On alpha fade rate – The Hindu

We had discussed why popularity is not necessarily good (alpha scalability) when it comes to active fund investing. Now, look at a related characteristic viz. alpha fade rate.

Alpha decay

Alpha fade rate refers to the gradual decay in the alpha strategy. This happens because the rate at which an alpha strategy fades can be faster than the rate at which a newer alpha strategy can be developed. Why?

Alpha is the excess returns that a portfolio generates over its appropriate benchmark. An alpha strategy is a rule a portfolio manager applies to create a portfolio from the investable universe to generate positive alpha. Suppose a portfolio’s investment universe is the 100 large-cap stocks. An alpha strategy can be a combination of fundamental factors such as profit margin, five-year sales growth and net profit growth of firms in the universe and technical factors such as each stock’s price volatility and trading volumes. A portfolio manager and investment team will arrive at an optimal combination of these factors to help them generate alpha returns.

But why should alpha fade? Significant changes to market norms over the years reduced information asymmetry — market participants have access to the same company information. Using this information to test an alpha strategy is easy because of cheap computing power. This means a level-playing field among market participants, especially the institutional investors. Even if one portfolio manager beats the others to designing a new strategy, it may not be long before the others catch up. When many institutions follow the same strategy, it will eventually fade. Note, a strategy must be unique to be able to generate the alpha. Therein lies the problem.

Conclusion

Creating new alpha strategy may not the issue. Rather, the problem is in applying the strategy to the same universe of stocks. Suppose a portfolio manager applies 10 factors to pick stocks and another applies a different set of factors. If both are large-cap managers, they will apply the rule to the same 100 stocks. So, it is highly likely both buy similar stocks, despite applying different set of rules. When a large cohort of managers take similar action, consistently generating alpha becomes difficult. This is true in markets such as the U.S., but emerging markets such as India may not be far behind. You must be mindful of this factor when you buy active funds.

(The author offers training programmes for individuals for managing their personal investments)