Zero Sum Alpha: Heisenberg’s Uncertainty
Is alpha a zero sum game? Perhaps a better question is whether net alpha justifies the fees allocators pay to managers.
A few days ago, I stumbled upon a series of tweets by blogger Philosophical Economics. He was articulating an argument which would make John Bogle proud:
To which I replied:
This isn’t a particularly novel concept. As I mentioned earlier, Bogle founded an empire on the viewpoint. However, the quantification of active management as purely zero sum has deeper philosophical ramifications. It calls into question the social need for such a large industry, and vis-à-vis our involvement in this blog, the role of hedge funds and endowment-style investment.
Jeremy Grantham, founder of GMO, has chimed in on the subject, specifically with regard to Endowments. As the FT has reported (partially from interviews with Grantham, as well as from his investor letters), “The business is a zero-sum game, he points out, and ‘we collectively add nothing but costs’. Costs have grown because there is no fee competition, due to the agency problem and the information advantage the agent has over the client. Growing complexity has increased the client’s dependence on the industry.”
If this is true (a big if), for an entire industry of charitable and mission-based investment vehicles (“Endowments”) to invest heavily in active versus passive would be a devastating social outcome. Alpha would be neutral between Endowment winners who optimized their portfolios, and Endowment losers who failed to. The net social impact would be the extraction of fees. It is game theory run foul.
Having heard Grantham speak on the matter and having my thoughts jump-started by the twitter exchange above, I have come to the conclusion that the interaction between active investments and market dynamics is too complex for this edict to be 100% true. Evangelists of George Soros’ theory of market reflexivity would likely agree. A zero-sum alpha outcome can be proven mathematically true only if the interaction effect between active management and the broader market itself could be isolated. Cue Heisenberg’s Uncertainty:
Uncertainty (as demonstrated in this friendly video) makes it hard to separate the impact of one factor on another, because they are both fluid and interactive. Without drawing the analogy into particle physics, we can think about the benefits of active management through the lens of arbitrage. An underlying factor allowing capital market structures to work is providing participants an economic incentive for arbitrage to be captured. The arbitrage achieved by these financial hunters and gatherers is in effect the cost associated with keeping the machine humming along. Take for example an ETF which trades at a fundamental mispricing to its underlier – an index. An arbitrageur can buy all constituents of one instrument while shorting the other to achieve economic arbitrage. The fruit of her labor is risk-less profit (all things being perfect; ex transaction frictions). This is the four leaf clover of investing. The social benefit is an efficient and functioning capital market. The cost is the arbitrage born and by extension, a fee usually recouped from an investor looking to achieve that superior risk-adjusted return.
Active management – and by extension hedge funds, the 2.5 trillion dollar exemplar of the industry – operates in much the same way. By finding alpha opportunities, they are injecting the lubrication into the financial system’s feedback mechanism into the true economy. Take a long/short fund, which provides this “economic arbitrage” by shorting companies in secular decline (exacerbating their demise one might say), while funding those that can best re-invest the capital into the highest return opportunities (accelerating their growth). It’s all very Schumpter. Of course, the interaction effect of these investments into the actual economy is infinitely more complex than this simplification, but the idea that efficient capital allocation is required for functional markets is generally accepted. In a world solely governed by passive investments, a dearth of arbitrageurs theoretically should lead to sub-optimal market outcomes.
Therefore, Endowments should not ask whether alpha is zero sum. Rather, they must ask if the net alpha benefit to their objectives outstrips the fees they pay. There are already thought leaders in the field, including David Villa of the State of Wisconsin’s Investment Board who discusses this below with institutional investor:
Wisconsin leverages Novus to measure the alpha they end up paying their managers for. Villa notes in the video that great money managers can be great marketers. Our experience as former allocators corroborates this view. Providing the framework to discover true investment acumen and risk is the tool we as an organization furnish the Endowment community in the face of this giant philosophical quandary. With fees being the central active-management dilemma allocators grapple with, the industry as a whole will continue to think about this problem with – you guessed it – a great deal of uncertainty.
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