Monday, March 6, 2017

Incredible Shrinking Alpha

I have seen a lot of recommendations for The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches so maybe my expectations were too high, because I didn't like it. To me, it sounded like the same efficient market BS that one has been able to read about for decades.

The thesis of the book is that there are too many smart people now looking for market outperformance, and therefore it has gotten incredibly difficult to do so. There were occasionally some reasonable arguments to support this thesis. For instance, individual investors as a percentage of the entire market have dropped considerably over the decades. The authors argue that institutional investors are slightly more savvy, and as a result opportunities for enterprising investors are harder to come by.

But in my view there were also some major holes in their arguments. They use past data to find some factors that performed well over time (e.g. value, momentum), and then argue that managers who performed well over this period that had exposures to these factors merely took on more risk. Arguing that exposure to these factors is not risky is not something one can reason about with these guys either, because they have defined risk, rather than derived it, this way.

It seems crazy to me to just assume these factors are risky, especially when the factors sometimes make no logical sense, instead just fitting the data. Case in point, the factor for momentum is: the average return of the top 30% of stocks minus the average return of the bottom 30%, where returns are calculated over the last 12 months, but excluding the most recent month. Talk about force-fitting! So if over the next 20 years, the stocks with the 10% highest momentum over the last 18 months but excluding the most recent 3 months have the best returns, some guy will claim most outperformance is explained by this factor and therefore he outperformance was a result of taking on more risk?

There were also some aspects the authors completely ignored. For example, the average holding period for stocks has declined tremendously for example. As the market focuses myopically on the near-term, might there be opportunities for investors who focus on the long-term? Totally ignored by the authors, who seem only interested in one dimension: linearly factoring historical returns, and implicitly assuming these don't change going forward.

There is definitely a trend towards indexing in the market today. This is probably because the indexes (e.g. the S&P 500) are hot. But these things go in cycles. When too many people index, it likely results in prices that fluctuate too far away from intrinsic value, setting up another cycle where it becomes easier to outperform the market. But of course, in the aggregate, because of higher fees, active investors will always underperform. But you don't need a whole book to point that out, so I wouldn't read it.


Anonymous said...

How goes your performance YTD?


Anonymous said...

I agree. Book was a waste of money

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