Introduction
In the world of investing, the pursuit of alpha - excess returns above a benchmark index - has long been the holy grail. Investors and fund managers obsess over finding alpha, believing it to be the key to investment success. However, in his book "Better than Alpha," Christopher Schelling challenges this conventional wisdom and presents a more intelligent approach to investing.
Drawing from years of experience in institutional investing, Schelling argues that the quest for alpha is often misguided and doomed to fail. He reveals how alpha is frequently misunderstood, easily manipulated, and increasingly elusive in today's markets. Instead of chasing this financial mirage, Schelling proposes a radically different strategy for meeting investment objectives.
This book summary explores Schelling's key insights and recommendations for a smarter approach to investing. We'll examine why alpha is unreliable, how cognitive biases lead us astray, and what strategies can truly improve investment outcomes. By the end, you'll have a new perspective on what really matters for investment success.
The Allure and Pitfalls of Alpha
Defining Alpha and Beta
To understand the problems with chasing alpha, we first need to clearly define what it is. Alpha represents the excess return of an investment compared to a benchmark index. It's essentially a measure of how much an investor or fund manager is beating the market.
Beta, on the other hand, refers to the market return that can be achieved through passively owning securities in a specific market. While investors crave alpha, beta is much easier to obtain.
The Unreliability of Alpha
Schelling argues that alpha is far more unreliable and elusive than most investors realize. There are several reasons for this:
Alpha is easily manipulated. Fund managers can distort alpha by choosing easy-to-beat benchmarks or misclassifying returns. What appears to be alpha is often just beta in disguise.
Alpha is random and inconsistent. Even when true alpha is achieved, it tends to come and go unpredictably. Past performance is no guarantee of future alpha.
Alpha has been declining. Across public markets, private equity, and hedge funds, alpha has become increasingly scarce in recent years.
Large investors struggle to capture alpha. For massive institutional investors, suddenly shifting billions based on fleeting alpha opportunities is extremely challenging.
Individual investors are vulnerable to alpha illusions. As alternative investments become more accessible, retail investors risk being misled by false promises of alpha.
The Spectrum of Alpha
Schelling explains that alpha isn't a simple binary - it exists along a spectrum:
- True alpha: Excess returns generated solely through security selection, without any tilts or factor exposures.
- Manufactured alpha: Value created through active changes, like renovating a property.
- Transitional alpha: Temporary excess returns from holding an asset until prices normalize.
Most investors seek true alpha, but this is becoming increasingly rare and difficult to find.
The Decline of True Alpha
According to Schelling, true alpha is rapidly disappearing for two key reasons:
The explosion of market factors. As more and more factors that drive returns are identified, there's less left over that can be attributed to true alpha.
The data deluge. The sheer volume of financial data being generated makes it nearly impossible to gain an information edge.
This decline means investors need to rethink their approach and look beyond traditional alpha-seeking strategies.
The Cognitive Biases That Lead Us Astray
The Dangers of Intuitive Thinking
Schelling argues that our natural cognitive tendencies often lead us to poor investment decisions. He highlights several cognitive biases that can derail even experienced investors:
The inherence heuristic: Our tendency to identify patterns and create explanatory narratives, even when they're not valid. For example, assuming certain assets will always outperform because they have in the past.
Confirmation bias: Seeking out information that confirms our existing beliefs while ignoring contradictory evidence.
Loss aversion and the sunk cost fallacy: Holding onto losing investments too long because we're reluctant to accept losses.
Overconfidence: Believing we have special insight or ability to beat the market consistently.
These biases are deeply ingrained in human thinking, making it crucial for investors to recognize and counteract them.
System 1 vs. System 2 Thinking
Schelling draws on Daniel Kahneman's model of two thinking systems to explain how we can improve decision-making:
- System 1: Quick, intuitive thinking. Useful for many daily tasks but prone to biases and errors.
- System 2: Slow, analytical thinking. More accurate but mentally taxing.
The key is knowing when to rely on each system. For most routine decisions, System 1 is fine. But for crucial investment choices, we need to engage System 2.
Reserving Analytical Thinking for Key Decisions
Given our limited mental energy, Schelling advises conserving System 2 thinking for the most impactful investment decisions. He identifies two critical phases that deserve deep, analytical thought:
- Policy setting: Defining goals, risk tolerance, and success metrics.
- Asset allocation: Determining the optimal mix of investments.
For these crucial stages, Schelling recommends:
- Creating an informal environment that encourages diverse input
- Allowing ample time for research and deliberation
- Producing comprehensive documentation to guide future decisions
By focusing our mental resources on these foundational decisions, we can improve overall investment outcomes.
A Framework for Better Due Diligence
While policy setting and asset allocation require deep analysis, other parts of the investment process can benefit from a structured framework. Schelling introduces the 5P framework for conducting effective due diligence:
- Performance: Analyze past results to set realistic expectations.
- People: Look for managers with intelligence, integrity, and intensity.
- Philosophy: Ensure the investment team shares common values and goals.
- Process: Verify a consistent, predetermined investment approach.
- Portfolio: Conduct in-depth analysis and ongoing monitoring.
By systematically evaluating these five areas, investors can make more informed decisions and potentially improve returns. Research has shown that thorough due diligence can significantly impact investment performance.
The Crucial Role of Governance
The Importance of Leadership
Schelling emphasizes that having the right leadership is critical for investment success. Poor governance can lead to disastrous outcomes, as seen in cases like the Dallas Fire and Police Pension's ill-fated real estate investments.
Qualities of Effective Investment Leaders
The ideal investment leader should possess:
- Experience: A track record of evaluating diverse investments and making sound decisions.
- Charisma: The ability to motivate and influence others.
- Expertise: Deep knowledge of investment principles and markets.
Schelling argues that putting charismatic experts in positions of authority is crucial for organizational effectiveness. If this isn't possible, decision-making power should be given to the most qualified individuals, regardless of their formal titles.
Shifting Focus: From Alpha to Total Returns
Abandoning the Alpha Obsession
Given the elusive nature of alpha, Schelling advises investors to stop chasing it altogether. In public markets, most excess returns were likely never true alpha to begin with, but rather the result of factor exposures or luck. Even in private markets, alpha is becoming increasingly scarce.
Strategies for Success
Instead of pursuing alpha, Schelling recommends focusing on:
- Obtaining market exposure (beta) at the lowest possible cost
- Working with smaller, more innovative managers in private markets
- Prioritizing total net returns over beating arbitrary benchmarks
- Implementing smart governance and sustainable processes
He points to organizations like the State of Wisconsin Investment Board as examples of this approach in action. By focusing on sound decision-making processes and governance, they've consistently outperformed benchmarks and even achieved alpha as a byproduct.
Embracing a Scientific Mindset
Schelling encourages investors to adopt a more intelligent, scientific approach to investing. This involves:
- Keeping an open mind and continually learning
- Treating mistakes as valuable learning experiences
- Focusing on factors you can control, rather than chasing elusive alpha
Practical Applications of Schelling's Approach
While Schelling's book is primarily focused on institutional investors, many of his insights can be applied by individual investors as well. Here are some practical ways to implement his ideas:
1. Rethink Your Investment Goals
Instead of trying to beat the market, focus on achieving your specific financial objectives. Define clear, measurable goals and a realistic timeline for reaching them.
2. Embrace Low-Cost Index Funds
For most investors, capturing market returns through low-cost index funds is a more reliable strategy than trying to find alpha-generating active managers.
3. Be Wary of "Alpha" Claims
When evaluating investment opportunities or fund managers, be skeptical of claims about consistent alpha generation. Look beyond headline numbers to understand the true sources of returns.
4. Improve Your Decision-Making Process
Apply Schelling's advice on System 2 thinking to your most important investment decisions. Take time to research thoroughly, consider multiple perspectives, and document your reasoning.
5. Conduct Thorough Due Diligence
Use the 5P framework when evaluating potential investments or financial advisors. Don't skip this crucial step, even if an opportunity seems promising at first glance.
6. Focus on Total Returns
Rather than obsessing over beating a benchmark, pay attention to whether your investments are generating the returns you need to meet your goals.
7. Continuously Educate Yourself
Like Warren Buffett, make ongoing learning a priority. Stay informed about market trends, investment strategies, and potential biases that could affect your decision-making.
8. Consider Your Own "Governance"
If you're managing investments for your family or a small organization, think about how you can improve your decision-making structure. Are the most knowledgeable people involved in key decisions?
9. Look Beyond Traditional Assets
As alpha becomes scarcer in public markets, consider allocating a portion of your portfolio to alternative investments or niche strategies where inefficiencies may still exist.
10. Maintain a Long-Term Perspective
Avoid getting caught up in short-term market movements or the latest investment fads. Stay focused on your long-term objectives and the process you've established to reach them.
Case Studies: Putting Theory into Practice
To illustrate how Schelling's principles can be applied in the real world, let's examine a few hypothetical case studies:
Case Study 1: The Individual Investor
Sarah is a 35-year-old professional who wants to improve her investment strategy for retirement. After reading "Better than Alpha," she decides to make several changes:
She shifts most of her portfolio into low-cost index funds, reducing her reliance on actively managed mutual funds that promised alpha but consistently underperformed.
For her annual portfolio review, Sarah sets aside a full day to engage in System 2 thinking. She reassesses her risk tolerance, long-term goals, and asset allocation.
Sarah maintains a small portion of her portfolio for "exploration" investments. When evaluating these opportunities, she uses the 5P framework for due diligence.
Instead of checking her portfolio daily and making frequent trades, Sarah adopts a quarterly rebalancing schedule to stay aligned with her target asset allocation.
She commits to reading one investing book per month to continually expand her knowledge.
By implementing these changes, Sarah feels more confident in her investment approach and less stressed about trying to beat the market.
Case Study 2: The Small Foundation
The trustees of a $50 million charitable foundation are struggling with underperformance and high fees. Inspired by Schelling's ideas, they implement several changes:
They revise their investment policy statement, clearly defining their return objectives, risk tolerance, and liquidity needs.
The foundation reduces its allocation to high-fee hedge funds and increases its use of low-cost index funds for core market exposure.
For alternative investments, they focus on smaller, more specialized managers where alpha potential may still exist.
The trustees implement a more rigorous due diligence process using the 5P framework, including site visits and extensive reference checks.
They restructure their investment committee, ensuring that the most experienced and knowledgeable trustees have greater input on key decisions.
Over time, the foundation sees improved returns, lower fees, and a more stable investment approach aligned with its long-term mission.
Case Study 3: The Pension Fund
A state pension fund with $10 billion in assets is facing funding challenges and pressure to generate higher returns. The CIO decides to overhaul their investment strategy based on Schelling's recommendations:
The fund conducts a comprehensive review of its asset allocation, using System 2 thinking to challenge long-held assumptions about expected returns and correlations.
They implement a factor-based approach to portfolio construction, focusing on capturing systematic sources of return rather than trying to find alpha in each asset class.
The pension fund consolidates its roster of external managers, focusing on those with truly differentiated strategies and a track record of consistent outperformance.
They enhance their governance structure, creating specialized sub-committees with relevant expertise for different asset classes and investment strategies.
The fund improves its risk management capabilities, implementing more sophisticated tools to monitor factor exposures and potential vulnerabilities across the portfolio.
These changes lead to more stable performance, improved funding ratios, and greater confidence from stakeholders in the pension fund's investment approach.
Critiques and Limitations of Schelling's Approach
While "Better than Alpha" offers valuable insights, it's important to consider potential criticisms and limitations of Schelling's arguments:
1. Oversimplification of Alpha
Some critics might argue that Schelling's dismissal of alpha is too absolute. While true alpha may be rare, skilled investors can still add value through security selection and timing in certain inefficient markets.
2. Challenges for Small Investors
Many of Schelling's recommendations are geared towards institutional investors with significant resources. Individual investors may find it difficult to access some of the strategies he suggests, such as working with specialized private market managers.
3. Potential for Missed Opportunities
By focusing primarily on low-cost, passive strategies, investors might miss out on genuinely skilled active managers or innovative investment approaches that could enhance returns.
4. Governance Challenges
Implementing Schelling's governance recommendations can be challenging, especially for smaller organizations or family offices that may lack the necessary expertise or resources.
5. Market Timing Concerns
While Schelling advises against trying to time the market, some investors might argue that there are periods when taking a more active approach is warranted, such as during market bubbles or crises.
6. Neglect of Behavioral Finance
Some readers might feel that Schelling doesn't go far enough in exploring how behavioral finance insights can be applied to improve investment decision-making.
7. Limited Discussion of ESG Factors
The book doesn't extensively address the growing importance of environmental, social, and governance (ESG) factors in investment decision-making, which is an increasingly relevant topic for many investors.
Despite these potential criticisms, Schelling's core message about the importance of focusing on sound processes, governance, and total returns remains valuable for most investors.
The Future of Investing: Beyond Alpha
As we look to the future of investing, several trends and developments are likely to shape the landscape in ways that align with Schelling's thinking:
1. Continued Growth of Passive Investing
The shift towards low-cost index funds and ETFs is likely to continue, as more investors recognize the challenges of consistently generating alpha.
2. Increased Focus on Factor Investing
Strategies that target specific factors or "smart beta" are likely to gain further popularity as investors seek systematic sources of return.
3. Advancements in Artificial Intelligence
AI and machine learning may lead to new investment strategies and ways of analyzing data, potentially creating new sources of alpha or making existing inefficiencies harder to exploit.
4. Greater Emphasis on Risk Management
As markets become more complex and interconnected, sophisticated risk management techniques will become increasingly important for investors of all sizes.
5. Evolution of Alternative Investments
The alternative investment space is likely to continue evolving, with new strategies and asset classes emerging that may offer unique return profiles.
6. Increased Importance of ESG Integration
Environmental, social, and governance factors are likely to play a larger role in investment decision-making, potentially creating new opportunities for alpha generation.
7. Democratization of Investing
Technology is making sophisticated investment strategies more accessible to individual investors, though this also comes with potential risks.
8. Greater Scrutiny of Fees and Performance
Investors are likely to become even more discerning about fees and the true sources of investment performance, in line with Schelling's emphasis on total net returns.
As these trends unfold, Schelling's focus on sound governance, rigorous processes, and a scientific approach to investing is likely to become even more relevant.
Conclusion: Embracing a Smarter Approach to Investing
In "Better than Alpha," Christopher Schelling presents a compelling case for rethinking our approach to investing. By exposing the flaws in the relentless pursuit of alpha, he encourages readers to focus on what truly matters: achieving their investment objectives through sound decision-making and robust processes.
Key takeaways from the book include:
Alpha is increasingly elusive and often misunderstood. Investors should be skeptical of alpha claims and focus instead on total net returns.
Cognitive biases can lead even experienced investors astray. Recognizing these biases and knowing when to engage in deeper, analytical thinking is crucial.
A structured approach to due diligence, like the 5P framework, can improve investment outcomes.
Strong governance and leadership are essential for investment success. Organizations should prioritize putting experienced, charismatic experts in key decision-making roles.
Instead of chasing alpha, investors should focus on obtaining market exposure efficiently, working with innovative managers, and implementing sustainable processes.
Adopting a scientific mindset - one that emphasizes continuous learning and treats mistakes as valuable feedback - can lead to better long-term results.
By embracing these principles, investors can move beyond the alpha obsession and develop a more intelligent, reliable approach to meeting their financial goals. Whether you're an institutional investor managing billions or an individual planning for retirement, the insights in "Better than Alpha" offer a valuable roadmap for navigating the complex world of investing.
As we look to the future, the investment landscape will undoubtedly continue to evolve. New technologies, changing market dynamics, and emerging global challenges will create both opportunities and risks. However, by focusing on the fundamentals of good governance, rigorous analysis, and a long-term perspective, investors can position themselves for success regardless of how markets change.
Ultimately, what's "better than alpha" is a thoughtful, disciplined approach to investing that aligns with your specific objectives and risk tolerance. By shifting focus from beating arbitrary benchmarks to achieving meaningful financial goals, investors can find greater satisfaction and success in their investment journey.