“Sustainable Alpha” or Why an Investment Advisor’s Job Isn’t What You Think It Is

“You keep using that word. I do not think it means what you think it means.” Inigo Montoya from the 1987 film The Princess Bride.

“Alpha” is the holy grail of investing. Alpha simply means outperforming the appropriate risk-adjusted benchmark. Basically, alpha shows whether an investment manager is adding value.

The object of every active investment manager is to achieve as much alpha as possible. The object of every investor is to find those managers that achieve alpha.

Here’s the problem: Alpha is exceeding rare in the investing world, and, what’s more, it doesn’t seem to last long when you find it.

Indeed, Larry Swedroe wrote a nice book called “The Incredible Shrinking Alpha!” that shows how investment managers’ ability to capture alpha via clever and unnoticed strategies has shrunk dramatically over time as academics have uncovered their methods, which, in turn, has allowed other investment managers or even index funds to replicate those strategies.

So, is alpha dead?

Well, yes and no. Alpha generated by being smarter than everyone else in the room for long periods of time – what I’ll call IQ Alpha – appears to be going the way of dial up internet. It’s simply too difficult in a world of super computers, huge data bases and armies of genius-level finance experts (whom I’ve heard look a bit like this) to outsmart Wall Street for long.

However, all hope is not lost. A different form of alpha is achievable, and not just achievable, but achievable by us mere mortals. But beware, while this form of alpha doesn’t require a perfect SAT score, it does require something rarer: Discipline. Wes Gray, a former finance professor at Drexel University and founder of the investment firm Alpha Architect, calls this other form of superior performance “Sustainable Alpha.”

Wes uses a great poker analogy to explain sustainable alpha. For poker players, picking the right table is crucial. You need to know who the fish (the suckers) at the table are and who the sharks are. What’s more, you need to figure out a way to beat the other sharks.

The Fish

We know from actual results that your average investor is a fish. Tricked by brains that evolved to stay alive in the wilderness not Wall Street, investors make a host of behavioral mistakes that lead to mispricing any number of assets. We’re simply not mentally built to make good investment decisions.

The Sharks

Hedge fund managers, mutual fund managers and institutional money managers are the sharks. They literally have rooms full of the smartest minds in the world analyzing huge amount of data looking for any little advantage.

Looking at these competitors, we quickly realize that we’re not going to beat them via superior brain power. (Heck, they can’t even beat each other because their big, throbbing brains are canceling each other out.) Luckily, they have an Achilles’ heel that we can exploit.

Those asset mispricings that investors create through their bad behavior, well, they come with a poison pill for our fellow sharks.  You see, those mispricings that sometimes unfairly drive asset prices too far down or too far up can take a very long time to get corrected. A shark that tries to take advantage of those investor mistakes may have to wait years – sometimes more than a decade – to get rewarded.

This presents a serious problem for hedge fund managers, active mutual fund managers and institutional money managers. While they may be willing to wait, their investors are not. Research and surveys show that most investors won’t tolerate “underperformance” for more than a couple of years – if that. Money managers know that they can profit from investor mistakes over the long run, but they also know that their clients operate in the short run.

Employing a strategy that captures the alpha created by investors’ behavioral mistakes will get them fired, and they know it. For them, the alpha dangles just out of reach on a cliff’s edge.

That’s what makes Wes Gray’s alpha sustainable. Big-time money managers face too much career risk to go after it. The other sharks at the table can’t take that pot of cash.

But what if an investment advisor was careful about picking clients and helping them understand what investing really means? What if an investment advisor figured out that his or her real job was less about being the smartest guy in the room and more about educating clients on investing fundamentals and, more importantly, investing history so they were mentally prepared to wait out the eventual periods of underperformance?

As Wes likes to say, “To capture sustainable alpha, you need sustainable clients.”

People often think that an investment advisor’s job is to make a lot of moves, reacting to or anticipating trends in the market. It’s not. A good investment advisor is, above all, an educator. An educated client stops being a fish. An educated client with enough of an understanding of our investment strategy to maintain the discipline needed to capture sustainable alpha becomes a shark.

Stop being a fish and start being a shark!

About Mark Helm, CFP, EA

Mark Helm is a Certified Financial Planner and Enrolled Agent. He is the founder of Helm Financial Advisors, LLC, a fee-only financial planning firm dedicated to helping people reach their life goals.
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