This Book Obliterates Active Management

An intriguing new book, "The Incredible Shrinking Alpha," presents an overwhelming weight of research which leads to the inescapable conclusion that the pursuit of "alpha," or returns above an appropriate risk-adjusted benchmark, is a fool's errand. The book was written by my colleague Larry Swedroe, director of research at The BAM Alliance, and Andrew Berkin, a Ph.D. and director of research for Bridgeway Capital Management.

Let's start with the basics. If you are seeking a higher return than a designated benchmark, you are going to hold a portfolio that is different and less diversified than the stocks or bonds in the benchmark index. In other words, the trade-off for higher-expected returns than the benchmark is a greater risk than the benchmark. The issue for active investors to ponder is whether the expected alpha from this strategy will be adequate to compensate you for the increased idiosyncratic risk. Swedroe and Berkin make a compelling case that it isn't.

You are likely to be a victim. In his seminal paper, "The Arithmetic of Active Management," Nobel Prize-winner William Sharpe demonstrated that, before costs, active management is a zero-sum game. After costs, it is a negative-sum game. For active managers to achieve alpha, they need victims to exploit. These victims are individual investors, and they are exploited by institutional investors. Swedroe and Berkin demonstrate this finding by citing research showing that, in the aggregate, global individual investors underperform standard benchmarks. Even the best traders find it difficult to cover their costs.

Who are the winners? They are mainly actively managed funds, which are often able to generate alpha, before costs. However, when their total expenses (management fees and trading costs) are considered, investors in these funds are left with a net-negative alpha. Active management is the perfect storm for individual investors. Whether you attempt to generate alpha by picking stocks on your own, or you invest in actively managed mutual funds, the result is the same: You will likely underperform the benchmark index.

The pool of victims is shrinking. Investors aren't stupid. The Internet levels the playing field considerably, and gives advocates of index-based investing (more appropriately called "evidence-based investing") a forum. They have been using it wisely. Investors are getting the message that active management is essentially a scheme to transfer wealth from their pockets into those of the people who "manage" their money. The pool of individual investors willing to become the victims exploited by active managers is getting smaller, as many of these investors are converting to passive strategies.

This diminishing pool of potential victims makes achieving alpha even more formidable.

The diminishing possibility to identify mispricing. Picture how unfair the odds against you are. You are sitting at home with your computer, possibly using software sold by various vendors or fund families. Your competition is institutional investors with hundreds of millions -- if not billions -- of dollars available to invest in gathering data, crunching it and implementing trades using massive computers, often located in close proximity to the New York Stock Exchange.

How likely is it that you will be able to glean some piece of information that hasn't already been factored into the price of every listed stock by millions of individual and institutional investors, some of whom have access to far superior data? And even if you could find this data, will you be able to use it to your advantage?

More assets chasing less alpha. Swedroe and Berkin note that more money is chasing less alpha. They refer to research indicating there is a finite amount of available alpha for the entire hedge fund industry, or roughly $30 billion a year. As more money enters the industry, there is less and less alpha for each hedge fund to capture, according to an estimation from David Hsieh, professor of finance at Duke's Fuqua School of Business. Studies cited by Swedroe and Berkin show that, today, only 2 percent of all active managers generate statistically significant alpha.

Twenty years ago, 20 percent of active managers were able to do so. The enormous amount of money chasing limited alpha may account for the fact that for the 10 calendar years from 2005 to 2014, the annualized return of the HFRX Global Hedge Fund Index was a puny 0.7 percent. It underperformed every major asset class, including one-year Treasurys. Are you smarter than the average hedge fund manager?

The good news. Once you wrap your head around the data indicating the pursuit of alpha is a game that's possible to win, but with odds so low that it's more prudent to not even try, you have some really attractive options. The cost of becoming a passive investor is continuing to decline as competition from providers of exchange-traded funds, or ETFs, increases.

Instead of chasing butterflies, your new goal should be to capture the returns provided by the market at the lowest-possible cost. "The Incredible Shrinking Alpha" is a short book that can be read in a couple of hours. If you have a genuine interest in becoming an intelligent and responsible investor, guided by sound, peer-reviewed evidence instead of hype, I highly recommend it.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."