A quarter vs. three nickels and a dime…
May 13th, 2007 | Filed under: Portable Alpha & Alpha/Beta SeparationDoes anyone remember the series of fake commercials on Saturday Night Live in the late 1980’s for the “First Citiwide Change Bank”? (click here for a video excerpt from one of these commercials). Fictitious First Citiwide wanted to introduce bank customers to the world of options they had to change a large denomination bill. Said the commercials:
“You can come to us with 16 quarters, 8 dimes and 4 nickels, we can give you a 5 dollar bill. We can give you 5 singles…Or 2 singles, 8 quarters and 10 dimes. You’d be amazed at the variety of options you have.”
“We will work with the customer to give that customer the change that he or she needs…We will work with you.”
“We have been in this business a long time. With our experience, we’re gonna have ideas for change combinations that probably haven’t occurred to you. If you have a fifty-dollar bill, we can give you fifty singles. We can give you forty-nine singles and ten dimes. We can give you twenty-five twos. Come talk to us. We are not going to give you change that you don’t want. If you come to us with a hundred-dollar bill, we’re not going to give you two-thousand nickels - unless that meets your particular change needs. We will give you the change equal to the amount of money that you want change for!”
Okay. So what? Well, this Vanguard article entitled “Alpha-Beta Separation: Appealing Theory, Problematic Reality“, begins with the familiar line “Would you rather have a quarter or three nickels and a dime?”, and goes on to describe alpha as the dime and beta(s) as the nickels.
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Unlike at 1st Citiwide, when you buy alpha you don’t get shiny coins: you get a piece of paper good for whatever the bank deems it to be worth in 90 days — maybe, they’ll give you some beta coins, maybe regret that in fact, the alpha portfolio went down by half.
The whole game has been to find alpha and most investors have entirely inadequate tools to evaluate the quality of managers’ approaches. However, if there are huge uncertainties about whether a given manager will add value, at least you can be sure that the costs will be pretty much in line with the contracted amount, and you should negotiate those to be reasonable given your beliefs about their alphas and other quality factors.
Finally, the point is interesting: if only say, 100 managers offer 130/30 investing strategies, and you run a 130/30 search, you’re limiting your investment options the same way as the long-only managers are said to be limited in their expression of alphas. Hoisting on one’s own petard.