Course 506: Factor Investing
Redefining Alpha
In this course
1 Introduction
2 History
3 Other Factors
4 Redefining Alpha

An implication of factor-based investing is that what was once legitimately deemed "alpha"--excess returns attributable to skill--has morphed into "beta" (or a factor) once researchers identify a simple strategy that replicates the alpha. For instance, certain hedge fund managers in the 1980s and 1990s pursued then-exotic strategies such as merger arbitrage that produced excellent returns uncorrelated to the market. However, once researchers identified how the arbitrage strategies worked and created mechanical replications, the managers' alpha became beta.

A consequence of this process is that the hurdle for being declared a truly skilled manager has risen over time. In the 1980s, it was good enough to beat your benchmarks. These days, studies looking for evidence of skill in equity mutual funds control for exposure to size, value, and momentum factors. In other words, if your excess returns come during times that value, smaller-cap, or momentum stocks outperform, the procedure will adjust your "excess" return to zero.

If you believe the excess returns of value and momentum strategies reflect risk, then it's a reasonable adjustment. If you believe value and momentum produce excess returns because of market inefficiency, then it's not--what you've done is redefine outperformance.

Next: The Quiz >>


Search
Print Lesson |Feedback
Del.icio.us Del.icio.us | Digg! digg it
Learn how to invest like a pro with Morningstar’s Investment Workbooks (John Wiley & Sons, 2004, 2005), available at online bookstores.
Copyright 2015 Morningstar, Inc. All rights reserved. Please read our Privacy Policy.
If you have questions or comments please contact Morningstar.