Why Passive Investing Generates Alpha

Markets are pretty efficient. Most of the currently-existing research, analysis, and information is reflected in the price of assets. This means that generating “alpha” is difficult. You must exploit mispricing in the market, profiting as the market “corrects”.

For this mispricing to exist, the asset must be “incorrectly” priced in the first place. But this is rare. Mispricings get corrected. Alpha gets arbitraged away. As others realise the mispricing, they enter the market with the same trade, shrinking the spread between the theoretically correct price and the actual price. This process continues until the alpha is no longer available.

How to win

Why do markets arrive at the “incorrect” price? Something about the information, or analysis, or research, or psychology, or cognition, or something else of some of the market participants is defective. But not all of them – some will be without these defects. These non-defectives can trade with the in-some-way-defectives to generate excess returns, because they are pricing assets differently and can therefore agree on a price to trade that both think is a good deal.

To be less defective consistently means you have to have a consistent advantage over other market participants. These advantages fall into one of the following categories:

1. Analytical. Can you think better than others? Do you employ better analytical techniques? Do you have a more accurate model of the world? Example: Renaissance Technologies. They use, to put it lightly, advanced mathematical models to analyse prices, correlations, spreads, and other things to identify profitable trades. They have more analytical capability than anyone else.
2. Technological. Do you have better technology than others? More computational power? Can you compute/execute quicker than others and at a larger scale? Example: Michael Lewis’s “Flash Boys”. These boys obsessed over speed – seeing order flow before everyone else did and being able to execute trades quicker than anyone else, due to better technology, gave them an advantage.
3. Informational. Do you know more than other people? Do you have better information? More data? Example: Billions. Bobby Axelrod and co. were constantly sniffing out information and milking their extensive networks for any type of news that would give them an edge. Although fictional, this is reflective of reality.
4. Psychological. Can you buy when everyone else is selling? Can you avoid investing in bubbles? Example: Warren Buffet being “Greedy when others are cautious and cautious when others are greedy.”

How to be alpha

But, wait, let’s take a step back – what is “alpha”, exactly?

Alpha is usually defined as the return in excess of a comparable market. It doesn’t make much sense to claim I am generating alpha when I return 5% if the market I am trading in generated 7%. I could have just bought everything at the start of the year, gone to Spain to eat tapas and drink sangrias and come back to collect 7% returns.

When most people talk about alpha, they talk about return less the return of the market:

alpha = R(p) – R(m)

A more technical definition is Jensen’s alpha. This is based on the Capital Asset Pricing Model (CAPM) – on the idea that we only care about uncorrelated excess returns. Because this results in excess return whilst volatility remains constant, due to diversification. That is true alpha – otherwise we can just slap as much leverage as we want on the market as a whole to generate as much return as we like. But this will result in higher volatility, which is a bad thing. According to CAPM:

alpha = R(p) – [R(f) + B x (R(m) – R(f))]

where R(f) is the risk “free” rate of return and B is a measure of the volatility of the portfolio in comparison with the market as a whole.

What happens when we just buy the market? In the simple definition, alpha = R(m) – R(m) = 0. No alpha for us. Using CAPM, alpha = R(m) – [R(f) + 1 x (R(m) – R(f)] = 0. Still no alpha. Sad.

So, by these definitions, passive investing, viewed in a single market, cannot generate alpha.

But this neglects the fact that assets exist as part of a portfolio across several markets. It doesn’t make sense to analyse our alpha-generating capacity in each particular market – who cares? I only care about the returns of my portfolio in aggregate and over time.

Being beta is cool now

We need a new definition of “market” return to act as a benchmark for comparison. Rather than looking at the total returns of assets in an individual market, we can look at the returns of investors. Now, alpha becomes R(p) – R(i), where R(i) is the return of the typical investor (AKA the median return).

Note how our required excess returns advantages explained at the start of this piece haven’t changed; to generate alpha, you must still have one of these advantages. You must still be “better” than the average investor in some way.

How can we do that?

They are professionals for a reason

To answer that we must know who these market participants are and what they’re good at.

Most markets are composed mostly of institutional investors. Let’s go back to our original advantages – do you have an edge over institutions?

1. Analytical. Can you analyse assets better than the combined brain power of professional institutions?
2. Technological. Do you have better technology than companies?
3. Informational. Do you have access to more/better data and a better network than investment teams?
4. Psychological. Do you have a longer investment horizon, a stronger commitment to sticking to a strategy, and fewer incentives to generate quick-and-easy returns?

The answer to the first three for the vast majority of people will be categorically NO.

But there is hope – retail investors can generate alpha by utilising their psychological advantage.

Your advantage

Because passive investing, done correctly, should be robotic and unconscious. You should buy at set times and in set quantities via DCA, or at least have rules for buying and selling. Yes, you can be a little more aggressive in down years, and cautious when the market is booming, but this emotionless method should be the bedrock of your investing technique.

Institutions have analytical, technological, and informational advantages…but not psychological. These professionals are worried about their jobs. They don’t want to get told off by their bosses. They want gold stars and pats on the backs and promotions. This means they are subject to panic in down years and return-chasing is up years. They are human, too. Their other big psychological disadvantage is the time scale by which they operate. They are usually thinking about the P/L this week/month/year – not 30 years from now. They are too short-term-focused.

But they are not your only competition. The market – any market – is dominated by institutional investors, but retail investors participate, too. These investors – beginners, investors who think they can beat the market, day traders, etc. – are prone to panic when the outlook is negative, and to get too excited in bull markets. They feel FOMO intensely, joining bandwagons, investing in bubbles, and end up holding the bag when the bubble bursts. They trade too much, incurring fees. They are convinced by active management pitches, investing after a few good years of performance only to be disappointed when the fund regresses to the mean in subsequent years.

This is why you can beat these guys. All of them. Because Y.O.U have the following:

• Ability to buy cheap. When others are panicking and selling, either out of fear or to protect their P/L, you continue to buy. You continue to invest, to reduce your average buy price.
• No FOMO, no bubbles. You don’t participate in trends, in fads, in hype cycles. Sure, this means you’ll miss out on some eye-watering returns. But this also means you won’t be holding these assets when the bubble bursts. This is important because, in investing, losses matter more than gains.
• Long-term investment horizon. This means that you are 1) not concerned with short-term P/L and can afford a few down years in order to win bigger later on and 2) you leave investments to compound. Your portfolio grows more than others’ because it is constantly being added to and you don’t sell, meaning the assets perpetually grow.