Unfortunately for active managers, this “pool of victims”, or investors who make bad choices, is shrinking. Swedroe and Berkin point to research which illustrates that the losers of the zero-sum game tend to be non-professional, individual investors. The Number of Bad Decision Makers is Shrinking, Tightening the Competition Or, as Nobel Laureate Bill Sharpe put it, the quest for alpha is a zero-sum game. Therefore, the pool of alpha available to active managers is limited to the sum of mistakes made by uninformed and undisciplined investors. After all, if the market return is simply the weighted average performance of all market participants, then for each participant who makes a winning investment choice there must be a loser who has made a bad decision. In their view, Yale’s inability to generate alpha is a result of the high degree of competition in modern securities markets. They cite academic studies which indicate that – aside from private equity – Yale hasn’t generated any alpha. ![]() Although Swensen has outpaced industry benchmarks and his endowment peers over the course of his tenure, the authors argue that a high-risk investor could match Yale’s performance with passive index funds and a little leverage. Alpha, the Product of a Zero-Sum Game, is a Finite ResourceĪfter taking down the Oracle of Omaha, Swedroe and Berkin shift their focus to another legendary investor, David Swensen, the Chief Investment Officer of Yale’s Endowment Fund. ![]() But the authors don’t take all the credit away from Buffett, acknowledging that it took skill to identify those risk factors and invest in them before they became popular. To support this position, the authors reference academic research which finds that Buffett’s outperformance can be explained by his exposure to risk factors like size, value, and leverage, not his stock-picking skills. ![]() Swedroe and Berkin refer to this phenomenon as the “shrinking pool of alpha.”Somewhat controversially, the book applies this concept to Warren Buffett’s market trouncing track record, claiming that Berkshire Hathaway has generated a “statistically insignificant” amount of alpha. Naturally then, as our understanding of risk matures, the amount of unexplained return, or alpha, decreases. The Pool of Alpha is Shrinking as Alpha Becomes Beta In this case, he did not generate any alpha because his excess return can be explained by the elevated risk, or beta, of his portfolio. Over a meaningful investment horizon, this manager should earn a higher return than a benchmark comprised of large-cap equities, because he is invested in smaller, riskier companies. Take for example a US equity manager who outperforms the Russell 1000 index, but “cheats” by adding highly volatile microcap stocks to his portfolio. Thus, the key to accurately estimating an investor’s alpha is properly assessing the amount and type of risk, or beta, in his portfolio. Swedroe and Berkin define alpha, or investing skill, as “returns above the appropriate risk-adjusted benchmark.” Put another way, alpha is the portion of an investor’s return that is not explained by the level of risk in his portfolio. Alpha is the Return from Skill, Beta is the Return from Risk This matters because active managers must prove the ability to generate alpha in order to justify charging higher fees than an index alternative. The basis for this assertion is that the pool of alpha available to investors is both shrinking and getting more crowded with skilled competition. The thrust of this work is that active management is a loser’s game, which will only get tougher to win going forward. Buffett would find kindred spirits in Larry Swedroe and Andrew Berkin, collaborators on the recently published book The Incredible Shrinking Alpha. In Berkshire Hathaway’s 2016 annual shareholder letter, Warren Buffett estimates that active investors have wasted over $100 billion seeking to beat the market over the past decade.
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