Better than Alpha

Alpha might seem like the holy grail of investing, but there's a smarter, more reliable method to achieve success.

1. The Illusion of Alpha

Alpha is often thought of as the measure of an investor's success, representing returns that surpass market benchmarks. However, this advantage is not as concrete as it seems. Misunderstanding and manipulation of alpha can lead to false conclusions.

Alpha measures returns beyond a benchmark, while beta reflects market-wide returns through passive security ownership. But managers can distort alpha by cherry-picking benchmarks or presenting beta returns as alpha. What looks like skillful investing may simply be the result of an easy-to-beat comparison.

Investors must approach alpha claims with caution. The author highlights how hedge funds once boasted high alpha returns, yet since 2005, hedge fund alpha has declined sharply. One fund known for its "100% pure alpha" collapsed just years later, exposing the risks of relying on alpha alone.

Examples

• Hedge fund managers selecting benchmarks they could easily outperform.
• A hedge fund with extraordinary historical returns failing within a few years.
• The randomness of alpha creating difficulties for large asset owners managing billions.

2. The Decline of True Alpha

True alpha, or genuine market-beating returns, has become increasingly rare, largely because of the explosion of factors and data. As more elements driving returns become understood, alpha shrinks.

True alpha comes solely from security selection, yet it's being squeezed out as the number of identifiable factors grows. Returns once attributed to alpha are now explained by aspects like market capitalization or volatility. Additionally, the sheer volume of new data overwhelms human ability to parse it effectively.

The result? Methods that worked in the past are often no longer viable. Investors now seek alpha in unconventional areas or manufacture it through activities like improving undervalued assets. But this shift highlights an important change: perhaps we need to stop idolizing alpha altogether.

Examples

• Studies showing a decline in true alpha as factors expand.
• The daily creation of data equating to 250 Libraries of Congress.
• Investment managers achieving excess returns by manufacturing alpha through asset improvements.

3. Cognitive Biases in Investing

Investors often fall prey to mental shortcuts and biases, which can cloud judgment. For instance, the inherence heuristic leads people to turn patterns into misleading narratives.

One common bias is believing certain asset types are inherently superior due to past outperformance. But these returns depend on specific conditions like dividend yields, not any inherent guarantee of success. Other traps include confirmation bias, where individuals favor information that supports their preexisting views.

Warren Buffett stands as an antidote to such hasty conclusions. Instead of relying on intuition, Buffett dedicates significant time to research, reading for hours daily. His success underscores the importance of combating biases with knowledge.

Examples

• Investors assuming publicly traded assets will always outperform.
• Confirmation bias influencing decision-making toward preferred beliefs.
• Warren Buffett’s reading habits as a model for informed investment.

4. Balancing Intuition and Analysis

Quick thinking (System 1) is useful for everyday tasks, while slow, analytical thinking (System 2) ensures better outcomes for major decisions. However, overuse of System 2 can lead to exhaustion.

For example, studies of Israeli parole hearings found that decisions made in the morning were more favorable than those made later in the day, when judges were mentally fatigued. This highlights the limits of constant deep thinking.

In investing, System 2 should be applied sparingly, especially during key phases like policy setting and asset allocation. By prioritizing careful thinking for critical decisions, investors can conserve their energy and avoid poor judgment.

Examples

• Judges favoring quick “no” rulings later in the day due to fatigue.
• The decision-making process for initial investment policies.
• System 1 guiding quick decisions while reserving System 2 for foundational choices.

5. Mastering Due Diligence with the 5P Framework

The due diligence phase is less strategic than policy-setting, but using a structured approach like the 5P framework can improve results. This framework focuses on performance, people, philosophy, process, and portfolio.

Performance and people relate to selecting the right managers. Past results set reasonable expectations, while traits like integrity and passion ensure reliability. Philosophy reflects a team's shared goals and values, while process and portfolio guide consistent, active monitoring and rebalancing.

Due diligence may not always uncover alpha, but it improves accuracy. Research even shows investing over 40 hours in due diligence correlates to better results, especially for risky investments like startups.

Examples

• Selecting managers based on traits like trustworthiness and expertise.
• Collaboration and shared philosophies among investment teams.
• Research demonstrating improved outcomes with extensive due diligence.

6. The Importance of Leadership in Governance

Good governance starts with strong leaders who combine experience with influence. Without it, organizations can face catastrophic mismanagement.

For instance, the Dallas Fire and Police Pension suffered due to poor investments under a leader with no finance background. Contrast this with organizations prioritizing charismatic, experienced leaders who drive teams and make informed decisions.

Leadership extends beyond choosing the right person. Hierarchies should empower expertise, placing decision-making authority in the hands of those most qualified to act.

Examples

• A pension fund’s collapse following bad leadership choices.
• Effective leaders pairing charisma with financial expertise.
• Studies linking governance structures to strong investment outcomes.

7. Moving Beyond the Alpha Obsession

Fixating on alpha distracts from better strategies for achieving financial goals. For most investors, it makes sense to focus on total returns rather than attempting to "beat the market."

In public markets, excess returns that appear to be alpha are often luck or specific factors. In private markets, smaller managers with niche expertise may add value, but success depends on informed, adaptable investments.

Ultimately, success lies in sustainable processes, fair governance, and long-term vision. Hitting goals matters more than outperforming arbitrary benchmarks.

Examples

• Public market “alpha” frequently revealed as factor-driven returns.
• The value of working with smaller, nimble managers in private markets.
• Wisconsin’s investment board achieving objectives sustainably.

8. The Role of Knowledge and Learning

Constant learning is essential to sound decision-making. Even the most seasoned investors need to dedicate time to understanding the evolving market landscape.

Warren Buffett serves as a prime example. His extensive reading habit fuels his market insights and reinforces the role of education in successful strategies.

As knowledge grows, decisions improve. Investors who prioritize learning over shortcuts are better equipped to adapt and thrive.

Examples

• Buffett’s daily reading to refine his market understanding.
• Investors uncovering opportunities by deeply studying industries or sectors.
• Avoiding pitfalls like cognitive biases through active learning.

9. A New Definition of Success

Success in investing is not about chasing illusions but aligning actions with outcomes. By focusing on structure, governance, and learning, investors can create their own version of the "gold standard."

Institutions like the Wisconsin Board demonstrate how this approach outshines traditional alpha chasing. Strong leadership coupled with rules-based strategies results in meeting objectives and consistent performance.

Every investor has a role to play in redefining success. With a shift toward scientific, informed decision-making, even small efforts yield improvement.

Examples

• Wisconsin’s success through structured, rules-based strategies.
• Outperformance by organizations prioritizing governance and sustainability.
• Investors achieving goals by avoiding alpha myths and focusing on returns.

Takeaways

1. Focus on key decision phases like policy setting and asset allocation, applying thoughtful decision-making strategies.
2. Use frameworks like the 5P model to streamline due diligence and improve evaluation accuracy.
3. Prioritize leadership and governance, ensuring experienced, charismatic individuals drive investment strategies.