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Alpha Hunters and Beta Grazers

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In this article, Martin Leibowitz shares his thoughts about the sources of alpha. He points out that the great producers of alphas do not play the loser game (analogy with the tennis) but they do not hesitate to concentrate their risk and be more aggressive when the opportunity comes. They are often unconventional.

The author distinguishes between alphas coming from acute inefficiencies and from chronic inefficiencies. Acute inefficiencies are easy to identify (discernible), are short-term in nature and can be arbitraged away. Chronic inefficiencies are more difficult to identify, more ambiguous and more persistent. They arise because of structural or behaviorial inefficiencies such as “trading frictions, organizational barriers, imbalances in capital flows, valuation ambiguities, lack of catalysts for resolution, convoy or herding behavior, artificial peer comparisons, rebalancing inconsistencies, compulsive confirmation seeking,filtering of conflicting data, misreading of market signals, inertia, formulaic action plans, and overly rigid “policy portfolios.””

The author discusses several inefficiencies in detail:

Investors focus too much on the outcome and fail to evaluate the investment process especially when the outcome was positive.Investors find security in a crowd. They tend to herd with the crowd (“convoy behavior”).

They have some specific investment horizons and they seek expert views consistent with their own.Investors do not update their views when faced with new information (“Bayesian rigidity”).

Investors who use price targets often change these targets as prices move closer to them. This is inefficient as it increases risk and is not consistent with the initial idea of setting a price target in the first place.

Investors take more risk when their investments have performed but fall into inaction when they have underperformed (“the ebullient cycle”).

Investors can have inefficient rebalancing strategies. The authors classify them into holders, rebalancers, valuators and shifters. Holders have passive allocations. Rebalancers rebalance their allocation towards a target as the market moves. Valuators are active investors looking for cheap and rich signals and change their allocations based on these signals. Shifters change their allocation because of an exogenous change of circumstances.

The different allocation strategies can produce market impact. For instance valuators who follow momentum strategies or shifters who change their allocation in adverse markets can impact the market.

The strategies can be source of inefficiencies for instance when rebalancing is done towards some arbitrary and rigid allocation target or a valuator may not exploit indiscernible market inefficiency.Some fund managers might want to avoid shifting their allocation and choose a lower risk profile and control their shortfall risk from a predefined optimal allocation.

Investors also tend to be too optimistic and underestimate the frequency of discontinuities.

The author concludes by comparing great investors to great sailors who have a strong sense of direction, a strong gyroscope, a sense of the dangers ahead and a willingness to stay the course even in solitude.   

Martin A. Leibowitz, “Alpha Hunters and Beta Grazers”,  Financial Analysts Journal, Vol. 61, No. 5, pp. 32-39, September/October 2005   



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