Finding Alpha
First we need to define exactly what "Alpha" is.
For our purposes it is not the star mammal of the 1973 movie: "The Day of The Dolphin"
Where "Pa loves Fa" (Fa is short for Alpha)
Simply put Alpha is the ability of an investment fund or portfolio to perform better than the index or set of indexes that it is bench-marked against.
for example: A Canadian Large Cap mutual fund would be bench-marked against the S&P TSX index.
If the fund manager can produce a higher rate of return (before fees) than the corresponding index, then that fund manager is said to be "adding alpha".
Interestingly, most mutual fund managers, on average, are unable to match the index and therefore do not add alpha.
SPIVA Canada, which compares the performance of actively managed Canadian mutual funds against their relevant S&P indexes, has become the de facto scorekeeper in the active-versus-indexing debate.
Based on asset-weighted returns for the five years from 2008 to 2012, it is a clean sweep for the indexes. The majority of actively managed funds failed to outperform their comparative indexes in all seven fund categories.
In the three critical categories, Canadian, U.S. and international equities, a staggering 89.7%, 94.4% and 88.9% of the actively managed funds respectively failed to beat their comparative indexes. The best showing was in the Canadian small and mid-cap category, but even here 78.7% of the funds underperformed the index.
That is where Exchange Traded Funds (ETF's) enter the realm of investing.
Even if the fund manager is able to match the index (which defies the probability) there is the MER (management fee) plus your advisor's fee.
A Globe and Mail article from Nov. 2014 citing a Vanguard study from 2013 suggested that the average MER for a Fee-based ("F" class) fund was 1.36%. Plus the average fee-based advisor's fee of 1.25% = 2.61%.
In other words why, when the probability is that the fund likely won't even match the index , would anyone want to start "in the hole" by 2.61% (each year)?
Why not just buy the index ETF where you can be certain to get the index performance and only have to pay an MER of .05-.10%?
No Alpha there, but at least you are saving yourself an additional 2.61% (in all likelihood).
Alpha can be added in other ways:
- Find a portfolio manager who has a decent strategic method for getting above bench-mark performance on a consistent basis (although past performance will not necessarily guarantee future performance, it may improve the probability).
- Find a way to reduce the cost.
- Make certain that there are other service features that are built in to your relationship with your portfolio manager:
- Financial Planning (and on-going updates)
- Regular portfolio re-balancing
- Communication (can you talk directly to the portfolio manager?)
- Regular reviews
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Note: This hypothetical example below does not represent the return of any particular investment. Assumptions include a 7% compound annual return and an initial investment of $1,000,000. It does not include any transaction costs, bid/ask spreads, inflation or income taxes payable. Actual results could vary and the example does not factor in risks associated with market volatility or short term events.
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