The Quest for Alpha: The Holy Grail of Investing

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