Saturday, July 18, 2009

Alphas, Betas, and Predetermined Rates of Returns


In the ongoing social debate on what kind of an economic system we should build on top of the rubble of the present financial mess, we as investors should focus less on the philosophical nuances and more on how to adjust our investment framework, expectations, and tactics.

As the work of free-market proponents Milton Friedman and Margaret Thatcher falls to pieces under the weight of human greed and hubris, it is important to acknowledge that greed and hubris were also the culprits in past socio-economic collapses: communism, failed monarchies, etc. It seems safe to say that whatever policy will be implemented next will carry within its DNA the same self-destructing gene.

History may not repeat itself but it certainly rhymes, as Mark Twain once said.


The strongest elements of a highly productive society are still rooted in free market and entrepreneurial ideologies. The European model—so much in vogue today as a potential replacement of our own socio-economic system—has for years created much higher unemployment, lower GDP growth, and less original scientific research than the US. In addition, it did not prevent the system from falling under economic dislocations. In fact, the European Union is currently in a much more precarious position in terms of its banking system and public deficits than even the US. (And by the way, I am from Europe (and still proud of my ancient historical heritage) so I should know…)

If the U.S. ends up moving toward a more European type of economic system, the result could be much lower rates of return for the foreseeable future in most asset classes. From a beta perspective, the driver of passive returns, which is an indicator of the long-term rate of growth of an economic system, may be inexorably muted for years, perhaps decades.

So if equities are going to underperform as a passive asset class, in absolute terms, will they at least outperform bonds or commodities (in relative terms)? While bonds should outperform in a deflationary environment, they will underperform in a highly inflationary environment (a situation when pretty much everyone loses). In other words the beta of bonds does not seem to be assured either.

But what about commodities?

My business partner and I have produced research that indicated there is no beta in commodities, only contingency-driven opportunistic returns. And real estate? The hangover of the last few years would seem to make this asset class a flat bet at best.

Silver Lining

Before you start reaching for the Prozac, I would like to stress that there is a silver lining in this analysis. The absence of predetermined beta-type rates of return means that superior analytical work will uncover possibilities for excess absolute returns, for example, alpha or investors’ edge or value process. In other words, a regime of muted expected returns for most asset classes will enhance the ability of the superior analyst to work out an edge.

From a statistical point of view—and based on current valuations—the risk-reward ratio of owning equities for the next 10 years is more favorable than 10 or even 20 years ago.

However, the lesson to be learned is that valuations, market timing, leverage, and risk management are the essence of investing–not beta exposure. Whether you use a micro-economic valuation model or a macro–based, asset-allocation paradigm, pricing and risk filters are key. Even within the context of my beloved core-satellite(s) strategies, the core still has to be managed somewhat and altered by virtue of superior analysis.

The laissez-faire society with all of its misplaced entitlements and outsized rewards may have ended, but its gift to us may well have been the rediscovery of our own worth and the belief in our own unique contribution to a better personal and social future—that is, unless populism and ideologies of mere redistribution win over.


Related Articles:

http://globaleconomicnews.blogspot.com/2009/06/world-bank-cuts-2009-global-growth.html

http://globaleconomicnews.blogspot.com/2009/07/big-media-seek-21st-century-business.html

http://globaleconomicnews.blogspot.com/2009/07/greenspan-fears-inflation.html

http://globaleconomicnews.blogspot.com/2009/07/uk-economy-shrinks-most-in-50-years.html

http://globaleconomicnews.blogspot.com/2009/06/microlending-taking-off-in-us.html

http://globaleconomicnews.blogspot.com/2009/06/at-stanford-research-surpasses.html


Source: http://gbr.pepperdine.edu/blog/index.php/2009/05/27/946/

Tags: Alpha, Beta, Rates of Return, Valuations. Asset allocation, financial strategy, investing risk, real estate, leverage, beta exposure, Global Economic News, free market proponents, Milton Friedman, Margaret Thatcher,

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