Big Alpha

A gram of brains weighs more than a kilo of muscle.

There are only three ways to generate alpha, and a modicum of any one of those will outweigh a cacophony of marketing bluster about mediocre returns.

Information

SAC Capital has outperformed everybody else for decades (30% per annum over 18 years) by making better calls on where stocks are going to end up than anyone else.

A few ex-colleagues work in the risk department there, a good gig.

One case in particular has brought to light how easy it is to make the right calls on pharmaceutical companies when you can see drug test reports before anybody else.

A typical manager is scavenging for crumbs at SAC's table.

An investor paying anything but the lowest fees should demand a such a significant advantage for her money.

Very few can match SAC's return record.

Muddy Waters figured out that Sino-Forest was a sham. Tilson found Lumber Liquidators was pumping its timber with chemicals. John Hempton of Bronte Capital often writes up his firm specific research.

But the time and resources required to gain a legal informational advantage is prohibitive and doesn't scale. Information gleaned from one company won't give you an advantage trading others.

Even the most heralded funds will rarely have an appreciable advantage over the long term. Paulson was once top, but now seen as the biggest post crash loser.

Intellect

The second way for a manager to make money is hiring Nobel prize winners. LTCM is the poster boy for intellectual capital and almost destroyed the US banking system.

Most funds claim intellectual value add. But think back over the last 20 or so years. Have we had any big intellectual revolutions in financial economics?

Nope.

There's nothing out there which will give a significant year on year advantage over everyone else.

Sure there is the odd noisey anomaly; or multi-year risk premium to be earned; but intellectual capital walks out of the door every other year. If the idea is big enough, it will spread and even the playing field.

As LTCM showed, even Nobel prize winners don't guarantee a significant advantage for your money.

Technology

The final way to generate large returns, is having significantly better technology than your competitors. This could be HFT-related or technology which helps in information retrieval (hacking?) or intellectual capital generation (hacking?).

If you reckon better tech is worth paying fees for, then you should probably just buy FB stock, they probably have better technology people than any in the finance industry. It's not impossible of course (Thomas Peterffy is testament to that) but very expensive and difficult.

Upshot

If you pay for alpha, pay for very large alpha that's the result of an unfair advantage.

Otherwise, don't mess around with funds nibbling on crumbs and stick with index beta.

[Thanks to Justin D. for inspiring this post]