Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 125

Competing for alpha

In finance, the excess return of a fund relative to a benchmark is called the alpha, and never has the competition for alpha been so intense. And it is just that: a competition. Ultimately, total alpha across the marketplace must equal zero on a gross (of all fees) basis. Investment banks are not charities and so net alpha is more negative on an after-transaction costs basis. There aren’t that many not-for-profit fund managers either, and their fees take another slice off aggregate alpha. While some negative alpha may be experienced by arguably less informed investors (commonly industry puts retail investors in this category, but perhaps this is not always the case), it is naïve to assume that the investment management industry has a licence to produce positive alpha.

Stricter judgement of ‘real alpha’

Historically in a world of passive funds and active funds, alpha was simply defined as the performance of an active fund against its market benchmark. Now we have around 25 years of academic literature behind us exploring how simple style factors such as value, size and momentum can explain stock portfolio returns (see Fama and French (1992) and Carhart (1997) for early seminal examples – www.scholar.google.com makes this easy).

Many of these factors are now being used to manufacture low cost product under various names such as smart beta and smart indexing. Consultants the world over, super funds and any quality institutional investor assess the performance of funds against a range of these benchmarks. In some cases this type of analysis (often simply regression-based) explains some of what may have been labelled as ‘alpha’.

Fierce competition for alpha

Where historically the universe of investment management products consisted of passive and active funds, today we have a broader spread of product. The competitors for alpha charge different levels of fees, have varying degrees of flexibility and take different amounts of active risk. This is all presented stylistically in the diagram below (with the size of the bubble being a proxy for the level of active risk).

The flexibility in some of these structures (for instance hedge funds are not benchmarked and can use a wide range of techniques such as leverage, short selling and derivatives) potentially provides an advantage. On the other hand a simple active traditional fund may keep life simple from a risk perspective and allow the manager to focus on idea generation.

And if the range of competitors was not enough, the degree of observation and analysis of a fund’s activities is greater than ever. We have asset consultants and other research groups as well as institutional investors all analysing how managers generate their returns. Nor are investment banks shy about trying to identify trading opportunities. It is easy to understand how proprietary trade ideas and process components get leaked across the market – many groups who analyse funds can be inadvertent disseminators of information. Consider the following innocent conversation:

Asset consultant to Fund Manager 1: What is your competitive edge?

Fund Manager 1: Well, we search hard for this particular characteristic (insert name) in the stocks that we purchase and it has worked well for us.

Asset consultant to Fund Manager 2: Do you search for this particular characteristic (insert name) when you are screening for stock ideas?

Fund Manager 2: No … but, um, it is in our research pipeline (… as he makes a note to himself).

I recall a US-based hedge fund we were invested with years ago who found a clause in some bond documentation that the market had overlooked. They placed some trades but in doing so the secret got out and they only made a marginal return for their efforts.

And don’t forget the academics: they play their part in identifying what they call ‘market anomalies’. They have their own competitive challenge: to produce research that extends the literature and is sufficiently insightful to get it published in top journals. This research is then available to the broader public, including fund managers. A paper by Bill Schwert from the University of Rochester, titled Anomalies and Market Efficiency (2002), identified that the returns from many market anomalies identified in academic literature deteriorated or even disappeared once the academic literature was published. This is reasonable: if the research is significant then it is being read by fund managers and investment banks and being incorporated into investment products. Indeed it is common, particularly in the US, to see many leading finance academics also working in industry.

Preserving the alpha edge

If a fund manager believes it has a true investment edge over the market then how can this be preserved and protected? Not easy but here are some considerations to look for:

  • The competitive edge should be clearly defined. What is the foundation of the fund manager, what does it believe in? If that foundation feels like a general statement rather than something that is specific and well considered, then I would have doubts from the start.

  • Continual self-assessment of the edge and performance. Has the market structure changed? Are there more managers thinking about the same thing? Does performance support their beliefs about alpha, accounting for the market environment? It is surprising how many fund managers do not assess their performance against a relative style index (e.g. a value manager should compare its performance against a value index).

  • Ongoing process enhancement. A good example here is making the most of technological developments. It is impressive to see how many discretionary (where the analysis and decision is made by a person and not a computer) fund managers now use computer screening to help filter their universe down. They remain a discretionary fund but they are making good use of technology to keep them efficient.

  • Diligence in managing fund capacity. Every strategy has a capacity limit before the alpha profile starts to decay. What I find interesting, and potentially flawed, is that many managers consider the capacity of their own fund without considering the capacity of their strategy as a whole, ignoring the size of other managers with similar strategies.

  • Hard work and hiring and developing the right people are obviously key to success for any business.

For investors looking to construct portfolios of actively managed funds, the assumption of positive alpha across the portfolio is possibly a naïve one. And yet there is this magnetic attraction to invest actively – an extra layer of return compounds nicely through time. My advice is to make use of all the information available (including smart index data and research), invest across the entire universe of funds management products rather than just along product silos, and always invest pragmatically with the low cost solution being your default position.

 

David Bell is Chief Investment Officer at Mine Wealth + Wellbeing. He teaches the Hedge Funds elective for Macquarie University’s Master of Applied Finance and is studying towards a PhD at University of NSW.

 

RELATED ARTICLES

The biggest rort of all

The best opportunities in fixed income right now

Active or passive – it’s time to change the narrative

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

7 examples of how the new super tax will be calculated

You've no doubt heard about Division 296. These case studies show what people at various levels above the $3 million threshold might need to pay the ATO, with examples ranging from under $500 to more than $35,000.

The revolt against Baby Boomer wealth

The $3m super tax could be put down to the Government needing money and the wealthy being easy targets. It’s deeper than that though and this looks at the factors behind the policy and why more taxes on the wealthy are coming.

Are franking credits hurting Australia’s economy?

Business investment and per capita GDP have languished over the past decade and the Labor Government is conducting inquiries to find out why. Franking credits should be part of the debate about our stalling economy.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

Latest Updates

Investment strategies

Trump's US dollar assault is fuelling CBA's rise

Australian-based investors have been perplexed by the steep rise in CBA's share price But it's becoming clear that US funds are buying into our largest bank as a hedge against potential QE and further falls in the US dollar.

Investment strategies

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Property

Soaring house prices may be locking people into marriages

Soaring house prices are deepening Australia's cost of living crisis - and possibly distorting marriage decisions. New research links unexpected price changes to whether couples separate or silently struggle together.

Investment strategies

Google is facing 'the innovator's dilemma'

Artificial intelligence is forcing Google to rethink search - and its future. As usage shifts and rivals close in, will it adapt in time, or become a cautionary tale of disrupted disruptors?

Investment strategies

Study supports what many suspected about passive investing

The surge in passive investing doesn’t just mirror the market—it shapes it, often amplifying the rise of the largest firms and creating new risks and opportunities. For investors, understanding these effects is essential.

Property

Should we dump stamp duties for land taxes?

Economists have long flagged the idea of swapping property taxes for land taxes for fairness and equity reasons. This looks at why what seems fairer may not deliver the outcomes that we expect.

Investing

Being human means being a bad investor

Many of the behaviours that have made humans such a successful species also make it difficult for us to be good, long-term investors. The key to better decision making is to understand what makes us human and adapt.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.