THE THREE SOURCES OF ALPHA
Pat Dorsey of Sanibel Captiva Trust was interviewed on Morningstar yesterday to provide some ideas for sources of alpha. He cited an old paper by Russell Fuller who notes the “three sources of alpha”. Fuller’s paper, which can be found here, describes these three sources:
1. Superior (Private) Information: Most traditional investment managers try to generate a better information set. For example, they may try to generate a superior earnings forecast, or they may try to better understandthe economics underlying a particular industry’s profitability. These types of managers are frequently referred to as traditional managers or fundamental managers.
2. Process Information Better: Some investment managers assume that most information is commonly available to all investors and focus their energy on trying to develop better procedures for processing this information. Managers that try to do this in a formal way are frequentlycalled quantitative managers.
3. Behavioral Biases: Scholars in psychology and the decision makingsciences have documented that in some circumstances investors do not tryto maximize wealth and in other circumstances investors make systematicmental mistakes. Both of these cases can result in mispriced securities andboth are the result of behavioral biases.
This is a good expansion point from the Montier post the other day and his ideas on tail risk (see here for more). Of course, investing isn’t just about reducing risk, but also maximizing rewards. Maximizing those rewards is easier said than done. For most investors it’s easiest to just ignore the whole rat race of the markets. If you’re not willing to put in the time and effort to be a great investor you need to accept the fact that you’re not going to have any of the alpha edges described above. This means you need to accept the old Random Walk approach most likely via a diversified portfolio of ETF’s.
For those of us who pride ourselves on being able to outperform the market you need to find that edge. The behavioral edge, though difficult to overcome, is the easiest of the three to overcome in my opinion. This can generally be achieved through a rules based approach or a systematic approach. Unfortunately, you need to develop the system that generates the alpha. Therefore, the behavioral approach overlaps with discovering the quantitative approach. This is your true competitive advantage and generally overlaps with the information edge. Better information results in a better system which can be perfected within a systematic investment approach. Connecting the dots is easier said than done, but these are the building blocks.
In a future piece, I hope to expand on how to put those building blocks together to “close the loop”.
The full interview is attached:
Cullen, how much of a role does MMT play in your information edge? At all?
I believe a sound understanding of the monetary system is crucial to making wise investment decisions. It hasn’t dramatically altered my strategies, but it has definitely helped me better understand the world in which we live and that has played a crucial role in helping to formulate my approach to the markets.
U mean if you had taken a disinflationary trade on commodities after QE2?
No, like understanding the system in a way that helps you build a model which ensures that you’re bullish at the start of QE2 as I was:
http://pragcap.com/why-arent-equities-selling-off-more-significantly/comment-page-1#comment-25855
Or repeatedly stating that you need to be bullish on gold in previous years. Not because you believe gold is a useless rock, but because your understanding of the system allows you to understand how important it is to understand how OTHER investors perceive assets.
(Drools, wipes mouth with back of wrist, blinks, closes mouth slowly, then): Seriously looking forward to that peice that closes the loop!
i certainly dont claim to be a superior investor, but i believe you cant be a superior investor if you dont take a contrarian position, and this ties into the behavioral nexus. buying during pain and selling during joy are counter to the normal behavioral bias. normal behavior dictates that is you feel pain you recoil; feel joy and you expand. doesnt work in investing.
now, to buy a dog that you think simply has fleas only to find it has a terrible case of worms (sorry, started on the dog metaphor and just had to finish it) will not bring you profit, which is where the processing information nexus comes in. you have to be able to see what is likely to be correctable over what time frame.
i have been in and out of financials since 1/09, and have done reasonably well. i like them here because they are trading at about book under circumstances (low interest rate environment, high sloping yield curve) where i think they have a reasonable potential to trend to 1.5 book. also, as the economy improves, book should improve as reserves are wound down.
i use this example because alot of investors (especially this blog’s readers) wouldnt even think about financials because they are down and under some distress. that’s where the opportunity is, and you are making a behavioral mistake not to consider them. now, of course, i may be making a information processing mistake to be invested in them now on the belief that they will improve over the next 6-18 months.
anyhow, could post cullen.
not “could post” but “good post”….oy
“If you read the annual reports from start to finish, you have done more than 90% of people on wall street do”. jim rogers and charlie munger.
Just to give an example i’ve worked for a CEO of a major bank before he became CEO for a board he’s on where he’s involved heavily and i understand during our conversations with him and his staff that half the time they do not exactly know what’s going on inside ( case in point – a long time friend of mine working in their risk department, he’s on the job a few months came to me with a problem saying that the way he calculated the risk is 10-20 time as much as what was being shown in the departments reports sent to c level this was during 2005 & 6.
If the management of those financial institutions does not know exactly what’s going on in there, what can someone else from outside and with legalistic reports have an edge. ( especially when you remember that buffet said that he knows better than any bank supervisors about the banks in his holdings – how much he would have lost had it not been for the bail out- just to say that even he isn’t infallible when it comes to Banks)
Cullen, what do you think about Bill Gross opinions about economy? They in Pimco are certainly keynesians.
“Superior (Private) Information”. More often than not, that should be “Inside Information”. Expert networks, power breakfasts, confidential briefings etc. are all conduits for nonpublic information and insider trading. It’s Wall Street’s worst kept secret, and finally the SEC is beginning to catch on.