lessons about investing we probably learned from our parents.
I think it is true that most hedge funds don’t feel threatened by new entrants. Only the most traditional who are really more scared of their own inability to create alpha are usually scared.