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: