How to escape the clutches of the 'incredible shrinking alpha'

Author and speaker at upcoming WP Connect event puts forward five reasons why active management has been collapsing over the past 70 years

How to escape the clutches of the 'incredible shrinking alpha'

Wealth management is under siege from the “incredible shrinking alpha”, with active management collapsing over the past 70 years.

That’s the view of Larry Swedroe, chief research officer at Buckingham, who will deliver the closing speech at the virtual WP Advisor Connect event on July 28 titled Technology – Redefining the Future of Advice. The event is free for advisors, and registration details can be found here.

With co-author Andrew Berkin, Swedroe has just completed the 2020 updated edition of his book The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches, with new studies on what investors should do with this information. Some of the key moves around building portfolios will be explored during his speech later this month.

In the meantime, Swedroe set the scene for WP by explaining his five big themes around why alpha is shrinking.

The first one revolves around how beta doesn’t just mean market beta but means a trait or characteristics that's common. You could, therefore, have beta on a size factor (like small stocks), or quality, or low volatilityor whatever you wanted. With the first asset pricing model, CAPM, you could outperform it simply by owning small and value stocks, which had higher returns over the long term. An advisor could claim alpha relative to that one factor model.

Research from Fama and French created a three-factor model, which showed the returns for those managers wasn’t alpha, wasn't stock picking or market timing but was exposure to these common traits, which you could actually get through an index fund or similar paths of strategy, avoiding the high fees and trading costs.

Swedroe said: “If you were a value investor and beat the market because of that, well, you get credit because you figured it out before the academics. But once that's published, now you can get it in an index-type fund and it's beta, and you can't charge for it because it's a commodity.

“It gets exposed as beta, so momentum got added, then profitability and quality got added. Take [Warren] Buffett, for example … we know almost all of his returns are explained by these models. It doesn't take anything away from what he accomplished because he figured it out decades before everyone else but, today, you can no longer claim alpha because you own low volatility stocks or quality stocks or value, and you can get any of these factors in low cost ETFs, which are highly tax efficient.”

What were sources of "alpha" are gone, dramatically reducing the ability to generate alpha. The second major theme is that the supply of victims on the wrong side of the trade has gone down. Swedroe explained that the market is a zero-sum game before expenses – and a negative-sum game after. Out of institutional and retail, research shows retail is the “dumb money”.

He said: “Coming out of World War 2, 90% of stocks were run by individual investors, so Buffett could easily exploit them. Today, 90% of all trading is done by institutions and high-frequency traders, and they’re just as smart as Buffett. There’s not enough dummies to exploit anymore, so that's another sponsor of alpha that disappeared.”

The third theme is that the competition has just got tougher. Today, those who manage money are highly educated and have powerful computer programs to help them identify the sources of risk and mispricing. Plus, the weak managers drop out and those funds disappear and die. Swedroe added: “The share of active versus passive is going clearly in favour of passive. Who's dropping out? The less skilled [active managers], so the remaining competition keeps getting tougher and tougher. Although I would say every year a few new suckers are born!”

The fourth theme is the amount of cash trying to generate alpha has exploded. The author said that 20 years ago, the entire hedge fund industry was $300 billion, while today it's $3 trillion. Again, he explains how that breaks down.

“For argument's sake, say 20 years ago there was $30 billion of alpha out there through mistakes and mispricing, so the $300 billion hedge fund industry could generate 10% a year before expenses. Maybe their expenses took half of that, so they'd have 5%. Today, $30 billion is not 10%; it's 1%, and their costs alone are two and 20. That's why hedge funds have had God-awful returns. There's too much money and the competition's gotten tougher and the number of suckers at the table is way down.”

The final theme is that trading costs have come down, so some of the limits to arbitrage that exists to allow miss-pricings to continue are also gone. Swedroe said: “The obvious conclusion is that the likelihood of winning the game of active management is going to continue to decline, even as the percentage of active management goes down. The remaining competition is going to get hotter and hotter because the men and women left standing are more skillful than the people who were playing before."

To check out the full agenda, click here.