“Alpha” is basically the difference between what “the market” returns and what your advisor, mutual fund, hedge fund, pension fund, brother-in-law or you yourself are able to return for you. For instance, if the S&P 500 has averaged a 0% compounded return over the last 11 years and one of them / you have averaged an 11% compounded return during that time, their Alpha is 11% per year.
Why is Alpha important to you? Because it removes the pure luck factor on the part of your advisors. Without understanding Alpha, you might be quite happy if your advisor or fund returns 8.5% a year compounded for 10 years, considering that a pretty good return that keeps you ahead of inflation.
But what if a simple index fund, by virtue of being in the midst of a great bull market, averaged 11.5% over that time frame? Would you still be happy with a manager who over long time periods underperforms the market by such an amount? Why are you paying them to under-perform year after year? Or what if, in the 11th year, the market plunged 50% -- and your advisor or fund’s performance also plunged 50%? Would you still be happy with their previous 8.5% a year?
You must allow for the every x year unusual and untoward event! What you want is an advisor or fund that more often than not beats the averages in up years but is nimble enough to avoid the worst of the down year or years. That’s why smart investors use Alpha. It is a measure of how much better your portfolio does in any given month, quarter, year or lifetime than you would have had if you had merely held on to an index fund as a proxy for “the market” through thick and thin.
As John Bogle of index fund pioneer Vanguard Funds, and many others, have noted, some 90% of all active managers fail to beat index funds. That’s why Mr. Bogle is such an advocate of index funds. To his way of thinking, why not just ride the market up and ride the market down, since just doing that will beat 90% of the active managers out there? To my way of thinking, however, the intelligent investor’s quest should be to be among the 10% that beat both the other 90% and index investing. If I ever retire from this business, I’ll be seeking someone who can also do that.
Among the smartest ways I know of to stay in that 10% Club is to do things that are not always intuitive. For instance, we saw the market beginning in 2010 as “priced for perfection.” The VIX indicator also pointed toward a complacency unseen since the whistling past the real estate graveyard in 2007. For this reason, we went into cash and income and underperformed the market the entire first 4 months of 2010. On purpose.
We chose investments like floating-rate closed-end bond funds rather than chase the latest hot stock. Our “Alpha” suffered during this time but, then, on a chart like the one below, 4 months does not even show up. As our firm’s CIO (Chief Investment Officer) I believed the time for hot stocks has passed and that we are ready for a temporary correction within a cyclical bull market within a secular bear market. Does “correction within a cyclical bull market within a secular bear market” sound confusing? Maybe this chart will help:
If a picture is worth a thousand words, this chart is worth a million. Giving credit where credit is due, it was constructed by the estimable Sy Harding, one of the smartest technicians I know and I’ve known a few hundred in my career. (See Sy Harding’s Street Smart Report, 386-943-4081, well worth the subscription price. You might want to also check out his free daily blog at www.streetsmartpost.com)
“Secular” markets typically last 14-20 years as is clearly visible from the chart above; “cyclical” markets average 6 months to 3 years and are seen as all those ratchets up or down within The Big Move. “This time will be different” is what market amateurs want to believe, but Sy’s chart of the Dow Industrials clearly shows is that, for over 110 years, the market has behaved in a relatively predictable pattern over the long term. Over the short term, of course, it is eminently UN-predictable, no matter what some slick SPAMmer’s e-mail or direct mail piece may tell you! (As Ben Graham advised, “In the short run, the market is a voting machine. But in the long run, the market is a weighing machine.”)
Beginning with a secular bear market in the early 1900s, there followed three secular bull markets and three secular bear markets. I believe, as does Mr. Harding, that we are now in the secular bear market that has followed the rip-roaring, magnificent bull market from 1982 to the end of 1999. To create your own Alpha and distance yourself from the flock, I believe you may want to consider this possibility, no matter what happens tomorrow or what happened yesterday.
This secular bear began with the dot.com,bom in 2000, went sideways for a couple years, then plunged from 11,300 to 7,500 in one year. Then, in 2003, the market mounted a fine rally, mostly thanks to cheap government financing that inflated home prices at the same time it kept rates low enough to suck in millions via cheap, if unsustainable, mortgages. The ensuing rally soared way up to 14,000 and change, before plunging back to 6626, then enjoying a cyclical rally to today’s close -- not even back to its high point of the year 2000.
You’ll note that secular bull markets typically last somewhere between 14 and 20 years. Those are great times to “buy and hold!” But since one’s investing lifetime may typically encompass only one secular bull and one secular bear (equaling 32-40 years), most of us miss the long view. That’s why many investors, who began investing in the ‘80s believe that a secular bull is the norm and the current period is an anomaly. If so, they may be doomed to lose everything they made in the bull market, by seeing false signs of its return with every cyclical (6-month to 3-year) rally. Conversely, those who are entering the markets for the first time more recently have seen every rally dashed and are likely to disbelieve the next secular bull market that will come again in a few years. This is no time to take the short view, including the view of only our first 10 or 20 years in the market!
Now -- look at the chart below, covering just 2000-2010. In measuring this current secular bear market, you can clearly see periods of cyclical bull rallies, but the chart clearly demonstrates that we have effectively been going sideways since the year 2000. These cyclical rallies and declines are often well worth participating in. But our decision to exit at year-end 2009 certainly didn’t hurt us. After last week, the Dow is right back where it began the year. And, in addition to making more in interest and dividends than we might have made and lost in capital gains, we slept better at night, too…
The futures indicate that tomorrow will be a monster up day. Maybe so – but we don’t look at days. We are looking at where we think the market will be in 6-12 months, not 6-12 days!
There are two key lessons these charts hold for me:
(1) Bull markets charge ahead. Bear markets amble. Just like the animals chosen to represent them, bulls charge, bears amble. In the popular mind, bear markets plunge. But in fact, they are more like resting periods before the next advance, going down, going up, down and up, in a constant game of sideways tug-of-war. Bull markets, on the other hand, probably because the generation in their peak earning years remembers only the choppy up and down action of the bear they cut their teeth during, surprise them with its strength. The channel of their upward trajectory is as thin as bear markets’ channels are wide. This leads me to my second conclusion...
(2) Secular bull markets are profitable periods to buy and hold. Secular bear markets are only profitable if you are willing to reallocate your assets from fully invested to less invested and back again. That’s why, in so many previous articles, I have recommended re-allocating assets to protect your portfolio. And will continue to…
Author's Disclosure: We and / or clients for whom these investments are appropriate, are long NRP, PVR, ATLIF.PK, NZT, TBT, TIP, NSL, PFL, VXX, VXZ, GG, KGC, FNNVF.PK, RGLD and SLW – and still have a very large cash cushion, which we’d love to deploy – at lower prices.
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Past performance is no guarantee of future results, rather an obvious statement if you review the records of many alleged gurus, but important nonetheless – for example, our Investors Edge ® Growth and Value Portfolio beat the S&P 500 for 10 years running but we are flat in 2010. We plan to be back on track as the year progresses and we put our cash to work but “past performance is no guarantee of future results”!
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