Daily Academic Alpha: Dude, Where’s my Alpha?
Alpha is the most popular measure for evaluating the performance of both individual assets and funds. The alpha of an asset with respect to a given benchmark portfolio measures the change in the portfolio’s Sharpe ratio driven by a marginal increase in the asset’s portfolio weight. Thus, alpha indicates which assets should be marginally over/underweighted relative to the benchmark weights, and by how much. This study shows that alpha is actually a bad guideline for portfolio optimization. The reason is that alpha only measures the effects of infinitesimal changes in the portfolio weights. For small but finite changes, which are those relevant to investors, the optimal weight adjustments are almost unrelated to the alphas. In fact, in many cases the optimal adjustment is in the opposite direction of alpha – it may be optimal to reduce the weight of an asset with a positive alpha, and vice versa. Rather than employing alphas as a guideline, one can do much better by direct optimization with the desired constraint on the distance from the benchmark.
We provide new evidence for diseconomies of scale at the mutual fund level. Building on Berk and Green (2004) and allowing for gradual adjustment to equilibrium, we show that (quarterly) changes in fund performance are strongly negatively related to lagged predicted fund flows. We find that alphas would be more cross-sectionally dispersed and more persistent without the damping effect of flows. Thus, flows are an important factor behind the lack of predictability in mutual fund performance. This flow mechanism is strongest for smaller and more active funds with higher expense ratios, suggesting that it is related to the stock illiquidity and costly search for investment opportunities.
Note: This site provides NO information on our value investing ETFs or our momentum investing ETFs. Please refer to this site.
Join thousands of other readers and subscribe to our blog.
Please remember that past performance is not an indicator of future results. Please read our full disclosures. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.
Definitions of common statistics used in our analysis are available here (towards the bottom)