It was a huge game-changer when Yahoo message boards begin to fill up with posts from people doing legwork on individual companies. When someone reported that XYZ Tech’s employee parking lots were filled with cars 24/7 -- including weekends -- anyone paying attention understood that business was booming and that sales were going to beat investor expectations. For the few who grasped that, this was a period of large trading profits.
This advantage exists only when a small number of people know what a large number of people are going to find out too late to act on. When everyone knows, the advantage disappears.
• Too much capital chasing too little alpha: According to Nobel winner William Sharpe, there is only a finite amount of alpha, implying that trading is a zero sum game. Thirty or so years ago, there was greater information asymmetry. When pension and endowment funds were smaller and less invested in alternatives (like hedge funds, venture capital and private equity), there was more alpha to be divvied up among fewer players.
• Alpha is really only factor-based investing: What was once believed to be outperformance might be explained by specific portfolio characteristics, such as momentum, earnings quality and other features. Once these so-called factors and any additional risk are accounted for, the alpha all but disappears.
Nobel Prize winner Eugene Fama and Kenneth French developed the five-factor asset pricing model in which they found that various factors can account for “between 71% and 94% of the cross-sectional variance of expected returns.” In other words, alpha is more the result of these specific factors than most investors realize.
Other theories abound: Active managers have failed to adapt to the unique circumstances of the Federal Reserve’s monetary policy in response to the financial crisis; it’s easier than ever to put together complex, math-driven investment portfolios that would have been impossible in the past; the rise of passive investing is only a temporary shift and eventually the cycle will turn.
I suspect that the changes we have witnessed are of a permanent nature -- active management might again have its day in the sun, but those days will be fewer and further between than they have been in the past.