In 1688, Joseph de la Vega eloquently described profits on the exchange as the treasures of goblins, constantly shifting in form from carbuncle stones to coals, diamonds, flint stones, morning dew, and tears. This poetic depiction of the trading of shares on the Amsterdam Stock Exchange can also be applied to the modern-day pursuit of alpha – that elusive extra return investors seek. Despite the eagerness of investors to capture this alpha, academics struggle to define it rigorously due to the lack of an agreed-upon market model.
Alpha remains an enigma, with historical evidence showing limited ability to forecast security prices. Recent studies reveal that a significant percentage of large-cap mutual funds and institutional portfolios have underperformed market benchmarks by a considerable margin. The quest for alpha is compounded by its short-lived nature, fading away as investors attempt to exploit it.
While alpha may be challenging to capture, the costs of active investing are tangible and impactful. Investment expenses, including management fees and carry, are factual and measurable components that often go unaddressed. Inadequate disclosure of investment expenses by public pensions and endowments adds another layer of complexity.
Cost of active investing is directly proportional to the percentage allocation to alternative investments, as evidenced by the significant expenses incurred by institutions like Harvard University. Studies show that balanced mutual funds, public pension funds, and endowments often underperform market indexes by amounts equal to their costs.
In light of the increasing efficiency of both public and private markets, the focus on cost for active investors becomes paramount. Recognizing the burden that institutional investing costs pose, there are recommendations to reconcile elusive alpha and corrosive costs:
- Comprehensive understanding and acknowledgment of the investment program’s costs throughout the organization.
- Rethinking portfolio design to align with contemporary institutional investing realities, emphasizing passive investments over high-cost alternatives.
- Establishing an expense budget alongside a risk budget to foster cost-conscious investing.
- Evaluating performance against a simple passive benchmark to provide a transparent assessment of portfolio success.
Ultimately, the choice between a conventional portfolio laden with costly strategies that underperform or a more passive approach that outperforms by a smaller margin highlights the importance of reducing costs to give alpha a chance.
