Is The Market Getting More Efficient?

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Another Alpha Opportunity Bites the Dust

In 1998, Charles Ellis wrote “Winning the Loser’s Game,” in which he presented evidence that while it is possible to generate alpha and win the game of active management, the odds of doing so were so poor that it’s not prudent for investors to try. At the time, roughly 20 percent of actively managed mutual funds were generating statistically significant alphas (they were able to outperform appropriate risk-adjusted benchmarks). Today, that figure is much lower—about 2 percent (even before considering the impact of taxes). In our 2015 book, “The Incredible Shrinking Alpha,” my co-author Andrew Berkin and I described several major themes behind this trend toward ever-increasing difficulty in generating alpha:

  • Academic research is converting what once was alpha into beta (exposure to factors in which you can systematically invest, such as value, size, momentum, and profitability/quality). And investors can access those new betas through low-cost vehicles such as index mutual funds and ETFs.
  • The pool of victims that can be exploited is persistently shrinking. Retail investors’ share (stocks held in their brokerage accounts) of investment dollars had fallen from about 90 percent in 1945 to about 20 percent by 2008. Surely, it is much lower today And their share of trading is today is only about 10 percent.
  • The amount of money chasing alpha has dramatically increased. For example, 20 years ago, hedge funds managed about $300 billion; today it is about $3 trillion.
  • The costs of trading have fallen dramatically, making it easier to arbitrage away anomalies.
  • The absolute level of skill among fund managers has increased—the competition has gotten tougher.

These trends have contributed to the decline in the ability of active managers to generate alpha. In his wonderful book “Adaptive Markets: Financial Evolution at the Speed of Thought” Andrew Lo, while acknowledging that the markets are not perfectly efficient, described the process by which markets adapt, becoming ever more efficient as entrepreneurs exploit inefficiencies (anomalies) post-publication—the adaptive markets hypothesis.

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Disclosure: Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past ...

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