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A Crisis Review Of Negative Alpha
By Robert Arnott and John West |

Page 1 of 4

The past 18 months have been a fabulous learning experience for us all. Perhaps nowhere was the lesson more poignant and revealing than in the pursuit of alpha. As we described in the March 2009 issue of Fundamentals,¹ 2008 was the worst year ever for active management, citing the poor performance of hedge funds and even long-only strategies relative to passive benchmarks. Virtually all who reached for alpha were bitten by its evil twin, downside surprise, often highly correlated with the opacity and complexity of the strategy.

But what about the alternative approach—avoiding negative alpha … how did it perform? Did a strictly followed regiment of purging portfolio slippage lead to materially better results during the crisis of 2008 and the fledgling recovery of 2009? The answer is emphatically “Yes!” The past 18 months also reveals just how damaging negative alpha can be within a single asset class like equities, where the capitalization-weighted construction methodology inherently ensures a return drag.

Negative Alpha Refresher

Negative alpha is simply the slippage investors unnecessarily incur in the execution of their investment strategies. In institutional circles, it is often labeled implementation shortfall and it centers on allowing critical, returns-detracting mistakes. Three key contributors to negative alpha were reviewed in our October 2007 issue of Fundamentals:²

Equity Concentration. Most investors hold and continue to hold portfolios that are far too reliant on a sizable equity risk premium. With 50% or 60% invested in higher-risk stocks, equity declines overwhelm bonds and alternatives in this supposedly “balanced” construct. For this reason, the classic 60/40 mix has more than 0.97 correlation with the S&P 500 Index. But, there are plenty of alternatives to mainstream stocks and bonds. Commodity futures, emerging market local currency bonds, bank loans, high-yield bonds, and REITs all have unique return drivers and will respond differently to various market environments. They aren’t always inherently better than mainstream stocks and bonds. But, ignoring them leaves us with an inherently worse investment management opportunity set. Shouldn’t we employ these, selectively and opportunistically, in our asset allocation choices on a scale large enough to matter?
Failing to Rebalance. Rebalancing is an underrated activity that forces investors to buy low and sell high. When mean reversion occurs, the portfolio is already positioned to take advantage.³ Despite ample evidence of its effectiveness, many investors neglect this simple exercise. They fall prey to the “it’s different this time” mantra and so they “blink” when the time comes to sell their best performers and buy their worst. Most investors also fail to rebalance within their stock and bond holdings.
Chasing Winners. Significant temptation exists to invest in whatever has been “working” in the recent past. The gravitational pull of the peer group only exacerbates this trend. But past performance—in managers or asset classes—does not predict future results. The mean reversion that makes rebalancing profitable makes chasing winners unprofitable.

All three of these negative alpha sources are easy to address and eliminate; indeed, eliminating negative alpha is considerably easier than finding, isolating, and employing sources of positive alpha. Which brings us to the key question: Did avoiding these three sources of negative alpha help in the crisis of 2008 and the unfolding recovery of 2009?