Investment management when done with funds appears to have developed permanent blind spots. By being unaware or unconscious of these blind spots, investment managers using funds have quite often performed poorly. The greatest of these blind spots is a set of tools developed by Professor William Sharpe, a Nobel laureate and professor at the Stanford School of Business.
Prof Sharpe introduced three main tools into the investment world – the Capital Asset Pricing Model (CAPM), the Sharpe ratio and Style Analysis.
The CAPM basically states that an investor’s return is based on some multiple of the market’s return, which is usually called beta, plus a return based purely on the investor’s capability, which is usually called alpha. Having a beta of one and an alpha of zero means the investor’s portfolio is basically the market index.
What funds and investment managers do is compute their alpha – and their computations will not coincidentally result in a high positive alpha – and then promote this to potential clients as a reason to invest. There are several problems with this. First, the CAPM is explanatory, not predictive. It tells you why a portfolio behaved in a certain way, not how it will behave in the future.
Second, the calculation of beta and alpha is based on a statistical method called least squared estimate. The name alone tells you that things are being estimated, not to mention the fact that it is an arbitrary method to use (for example, why use the power two? Why not the absolute value of the power three, or the power of four?).
Third, the CAPM only looks at the market that the portfolio is invested in and excludes other markets. For example, traditional CAPM would not take into consideration the effect of the price of oil on the UAE stock markets. Fatal mistake. Similarly, if you allocate to a US fund manager, the CAPM results he produces for you will not tell you whether or not it would have been better to invest in China, for example.
Finally, beta is just as important as alpha, especially as beta can and does change over time. If markets are going up, you want a high positive beta. If markets are going down, you want a negative beta. Who says that generating alpha is easier than managing beta?
So, dear investor, I think it is safe to say that it is best to think of alpha and beta as two letters in the Greek alphabet. Nothing more, nothing less.
The Sharpe ratio is basically a measure of excess return because of excess risk. Prof Sharpe uses standard deviation of the portfolio as a measure of risk, which is the first issue as it suffers from some of the same flaws as the CAPM, in that it is more explanatory than predictive. In fact, in this area it is worse than the CAPM as it is only looking at risk – there is no alpha that might measure manager-value creation.
Put another way, if the market gives a strong return in a fast bull market, it will give a high Sharpe ratio. It will not, however, give any indication of the upcoming crash and massive losses, as many a trader has learnt globally over the past year.
The Sharpe ratio also shares one of CAPM’s other defects – absolutely no acknowledgement of correlation as a factor in portfolio construction. Although, to be fair to Prof Sharpe he has repeatedly pointed this out.
Style Analysis has not received the attention the first two tools have, in part because of controversy over how to apply it and also that it is harder to compute.
So has Prof Sharpe flooded us with harmful tools? Absolutely not. You don’t get a Nobel Prize in economics for nothing, although the bankruptcy of Long Term Capital Management might be considered a counter example. The problem is that the uses that Prof Sharpe envisaged are different from the uses for which his tools were used.
Prof Sharpe, an academic and intellectual, developed tools to understand investing. Investment managers used these tools to make themselves look good and to market themselves to unsuspecting investors, which I estimate to be about 98 per cent of money invested globally.
If you have not read Prof Sharpe’s seminal papers and fully understood them, then you simply cannot understand how to use these tools. It is not good corporate governance to simply state a number for alpha, or a Sharpe ratio. In fact, it is a recipe for disaster.