Alpha as a Net Zero Sum Game: How Serious a Constraint?
Dec 5th, 2006 | Filed under: CAPM / Alpha TheoryBy: Joanne M. Hill, Goldman Sachs
Published: Summer 2006, Journal of Portfolio Management
Although this article was published several months ago, Institutional Investor has recently posted it for free on its home page. If you’ve enjoyed reading some of the papers and articles in the Portable Alpha Hall of Fame, you’ll surely find this one interesting.
In it, Joanne Hill of Goldman Sachs unwittingly plugs this blog better than we ourselves possibly could:
“The interest in separating alpha and beta risk management shows that investors are becoming less willing to pay active manager fees for beta and are seeking index returns through low-fee fund products or tradable vehicles like exchange-traded funds (ETFs), index futures, and index swaps. The motivation for alpha-beta separation is a sound one because it aligns payment for investment skill with strategies focused on delivering relative or absolute returns.”
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.)
Differing Time Horizons and The Introduction of Exogenous Value
But she takes Darnell’s ideas a step further by explicitly recognizing time horizon differences as the central point of disagreement between investors. Tactical traders would measure alpha on a day-to-day (or tick-to-tick) basis while growth investors might measure alpha – on the very same portfolio – using a totally different benchmark. (To be sure, she does acknowledge that alpha would have to be zero-sum in a more traditional single-period analytical model.)
She also says that the introduction exogenous value into a closed system further confounds the zero-sum argument. She cites several examples to illustrate how these new sources of value can lead to positive aggregate alpha: China, Google, and the discovery of the Americas. (We are more skeptical of this argument since the growth contribution from each of these sources should be reflected in the benchmark.)
Investing with the Dart-Throwing Monkey?
Hill also makes an excellent point about what the world would look like even if alpha were actually a zero-sum game.
“Many argue that the quest for alpha is doomed to fail for half of the assets devoted to skill-based strategies. Of course, this does not mean that those who make this argument are not devoting their efforts to finding alpha. It just means that they think they will be part of those consuming the winning half of the alpha pie.”
We concur. Hiring the proverbial dart-throwing monkey to randomly select funds (or stocks) in a zero-sum game will indeed guarantee underperformace in the long run (due to expenses). But while the zero-sum argument has driven many investors away from active management in recent years, most of the investment world still wakes up in the morning convinced that they can beat their benchmark (or pick a manager than can beat their benchmark.) So the quest for alpha should not be contingent on the average level of alpha produced.
The Mets vs. the Yankees
Hill makes an argument that we have likened to interleague play in Major League Baseball. She says that certain segments of the market might generate net positive aggregate alpha on the backs of other segments of the market.
Although Hill argues that attempting to reconcile alpha “winners” with alpha “losers” is fruitless, she remains bullish on alpha (which isn’t a total shocker given that she is an MD at Goldman…)
“Even though investor skill is costly to find and deliver, the recent track record for alpha seems to offer more promise for financial asset growth in the next decade than the prospects for taking equity beta and duration risk. Also, alpha risk is easier to diversify because of its low cross-strategy correlation properties…These factors suggest directions to look for the most fertile positive alpha ground—channels of investing that are less obvious, more constrained, higher-risk, and less crowded, including those that lie in the gray area between investment categories and clienteles.”
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[...] Alpha as a Net Zero Sum Game: How Serious a Constraint? [...]
[...] 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.” [...]
[...] Ineichen goes on to explain that the “fools” to which he refers are really just players behaving uneconomically.  Calling casinos the “second best business model ever”, he raises a point that is central to the argument that alpha actually exists. He says casino gambling losers aren’t really losers after all since they benefit from a “form of entertainment and sensation”. Regular readers will recognize this as being similar to the arguments put forth by Max Darnell and others to explain why alpha might be somewhat immortal. [...]