A Crisis Review Of Negative Alpha
August 19, 2009
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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
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?