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My thoughts on passive investment and achieving alpha; Common confusions about risk/return relationships, timing and selectivity. : UKInvesting


Alpha is one of the most studied things in empirical finance, if not the most studied thing. It is subject of concern of most people in finance academia, including the asset-pricing models, anomaly literature, tests of market efficiency etc. But why is alpha so concerning and how is it achieved?

In this sub I commonly see people touting passive investment as a strategy to outperform conventional asset managers, fund managers etc. The argument is simple but I think often the dynamics of risk/return is misunderstood. Passive investment is a relatively recent development in modern finance, since the EMH by Fama. However, one issue I present is that passive investment relies on rational expectations hypothesis and therefore the conditions where passive investment succeeds over active is one which has rational market prices.

PRICES ARE NOT RATIONAL

As much as the textbook wants you to believe, prices do not follow random walks around the fundamental value, there are plenty of opportunities to profit from arbitrage and some of these do persist, maybe not in every period ever, but opportunities do pop up and they persist for long enough to be profitable. This isnt just speculation its a fact. In addition, speculation (gambling) is a feature of the stock market itself, and by passive investing you can not benefit from the opportunities in speculation and arbitrage.

RISKS OF INDEX INVESTING

Index investing could fall from the same exact proposition which created it. If efficient markets are to hold in the long run, then index investing could self-implode from the irrational prices created by such high levels of index investing. Think about it, high valuation companies are by definition high valuation companies, if enough investors become too overexposed to mega-caps, this will create an arbitrage opportunity eventually cause enough index holders to sell. Why would you choose to hold wealth in an asset with low expected returns and no downside protection?

The risks of index investing are somewhat misunderstood by most people including newcomers to investing and unfortunately even the old ones too. Diversification does not hedge you from downside risk and suffers from lower expected returns (by definition).

DIVERSIFICATION HAS ITS COSTS TOO

Too often active investing is touted as costly and time consuming. Lets look at the costs of index investing as this is often misrepresented. No doubt a diverse portfolio is important to reduce volatility and concentration risk. However, diversification has its costs too. To diversify is to limit expected returns, this is a fact. High expected returns are born out of high risk, assets which sport high levels of risk are systematically avoided by index investing and therefore diversification not only costs in terms of expected returns but also for opportunity cost.

That speculative asset youve noticed climbing in value, unfortunately you cant invest because youve limited your opportunity and limited your expected return and risk. If you have a good appetite for risk and some conviction to your predictions, why would you decide to spread your eggs? Holding a few carefully chosen stocks could outperform an index by factor of 10 over the short term.

TIMING ISNT IMPORTANT? WELL IT IS IF YOURE ACTIVE

I often see people say dont try and time the market. However, the reasons are misrepresented and poorly formulated. Timing can be so important to an active investor and there is value in things such as cyclical analysis and momentum trading which timing is a crucial factor and can be incorporated into an active investment strategy such as swing trading.

Why should I not try and time the market? There is significant opportunities in timing and even more so if youre active. For example, the passive investment argument often follows that no one can consistently “beat the market”. Its simply not true that you have to beat the market consistently to be able to achieve long term alpha. I could make gains in speculative assets in one period during high sentiment and transfer the wealth to something more stable in another period. To beat the index tracker, I dont need to beat it consistently, just beat it on average. By ignoring timing youre failing to recognise some of the important aspects of market performance, notably that market risk is conditional and the premium changes over time.

YOU CAN’T WIN THE LOTTERY IF YOU DON’T BUY A TICKET

Index investing by nature cant invest in timing opportunities or arbitrage opportunities, but it damn sure does create them! In my opinion the draw of active investing becomes even more, the more people adopt index investing, the more opportunity there will be for active investors to profit from your missed opportunities and opportunities you create. Additionally, there is no secret formula to alpha it gives you the chance to experiment and be creative, however, index investing is zero alpha and therefore you cannot achieve it.

If you want to gain from opportunities presented by speculation, risk, timing and selectivity, youve got to buy a ticket to the lottery. Luck plays a big part in the game and lets just face it, there is no free lunch in investing, so lets stop treating it like there is a big free lunch called passive investment.



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