The Quest for Alpha

The final word on passive vs. active investing

The debate on active investing-stock picking and market timing-versus passive investing-markets are highly efficient and almost impossible to outperform-has raged for decades. Which side is right? In The Quest for Alpha: The Holy Grail of Investing, author Larry E. Swedroe puts an end to the debate, proving once and for all that active investing is likely to prove futile as the associated expenses-costs, fees, and time spent analyzing individual stocks and the overall market-are likely to exceed any benefits gained. The book

• Presents research, data, and quotations that reveal it's extremely difficult to outperform the market
• Explains why investors should focus on asset allocation, fund construction, costs, tax efficiency, and the building of a globally diversified portfolio that minimizes, if not eliminates, the taking of idiosyncratic, uncompensated risks
• Other titles by Swedroe: The Only Guide to Alternative Investments You'll Ever Need and The Only Guide You'll Ever Need for the Right Financial Plan

Investors are on a never-ending search for a money manager who will deliver returns above the appropriate risk-adjusted benchmark, aka the "Holy Grail of Investing." The Quest for Alpha demonstrates that it's a loser's game-while it's possible to win, it's so unlikely that you shouldn't try.

Acknowledgments xi

Introduction xiii

The Holy Grail xiv

The Quest Begins xvi

Chapter 1 Mutual Funds: The Evidence 1

When You Wish upon a Morningstar 2

Focus Funds 4

Active Management of Bond Funds 6

Skill versus Luck 8

Who Cares about the Average Fund? 12

With Active Managers, How Long Is Long Enough? 12

Advice from Professional Investors and Academics 15

Admissions from Industry Practitioners and the

Financial Media 17

Chapter 2 Pension Plans: The Evidence 23

Counterproductive Activity 25

The Value of Consultants 27

The Performance of Funds Offered by 401(k) Plans 27

Fund Selection Skills 29

Please Don’t Do Something, Stand There 30

Advice from Professional Investors 30

Admissions from an Industry Practitioner 31

Chapter 3 Hedge Funds: The Evidence 33

The Problems with Hedge Funds 36

Advice from Professional Investors and Academics 40

Chapter 4 Private Equity/Venture Capital:

The Evidence 43

Characteristics of Private Equity Returns 46

Bias in the Data 48

Advice from a Professional Investor 49

Chapter 5 Individual Investors: The Evidence 51

Investment Returns versus Investor Returns 54

Advice from Professional Investors and Academics 56

Admissions from Industry Practitioners and the Financial Media 59

Chapter 6 Behavioral Finance: The Evidence 61

There Is Smoke, but No Fire 62

The Tyranny of the Efficient Markets 63

Further Evidence 64

The Failed Quest 65

The Value of Behavioral Finance 66

Even Smart People Make Mistakes 66

Admissions from Industry Practitioners 68

Summary 69

Chapter 7 Why Persistent Outperformance Is Hard to Find 71

The Quest for Alpha Is a Game Played on a Different Field 72

Successful Active Management Sows the Seeds of Its Own Destruction 74

Closet Indexing 76

Concentration and the Role of Trading Costs 77

The Role of Trading Costs 78

Drifting Out of Small Caps 79

Encore Performances 79

Who Gets the Money to Manage? 81

The Value of Economic and Market Forecasts 83

The Value of “Expert” Judgment 86

We All Want to Believe 89

The Value of Security Analysis 90

Buy, Sell, or Hold? 92

The Hurdles Are Getting Higher 93

Advice from Professional Investors and Academics 94

Admissions from Industry Practitioners and Academics 96

Chapter 8 The Prudent Investor Rule 103

The Prudent Investor Rule 106

The American Law Institute 106

The Uniform Prudent Investor Act 108

Chapter 9 Whose Interests Do They Have at Heart? 113

Advice from Professional Investors 114

Admissions from Industry Practitioners and Academics 115

A Triumph of Hope over Experience 120

The Arithmetic of Active Management 121

The Math Is Always the Same 123

The Costs of Active Investing 124

The Cost of Cash 126

An Expensive Quest 127

Summary 129

Chapter 10 How to Play the Winner’s Game 133

Indexing Is More than the S&P 500 Index 135

Does Passive Investing Produce Average Returns? 140

Enough 141

Needs versus Desires 144

Pascal’s Wager 145

Conclusion 147

The Yale Endowment Fund 148

The Way to Win Is Not to Play 149

The Quest for the Holy Grail 150

The Winner’s Game 151

Appendix A: Rules of Prudent Investing 153

Appendix B: Doing It Yourself 159

Notes 165

Sources of Data 176

About the Author 177

Index 179

LARRY E. SWEDROE is a principal and the Director of Research for the Buckingham Family of Financial Services, which includes Buckingham Asset Management and BAM Advisor Services. He has also held executive-level positions at Prudential Home Mortgage, Citicorp, and CBS. Swedroe frequently speaks at financial conferences throughout the year and writes the blog "Wise Investing" at CBS MoneyWatch.com.

King Arthur and his court pursued the Holy Grail, the mythical cup or dish used by Jesus at the Last Supper.The financial equivalent of the pursuit of the Holy Grail is the quest for the money managers who will deliver alpha—returns above the appropriate risk-adjusted benchmark. The quest for alpha is based on the theory that the markets are inefficient, and smart people working diligently can discover pricing errors the market makes. But there is a competing theory based on about sixty years of academic research. Its premise is that markets are highly efficient—the market price of a security is the best estimate of the right price. If markets are highly efficient, efforts to outperform are unlikely to prove productive after the expenses of the efforts. So which theory is correct?

In The Quest for Alpha, Larry Swedroe presents research, data, and advice from some legendary market gurus to show that it is extremely difficult to outperform the market. Examining the evidence from academic studies on mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors, and behavioral finance, he demonstrates that the markets are indeed highly efficient. Swedroe then explains why investors should instead focus on asset allocation, fund construction, costs, tax efficiency, and the building of a globally diversified portfolio that minimizes, if not eliminates, the taking of idiosyncratic, uncompensated risks.

And to those who ask, "But how do you explain Warren Buffett?" Swedroe's answer is simple. "I tell them if they see Warren Buffett when they look in the mirror, go ahead and seek the holy grail of alpha," he says. "If they don't, give up the quest and play the winner's game."

The final word on active vs. passive investing!

King Arthur and his court pursued the Holy Grail, the mythical cup or dish used by Jesus at the Last Supper. The financial equivalent of the pursuit of the Holy Grail is the quest for the money managers who will deliver alpha—returns above the appropriate risk-adjusted benchmark. The quest for alpha is based on the theory that the markets are inefficient, and smart people working diligently can discover pricing errors the market makes. But there is a competing theory based on about sixty years of academic research. Its premise is that markets are highly efficient—the market price of a security is the best estimate of the right price. If markets are highly efficient, efforts to outperform are unlikely to prove productive after the expenses of the efforts. So which theory is correct?

In The Quest for Alpha, Larry Swedroe presents research, data, and advice from some legendary market gurus to show that it is extremely difficult to outperform the market. Examining the evidence from academic studies on mutual funds, pension plans, hedge funds, private equity/venture capital, individual investors, and behavioral finance, he demonstrates that the markets are indeed highly efficient. Swedroe then explains why investors should instead focus on asset allocation, fund construction, costs, tax efficiency, and the building of a globally diversified portfolio that minimizes, if not eliminates, the taking of idiosyncratic, uncompensated risks.

And to those who ask, "But how do you explain Warren Buffett?" Swedroe's answer is simple. "I tell them if they see Warren Buffett when they look in the mirror, go ahead and seek the holy grail of alpha," he says. "If they don't, give up the quest and play the winner's game." “As I noted recently, success in investing is somewhat counterintuitive, and requires most investors to set aside their pre-conceived notions of how to build a portfolio that will allow them to reach their goals. The task is made all the harder because the vast majority of the participants in the financial services industry spend hundreds of millions of dollars annually reinforcing the myth of active management. Fortunately for investors, experts like Larry Swedroe are hard at work pointing out the fallacies of those myths, while also detailing the undeniable logic and mathematics that underpin a passive approach. The Quest for Alpha is a wonderful addition to that effort, and investors will be well-rewarded by reading it and acting upon its wisdom.”
— Nathan Hale, moneywatch.com, March 2011