Alpha-bet soup

The simple truth behind a flashy industry buzzword.

Our first vocabulary word today is “alpha.”

If you're looking to invest a million bucks or so, you will hear this term until it etches a groove in your aural canal. Money managers brag about their skill at “generating alpha.” Institutional investors claim they've perfected “portable alpha” and can inject it into your portfolio. The Financial Times of London calls its investing site FT Alphaville and a new magazine called Alpha caters to hedge fund managers. So what is this wonderful stuff called alpha?

The term comes from the nerdy realm of the Capital Asset Pricing Model. But despite what many people think, alpha doesn't refer to a particular type of hightech investing strategy.

The way most money managers use the term, alpha translates as simply the ability to beat the market. When a manager says he can generate alpha, all he's usually claiming is that he's got a magic touch when it comes to making your money grow. (Phrasing the boast in terms of alpha makes it sound ever so much more scientific, doesn't it?)

This brings us to our second vocabulary word: gullible.

Let me use the word in sentence: You're gullible if you fall for the cult of alpha without asking questions.

You might ask how it's possible to predict that a strategy will produce alpha when even the great Warren Buffett can't predict with any precision what the market will be doing a year from now.

You might also ask why rich mutual funds don't get off the couch and go out and buy alpha. After all, two-thirds of actively managed mutual funds fail to beat the market in any given year. You would think that if alpha were so accessible, all the underperforming funds would trot down to the alpha store and get themselves some of it.

If you ask enough questions and read the literature on alpha, you will discover many money managers misuse the term. Strictly defined, alpha doesn't mean just beating the market. Instead, alpha is about getting a better return than you could have reasonably expected given the riskiness of your portfolio.

Accounting for risk is important, because anyone can beat the market — at least until they blow up — by taking silly chances. That's not good investing, and it's not alpha either. Real alpha is being able to consistently surpass the market without taking on any more risk than the overall market.

Generating alpha is so tough that academics question whether it exists in today's market. Many strategies that claim to generate alpha may be just Russian roulette in disguise.

You might, for instance, create what looks like alpha by selling put options that are far out of the money. This means you guarantee that you will buy a given stock at, say, $40 a share. If the stock is trading right now at $70 a share, selling these put options to people who want to put a limit on any potential losses might seem a safe bet. You could go for years making a lush profit from peddling your options — right up until the day the stock falls to $30, the option holders exercise their right to sell the stock to you at $40 a pop, and you lose a fortune. Traders call this picking up nickels in front of a steamroller. You do great until the instant you get crushed.

Of course, not all alpha strategies are doomed to fail. In the best case, you get a piece of a clever strategy designed to exploit tiny anomalies in the market.

But in the worst case, you're buying into a blowhard who's convinced he can see further ahead than other people. This confidence is often not justified. You may recall the implosion of the hedge fund Amaranth this past September after it made a series of disastrous bets on natural gas prices. Or you may remember the blow-up of Long-Term Capital Management back in 1998 after a couple of the Nobel Prizeâ??winning economists on its board of directors failed to get their equations in order. That's what happens when you get caught with your alpha down.

If someone's pitching you on an alphagenerating strategy, ask him how much of his own money he has invested in it. (The only right answer is, “All of it.”) Ask him how much borrowed money is involved. (If he's leveraging your capital by borrowing more than twice the same amount, especially if he's making unhedged bets on the direction of the market, you should be aware that you're taking on a heap of risk.) Then ask him to explain how his alpha-generating strategy works.

If you don't like what you hear, let me suggest that you use today's final vocabulary word: Goodbye.