Study hints that alpha may be finite (at least in the short term)
Jun 14th, 2009 | Filed under: CAPM / Alpha Theory, Today's Post
As the hedge fund industry smashed through the one trillion dollar level a few years ago, it became vogue to ponder whether the new assets would dilute existing alpha opportunities. Was alpha a finite resource that needed to be shared among an ever growing number of industry players? And if so, was the hedge fund industry destined to become a victim of its own success because managers, like chickens, become less productive as they become too crowded?
Research seemed to indicate that average alpha was indeed on the decline as the industry grew. But many also argued that the industry was being diluted by “unskilled” new entrants.
But if the new entrants were really “unskilled”, their effect on the returns of the incumbents should be minimal. If a group of 200 “skilled” managers were joined by 5,000 dart-throwing monkeys, then the original 200 should arguably be able to maintain their aggregate alpha. The simian stock-picking efforts of the monkeys should cancel themselves out.
So what really is the effect of new entrants on the alpha of the incumbents? And perhaps more importantly given the recent industry shrinkage, what will be the effects of removing players from the competitive landscape? More…
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