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It is prudent to have an idea which reflects your tolerance to risk

It is prudent to have an idea which reflects your tolerance to risk

When men refer to themselves as “alpha males”, I hear that in the context of software, alpha versions are unstable, missing important features, filled with flaws, and not for the public.

I’m sorry, this is a borrowed joke, and nonetheless, it sets the ground for my argument; that what we know as Alpha in finance is an equally “problematic” concept. Pardon my hyperbole, but it seems these days the odds of seeing a “flying saucer” are much higher than generating alpha.

This extra return that investors clamour for has become as elusive as the wind. Even when significant positive alpha gets generated, that incremental return is wholly skimmed by the fund managers via fees. What to do?

Note: A positive alpha indicates that the investment has outperformed the market index, considering the risk taken. Conversely, a negative alpha suggests underperformance.

Now, whether you believe in efficient markets theory (says markets are fairly priced hence no room for excess profits) or not, the reality is for all to see. A major portion of global assets are now firmly under passive strategies.

Partially, the lack of alpha explains this ongoing trend towards indexing. BlackRock, the world’s largest asset manager, with $12 trillion strong in managed assets, has over two-thirds of these assets under passive strategies.

Vanguard and State Street, which follow closely in size, are also widely known for their index products. Besides, S&P Global continues to show the world that most active strategies fail to beat their relative benchmark indexes.

While I have been accused in the past for referencing S&P SPIVA research, its wide and varied sample size makes it highly relevant and applicable locally.

So, is seeking positive alpha a worthy objective? Yes. But is finding top performing managers easy? No. This is not to say that skill does not exist in the fund management industry.

On the contrary, skills may be increasing as some studies show. But it’s the same reason explaining shrinking alpha opportunities (too many skilled managers chasing the same alpha). But even when you do locate this group, they are just like mist; they appear for a little while and then vanish.

Afterwards another set appears. This is because while it’s easy to identify these high performing managers after the fact, there’s no evidence of the ability to do so before the fact. Hence the familiar disclaimer required by the regulator; “past performance is a poor predictor of future performance.”

To a (potential) mutual fund investor, evidence in favour of positive investment in actively managed equity funds is currently weak.

However, the lack of index strategies in this market makes evaluating your performance relative to a simple passive benchmark (subject of my next article) more important.

Let’s call this passive benchmark your reference portfolio which may be purely stock or a bond index, or a combination of both. The idea is to have a basis that reflects your risk tolerance.

That way, a conventional portfolio that underperforms a legitimate reference portfolio say by 100 bps or more per year will be clear that your fund manager’s performance is sub-par. In that case, their alpha strategies beta improve (pun intended), if not, question why you’re paying for alpha-type fees for beta performance.

Mwanyasi is MD, Canaan Capital

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