This Book Obliterates Active Management

An intriguing new book, “The Incredible Shrinking Alpha,” presents an overwhelming weight of research which leads to the inescapable conclusion that the pursuit of “alpha,” or returns above an appropriate risk-adjusted benchmark, is a fool’s errand. The book was written by my colleague Larry Swedroe, director of research at The BAM Alliance, and Andrew Berkin, a Ph.D. and director of research for Bridgeway Capital Management.

Let’s start with the basics. If you are seeking a higher return than a designated benchmark, you are going to hold a portfolio that is different and less diversified than the stocks or bonds in the benchmark index. In other words, the trade-off for higher-expected returns than the benchmark is a greater risk than the benchmark. The issue for active investors to ponder is whether the expected alpha from this strategy will be adequate to compensate you for the increased idiosyncratic risk. Swedroe and Berkin make a compelling case that it isn’t.

You are likely to be a victim. In his seminal paper, “The Arithmetic of Active Management,” Nobel Prize-winner William Sharpe demonstrated that, before costs, active management is a zero-sum game. After costs, it is a negative-sum game. For active managers to achieve alpha, they need victims to exploit. These victims are individual investors, and they are exploited by institutional investors. Swedroe and Berkin demonstrate this finding by citing research showing that, in the aggregate, global individual investors underperform standard benchmarks. Even the best traders find it difficult to cover their costs.

Read the rest of the article at US News.