Monday, May 28, 2007

The Holy Grail in Asset Management: Producing Alpha

Producing Alpha is also known as Beating the Market in Layman’s Language. We shall talk about Alpha and Beta later on.

There are actually 2 games that are being played in town. The absolute return game that most retail investors and hedge funds play and the relative return game that most monkeys on Wall Street play.

The absolute return game has simple rules, bring me 20% return per annum. That’s the target. For retail guys, if you can do that and can sustain that performance for 20yrs (i.e. earn 20%pa for 20yrs), good for you, your track record is among the best in the world, probably you are a multi-millionaire now and you should really think about doing some philanthropy.

It is actually quite difficult to have negative return in the absolute return game if your investment horizon is longer than 10yrs. But we hear of so many folks losing their pants in stocks and investments. Why? Bcos most pple buy the hottest stocks in the markets, usually paying peak prices and of course after the fad, the stocks nosedive. Same for property speculators who bought 500sqf condos at $2000 psf during 98 and their successors buying 500sqf condos at $3000 psf today. (Actually even if you bought at these peak levels, if you could hold it out long enough, you would not have lost your principal.)

The relative game is a funny game. The rules state that you win when you earn a return that is better than the market return. If the market return 10% this year, you must bring in at least 10.1%. Conversely, if the market return is -10%, even if you lost -9.9% of your money, you have beaten the market and hence become a Big Swinging Dick (i.e. a hero lah), but in reality you have lost money. Btw the market return is usually proxied by an index like STI or Hang Seng or Nikkei etc.

In investment lingo, the excess return earned over market return is called Alpha. (whereas market return is called Beta). On Wall Street, Alpha is like the Holy Grail of Investing. Everybody is looking for it. Some knows where it is but they will never share with others their secrets. Some thinks that it doesn’t exist.

Tons of monkeys play this relative game of Alpha hunting and ironically 90% of them lose out to the market over the long run. In one particular year, some monkeys can beat the market flat, they earn 20-30% on top of market return but the next year, they become shit, and remain like shit for the next 5 years. Seems like to Holy Grail does not exist after all.

But yet we always hear of people who can do it. They can produce Alpha (earn excess return over the market), not just 1 year or 2 years but 10-20 years. People like Warren Buffett, Peter Lynch, fund houses like Pimco, Citadel etc. Is it possible that the Holy Grail actually exists?

Well, one theory says NO. These Alpha producers are just part of the statistics. If you conduct an experiment for 1,000 monkeys to flip coins, and the winners are the monkeys who can flip the most no. of heads. After 1 round, there will be 500 monkeys who managed to flip heads, that’s probability and statistics. By the same logic, after 8 rounds, there is bound to be 2 or 3 monkeys that actually flipped 8 consecutive heads. Are they skilled coin-flipping monkeys or just part of the statistics? So if we think of the stock market as the coin-flipping experiment, Warrren Buffett, Peter Lynch, Jim Rogers, Pimco and the whole lot of Alpha producers may just be part of the statistics. Actually nobody ever beats the market.

I would like to believe that true Alpha producers do exist. They are the outliers because of the effort they put into sharpening their thinking, enhancing their investment process and improving their rigorous analysis. They belong to the top 10% (of all market participants who beat the market) because they earned it. We have seen this in schools, in income distribution, in sports etc. The best of the best are there bcos they earned it. For the top investors 8%pa return is not good enough and they strive for more. Just as for top students, a pass is not enough. They want straight A's. And top income earners strive to earn the next million. They don’t just lament about how come their salary increment is only 5% this year. They constantly seek to improve themselves and come out with ways to earn more money.

Yes, if you want to beat the market, you need to work harder than the market. (And some luck help, of course). But for those who are not so diligent, the good news is the market return is 8%pa on average. You earn this 8% simply by buying indices. That’s probably the closest to get a free lunch, ever.