The End of Alpha

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Published on Monday, 06 August 2012 14:52

Written by Andrew Snyder, Editorial Director, Inside Investing Daily

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Too many investors yearn to "beat the market." They're setting themselves up for failure and mediocrity. Instead of trying to outpace the herd, eliminate risk.

One of my favorite writers is Ernest Hemingway. He could throw a knockout punch and lay down a line of prose... all without ever getting down from his barstool.

He was a complicated and fierce man yet a very simple writer.

One of his best short stories is one most folks have never heard of. It's called "The End of Something."

It's about a summertime love that's run its course. There's no fighting. No arguing. Nobody gets caught cheating.

The lust simply ends.

The girl rows the boat home. Young Nick walks the beach and fishes.

Life goes on.

Hemingway's story reminds me of a line uttered by a hedge fund manager I spoke with last week in Denver.

"Alpha is dead. Long live risk-adjusted return," he said.

It's not poetic. It's certainly not worthy of a literary discussion. But if you're an investor... it is the most important couple of sentences that you will read all year.

The idea of consistently outsmarting the market has faded. It was a rip-roarin' love affair while it lasted. But the flames have been extinguished, and both parties are happy with the idea that "it's not you... it's me."

If you're not familiar with the term, "alpha" is the industry's win/lose barometer. If the market rises by 5% and your portfolio returns 7%, the difference between the two is alpha.

It is considered a measurement of the "skill" of an investor.

The problem, though, is that very few professional investors manage to consistently beat the market. Legg Mason's Bill Miller was the king for a while... but then his bets went sour. He lost 55% one year and never caught up.

It's because of guys like him that the love affair with alpha is over.

I'm glad to see it go. It was a flawed relationship from the start -- like two stars married merely for the publicity.

Now that the breakup has started, the industry is shifting in our direction. Finally, the big money managers are using the logic that I've long touted to Unconventional Wealth readers.

Unless you're investing into perpetuity, benchmarking against an index is pointless. You set yourself up for failure and mediocrity.

Instead... measure risk.

In almost every issue of Unconventional Wealth, I somehow end up on the topic of the Sharpe ratio. It's not by design. It's just that the concept is that important.

In the simplest of terms, the ratio shows us whether or not we are adequately compensated for the amount of risk we take with each asset.

The higher the figure... the better.

But the Sharpe ratio truly stands out because it allows us to compare apples to apples. Not the conventional apples to a bushel of oranges.

If Asset A and Asset B are nearly identical, but Asset A has a higher ratio... buy it.

It's the perfect way to maximize return and minimize volatility. And just like Hemingway's writing, it's a simple and efficient equation.

But here's what has me worried: The herd is on our trail. When a major money manager announces the death of alpha, it won't be long until the sheep are grazing in our fertile pasture.

Am I going to change my strategy? No. It's worked too well.

In fact, over the next 12-18 months, as volatility rises and the herd nips at the heels of Bernanke's free money, our strategy will become more valuable than ever. There's no better way to eradicate risk and maximize return.

Hemingway aptly proved that there is more than one fish in the sea.

I am convinced that the greedy herd will move right on, past our homely strategy, and will fall in love with the next hot idea that comes along.

Meanwhile... we'll stick with our old flame. She's treated us so well.

Editor's Note: While U.S. leaders are distracted by the election, the stock market will be attacked. Congress is about to be caught with its pants down. Distracted by the election, its actions will lead to a direct attack on the stock market. Research indicates this attack will occur on Oct. 1 -- just one month before the election. Two more attacks will follow until the market has crashed. The result will be devastating for your personal wealth...

Unless you act right away to protect your money. I'll show you a more potentially profitable alternative to the stock market in this letter. With this information, you could be getting rich while the market panics.