How fund managers get alpha?
Alpha(=α), often defined as the active return on an investment, gauges the performance of an investment against a market index and is used as a benchmark. Long-only active equity funds are expected to earn higher alpha against their benchmarks such as equity indexes and so are long-only active bond funds higher than bond indexes.
Equity indexes are, for example, S&P500, FTSE100 and DAX. Bond indexes are Citigroup World Government Bond Index, Barclays Capital US Treasury Index and so on.
While, hedge funds pursue absolute return, they prefer setting their reference indexes to actual benchmarks, using HFRX(Hedge Fund Research Index), Credit Suisse / Tremont LLC index and Eurekahedge for each strategy.
Let’s see how active funds earn excess returns.
For long-only funds, especially equity funds, the source of excess returns are based on stock selection. So, it’s all up to fund managers whether they can pick good stocks that will make excess returns than the benchmarks in the future. In other words, stock-picking skill is literally value-added of the fund or fund manager.
However, now is a hard time for such long-only stock pickers because there are few differences between professional investors and ordinary individual investors when it comes to getting information for investment decisions. Advancement of IT technologies and further disclosure requirement have made professional players compete with amateurs in the same boat.
In addition to such evolutions, internal information that only a few executives know is hidden and unobtainable in many cases. We see some corporate scandals revealed suddenly and the stock prices dramatically dropped because, for example, nobody knew about the scandals except the president. Toshiba’s case is atypical; Their financial statements have been made up by three consecutive president for 10 years or so in order to cover up the huge loss which occurred in the nuclear power plant business.
This means that no fund manager can sell the stock before the bad news comes out. Then, they are forced to hold the stock until the price comes back. This is not active but a very passive investment strategy anyway.
Also, technically speaking, the less stocks the portfolio has, the more volatile the portfolio becomes. The more stocks the portfolio has, the closer the performance is to its benchmark. Thus, there is less opportunity to get excess return from the portfolio.
Although there are always excellent fund managers who are highly capable of stock-picking at any time, it is also true that it is very hard for fund managers to find out the potential of the companies they invest in. Like or not, we are facing low-growth economies now.
Besides, because of its higher ratio between management fee percentage and yields, bond funds are getting harder and harder to obtain excess returns.