The Alpha delusion

Does the systematic outperformance of fund managers relative to their benchmark over a long enough period reflect skill or luck? This is a debate that has been raging on ever since the proponents of the efficient market hypothesis entered the scene. If even the weak form of the efficient market hypothesis holds true, most of the outperformance could very well be attributed to just plain luck. The reasoning goes something like this: at a micro level, even if a gifted manager is able to identify industry trends, it is impossible to anticipate powerful random events such as unanticipated changes in government regulation or even natural events. In other words, there is a significant random component that can creep into and distort the earnings of a company.

This isn’t to say that skill doesn't play any role, it certainly does but the danger is that actual skill may be overestimated. Take the following example:
A hundred people are invited into a hall and asked to perform the simple task of flipping a coin. Those that obtain “tails” are kindly asked to leave the hall whilst the remaining persons are asked to repeat the coin flipping exercise. This experiment is continued until one person, the winner, is left. In terms of statistics, the probability of obtaining “heads” is 50%. Each draw is independent from the other, which means that the probability for each draw are not influenced by any other draw. Taking this into consideration, we can expect about 50 persons leaving the hall after the first draw, another 25 after the second and about 12 after the third etc. After about 6 draws there should remain only one person. Now if we forget about this experiment and try to visualize these results in terms of the performance of a particular fund manager, we could easily get carried away into thinking it was due to skill. As the experiment has shown us, the exceptional results could be a result of just plain old luck but the observers are totally blind to this. They are much likely to attribute the way better than average results to the manager's particular skills. That particular manager will be revered and a large amount of money will flow into the fund but if the results were more luck than skill, it will turn out to be a very bad investment.

In the midst of a deflation conundrum...

Sovereign issuer default risk scare apart, the deflationary bears are once again taking center stage as worries grow over the longer term impact of the mountainous debt that governments of the troubled economies have accumulated over a very short time span. If this actually translates into a protracted period of anemic growth, it could trigger a deflationary spiral with real consequences on an already troubled economy. The recent substantial rally in U.S. treasuries are partly symptomatic of this fear. Recall that an out of control deflation causes damage to the economy by shifting longer term expectations for both producers and consumers. As businesses face the prospect of downward spiraling prices they anticipate this by laying off a growing number of workers. Consumers feed into the frenzy by postponing consumption to a future date not only in anticipation of almost certain lower prices but also because of the growing job insecurity as unemployment inflates. All this bodes very badly for stocks which are likely to experience shrinking margins in such a scenario. Same goes for commodities that are a proxy for economic activity. Sovereign debt, on the other hand, tend to shine (which it is already doing) when deflation rears its ugly head as investors flock to it in search for greater security and income that becomes more valuable as prices take a nose dive.

What makes this downturn interesting is that we don't really know how investors are going to behave if real deflation takes hold. Will they be willing to park their hard earned cash into troubled sovereign debt which has lost its traditional "risk free" status or will they go elsewhere? I guess time will tell.