Where has all the alpha gone?

One of the biggest factors that investors have to deal with when turning their philosophy into a strategy is trying to figure out where their opportunity set lies. Competition in the markets has never been stronger, making it harder than ever to earn the elusive market outperformance that so many institutional investors actively seek.

In their book, "The Incredible Shrinking Alpha," authors and investors Larry Swedroe and Andrew Berkin lay out the case — backed up with loads of academic research — that risk-adjusted outperformance, or alpha in industry-speak, is becoming harder than ever to come by these days. But the reason has nothing to do with the old theory that a dart-throwing monkey can beat the investment professionals because they're all really emperors with no clothes. In fact, it's the opposite. Professional investors are more informed, more highly educated and more competitive than ever before. Yet they are all competing for a shrinking slice of the alpha pie.



This is what author Michael Mauboussin calls the paradox of skill. Mauboussin says, "It's not that managers have gotten dumber. It's precisely the opposite. The average manager is more skillful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results." How many institutional investors bother to ask themselves if the investment managers they are investing with are lucky or truly exhibit skill?

Swedroe and Berkin go on to cite the work of David Hsieh, a finance professor at Duke University's business school, who concluded that there is roughly $30 billion of available alpha for the entire hedge fund industry. It's impossible to know if this number is correct or not, but let's assume it is for the sake of argument. In 1990, there were roughly 600 hedge funds managing close to $40 billion in assets. Today there are well over 10,000 hedge funds collectively managing close to $3 trillion. That $30 billion in alpha is much easier to share when there are fewer funds. The opportunities that were once available to these funds just aren't quite there anymore.