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How serious a constraint?
The term alpha has become a catchword for favorable outcomes from investment decisions and processes. Today's investors seek alpha returns from taking idiosyncratic risk. They are engaged in alpha transport or alpha-beta separation, and they debate whether alpha is pure or tainted by hidden systematic risk factors, embedded short options, or liquidity premiums. The desire to increase exposure to alpha and active risk is growing, despite many skeptics.
I address a common caveat cited by those speaking about their ability to earn or generate alpha-that it is a zero-sum game. This would imply that the aggregate alpha gains by one set of investors must equal those lost by another set (after deducting trading and research costs). This is one of the cornerstones of the arguments against the "alpha quest." How relevant is this warning about the decisions investors face in the short and intermediate term, that the size of the alpha pie is not fixed, and that not all investors draw from the same benchmark or have the same constraints and access costs?
To state this differently, the alpha game in practice (rather than theory) is not a closed system, where there are a set of identical and finite chips available at the start and end, so that the returns delivered by winners must come at the expense of losers.
Rather, financial markets and the associated capital allocation process in a global economy are part of a highly complex system, where participants vary in terms of degree and form of access to investment choices, and their investment horizons, risk preferences, capital constraints, and tax regimes. They also come with behavioral biases, which could influence the judgment and decisions of investors with the same skills and information.
On a simpler level, one needs to look no further than the opening of new markets like China, new products like search engines (Googje), and the difficulties of defining pure alpha (skill) as separate from common risk factors to begin to question what the zero-sum alpha game means in practice.
THE ORIGINS OF ALPHA
Some 45 years ago, William Sharpe, a graduate student working at the RAND Corporation at the time, expanded on the work of his colleague, Harry Markowitz [1952], to postulate that...