Feb 18
Alpha – A New Definition
Yesterday a new book arrived in the mail and it is absolutely the most beautiful investment book I have ever laid eyes on! It is Mark T. Hebner’s “Index Funds: The 12-Step Program for Active Investors.” I’ve been paging through Hebner’s book and I came across these few paragraphs under the title, Changing the Definition of “Alpha.” Here are some quotes.
“The Fama/French Three-Factor (Five Factors with bonds) Model changes the definition of alpha. According to the one-factor Capital Asset Portfolio Management (CAPM), alpha is the amount by which an active money manager outperforms a broad market index. The Fama/French Three-Factor Model defines alpha for equities more precisely as the return an active manager achieves above the sum of the portfolio’s expected return due to all three equity risk factors. Alpha measures a manager’s skill in earning a return tha couldn’t have been achieved by indexing the same exact risk exposure as the portfolio run by the manager. In short, did the money manager earn anything above the indexed return?”
“A small-cap manager may overweight value stocks relative to a benchmark such as the Russell 2000 Small-Cap Index. As a result, the manager outperforms it. But if the extra return was simply compensation for taking additional non-diversifiable market risk, why should the manager get credit? The job of an active manager is to consistently outsmart the millions of other traders who get the same news at the same second and through this process provide additional returns that can’t be achieved through indexing.”
After reading this material and similar statements in other books, I realize the wonderful performance of the Passive Portfolio is due to taking on additional risk, even though the portfolio is diversified. You will hear more about the Passive Portfolio in later posts.
Physlab