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David Murray's Alpha Mail - Eureka Report Article

June 29, 2007
David Murray's alpha mail
By Scott Francis

PORTFOLIO POINT: Active investors, as a group, get the same market returns as index huggers; they just pay more fees, as the Future Fund boss points out.

David Murray was reported in a media article last week discussing plans for the investment of the $50 billion-plus Future Fund. This is going to be a very interesting story over the next 12 months: just how is Australia's biggest investment portfolio invested?

He was quoted in the article as saying: "What we are looking for will be the cheapest beta risk that we can find in the market, and on top of that, reliable alpha." He went on to say that "alpha is a zero sum game, but a negative sum game after you subtract fees, so to buy reliable alpha to deepen returns will be our objective".

So what are alpha and beta? "Beta" refers to the average market return. For example, if the ASX 300 market returns 24% over a three-year period, then that is the beta (market) return. "Beta" is captured using an index fund. Index funds invest in the whole market, owning all of the investments in the proportion as they sit in the index. For example, the ASX 300 index measures the return of the biggest 300 stocks listed on the Australian Stock Exchange. An ASX 300 index fund holds these biggest 300 stocks in a portfolio that mirrors the index, and therefore captures the overall return of the index.

"Alpha" generally refers to the activity of adding performance over the market average return. For example, if a large company fund manager produces a return of 27% over the same period that the ASX 300 returns 24%, then we would say that their alpha is 3%. If they only returned 21%, then their alpha is minus 3%.

"Alpha is a negative sum game after you subtract fees"

This is an interesting comment by Murray, and one that is particularly profound. He is suggesting that in the market has two groups of investors: passive and active. The passive, or index investors simply receive the average market return (beta), less fees. Averaging returns across all active investors produces the same result - the market return - but because they have been pursuing different stocks, there will be positive and negative alpha (and bigger costs).

Perhaps this is most easily explained by looking at some numbers. Let's assume that we are looking at a period in the market were investment returns were 10% a year, and that 10% of the investors are passive, so will receive the beta less, say, 0.5% costs.

Active investors, overall, also received 10%, whether they were individuals, stockbrokers, managed funds or institutions. However their costs will, on average, be much higher than the index investors because they cover research, brokerage, market impact costs (for large investors who buy and sell such big volumes of stocks such that they move the trading prices against themselves) and fund manager fees. Let's approximate this at 1.5% a year.

The average return in the active investor side of the market is, after costs, 8.5%. This is why David Murray commented that alpha is a negative sum game after you subtract fees.

The simple maths of alpha

Bill Sharpe, who won Nobel Prize in Economic Sciences in 1990, wrote an article in 1991 entitled The Arithmetic of Active Management, which was published in the Financial Analysts Journal. In it he made the following statements, which support David Murray's comments about alpha (active management) being a zero sum game:

"Over any specified time period, the market return will be a weighted average of the returns on the securities within the market. Each passive manager (index manager or beta manager) will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return.

"Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management."

Once again, the proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic


This is a major investment debate raging at the moment: active or passive? The great thing is that as an independent investor, you don't have to take sides. It is possible to use a beta and alpha strategy where you capture the market performance in a low-cost way, and look to add value with active strategies in other parts of the portfolio, always acknowledging that this is a "negative sum game".

David Murray provided a little bit of investment advice in the article as well. He said: "If I were just leaving school, I'd invest in an index product provided the fees were right." Surely this is not the same David Murray who spent a career at Commonwealth Bank selling active managed funds that charged fees of 2% a year to investors?