Monday, June 15, 2009

Study hints that alpha may be finite (at least in the short term)

Fascinating look (albeit not over a seriously long time frame) from AllAboutAlpha that is consistent with the long held economic view that if there are positive abnormal returns to be had (in financial or product markets), newcomers to market will drive down the returns (hence importance of barriers to entry etc).» Today's Post » Study hints that alpha may be finite (at least in the short term):
"As the hedge fund industry smashed through the one trillion dollar level a few years ago, it became vogue to ponder whether the new assets would dilute existing alpha opportunities. Was alpha a finite resource that needed to be shared among an ever growing number of industry players? And if so, was the hedge fund industry destined to become a victim of its own success...?

Research seemed to indicate that average alpha was indeed on the decline as the industry grew. But many also argued that the industry was being diluted by “unskilled” new entrants.

But if the new entrants were really “unskilled”, their effect on the returns of the incumbents should be minimal. If a group of 200 “skilled” managers were joined by 5,000 dart-throwing monkeys, then the original 200 should arguably be able to maintain their aggregate alpha. The simian stock-picking efforts of the monkeys should cancel themselves out...."
The finding? Sure enough the collective alpha of the industry fell thus supporting the long held view that competition will drive down abnormal returns.

BTW the finding that new entrants outperform (on average) existing participants really should not be surprising given that the new funds were presumably created to take advantage of an existing pocket of inefficiency and for at least a short period of time, would be more liekly to outperform.

The article is based off of this Weidenmueller and Verbeek paper.

Good stuff.

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