Why investors should avoid alpha

Alpha is a term that quantifies beating the market. Here, Allan Roth, founder of WealthLogic, discusses why investors should always buy the market instead.

Allan Roth


First, let me say that I wish I had owned the right active ETFs from last year. The list below shows the best-performing ETFs of 2020. ARK ETFs dominated, and CIO Catherine Wood took in $36.5bn in ETF flows in the 12 months ending 28 February, according to Morningstar.

Here is why I think you should avoid alpha.

The argument for alpha

First, let me say that I wish I had owned the right active ETFs from last year. The list below shows the best-performing ETFs of 2020. ARK ETFs dominated, and CIO Cathie Wood took in $36.5bn in ETF flows in the 12 months ending 28 February, according to Morningstar.

The flagship ARK Innovation ETF (ARKK) returned 122.4% in the year ending 8 March, and 46.4% annually in the five-year period ending 8 March 8. By comparison, my Vanguard Total Stock Market ETF (VTI) earned only 16.7% annually over the same five-year period.

No matter what the proper benchmark is, ARKK delivered on alpha. Furthermore, both Fox and Motley Fool predict ARKK should make you rich over the next 10 years.

Indeed, active ETFs in the US are hot, and investors want them, diving into active management like never before. And according to SeekingAlpha, ARKK just had a record day on 9 March, gaining 10.4%.

The argument against alpha

So, yes, I wish I had owned ARK ETFs, as I would be a lot richer. But let me clue you in on a secret: The total alpha ever delivered in the stock market since inception is zero. To make matters worse, that zero is before costs.

It is actually impossible for the overall market to beat the market. Some money (like ARK ETFs) trounced the market last year, and some badly underperformed (smart beta ETFs). On average, active investing earns the market, before costs.

Though it is not certain whether ARK ETFs will continue to produce alpha, the odds are at least as much against it as they were against smart beta several years ago. Owning the market according to market cap back then seemed downright dumb, and I embraced dumb beta, merely accepting the return of the stock market.

My take

Alpha is a Wall Street invention to convert your money into my industry’s money; that is to say, in the aggregate, alpha is zero before costs. This means the following formula must be true:

  • Investor return = market return - fees

This formula must be true as described simply by William Sharpe’s Arithmetic of Active Management. It has nothing to do with the efficient market hypothesis; only the simple laws of arithmetic.

So, the more you pay in fees, the lower your expected return. Active ETFs (ARK, smart beta, and the like) have higher fees and, on average, will produce lower returns.

Active picks part of the market to overweight and outperform. Cathie Wood overweighted growth companies with disruptive technologies while smart beta overweighted value, or old-economy companies.

Wood is winning this round, as ARK funds took in billions in asset flows, while value shops like Dimensional Fund Advisors saw billions in outflows as value badly underperformed.

Chart 1: Morningstar 2020 equity performance


Source: Morningstar

I do not know if growth or value will win out for the rest of the year, so I am avoiding alpha and owning growth and value according to market size. I am doing the same for tech versus energy and every sector. I will get the market return, also known as beta.

There are now 308 alpha-seeking ETFs on the US market now, with an average total expense ratio (TER) of 0.73% annually.

I predict two things:

  • Many will become extinct in a few years

  • On average, they will underperform the low-cost beta-seeking ETFs in their respective asset classes

Active ETFs may be the craze now, but most investors are still avoiding alpha. The largest ETFs are mostly beta-seeking funds with low expense ratios. But I praise those investing in alpha-seeking ETFs, as they serve a critical role in keeping markets efficient, and give those of us avoiding alpha a free lunch.

Allan Roth is founder of Wealth Logic. He is required by law to note that his columns are not meant as specific investment advice.

This story was originally published onETF.com

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