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Alpha is sexy

February 10, 2020

reading time: 3 minutes

by Sidi Staub, LGT

Leading investors have a great alpha

Alpha males are the strongest and smartest members of a pack, which makes them attractive to the opposite sex. And that doesn’t just apply to the animal kingdom: investors find alpha sexy too.

In financial jargon, alpha refers to the excess return of a securities portfolio relative to the return achieved by its benchmark. For example: if you invest in German stocks, your benchmark is probably the DAX, i.e. the German stock market index. If the DAX falls by two percent and your portfolio gains one percent over the same period – without having taken greater risks than the DAX – then you have achieved an alpha of three percent. Congratulations!

As you can see, understanding alpha is not that difficult. However, it is very difficult to generate alpha, i.e. to beat the market in the long term and invest better than the average achieved by other investors. Because investors are by nature interested in high returns, alpha has become the much sought-after holy grail of the financial industry, pursued by all.

Are markets efficient?

However, economists disagree as to whether it is even possible to generate alpha on a portfolio for a sustained period. Proponents of the so-called “efficient market hypothesis” assume that most markets are efficient. This means that all information relevant to the price of a security is fully reflected in its price at all times. According to this theory, it is not possible to predict future price developments in the financial markets thanks to more information or the more intelligent analysis of information. Consequently, it is also not possible to identify those securities that will deliver above-average performance. The theory also postulates that in any case, the more financial analysts and fund managers chase after alpha, the more efficient the markets become and the rarer it becomes.

Settling for mediocrity

Things that are rare are also expensive: fund managers and investment funds that reliably achieve alpha have their price. That’s why many investors are willing to compromise: if their portfolio performs as well as the market, they are content. So they settle for mediocrity and invest in inexpensive, passive index funds. These are funds that replicate an index as closely as possible and whose performance follows market developments exactly – both upwards and downwards.

Not sexy enough for you?

Are you convinced that markets are by no means always efficient? That there is more to be gained than simply average performance? If so, and you're not an investment professional, then your best bet is to focus on finding the few talented individuals who can effectively generate alpha. But that requires a lot of experience and know-how – as well as very good instincts. Because, unlike in the animal kingdom, the alphas among fund managers are very difficult to identify.

Picture: Unspleash, Eva Blue

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