Alpha Is Beta In Disguise

A friend forwarded me a fund deck last night. 16.5 pct a year for ten years against the index at 12.5. Four points of alpha, the deck said. Compounding at that gap turns Rs 10L into Rs 46L instead of Rs 32L, so I understand why the number sells.

I ran the same return through a factor lens before replying.

Extra market beta of 1.05 explained 0.6 points. A midcap tilt explained another 1.4. A momentum tilt explained 1.1 more. That is 3.1 of the 4 points accounted for by exposures, not decisions. Nobody picked a stock to earn them. The portfolio just leaned, and the factors paid.

What survived was 0.9 points of unexplained residual. The honest version: even that is a claim, not a verdict. At 4 pct tracking error over ten years, a 0.9 residual carries a t-stat of about 0.7. The bar for believing a number is not luck sits near 2. Carhart ran 1892 US funds through this exact lens in 1997 and found the persistence in returns came from momentum exposure and fee differences, not stock picking. Fama and French repeated the exercise in 2010. Net of fees, the average fund's residual is negative.

Here is the part that matters for your money. Every one of those exposures is rentable. A midcap or momentum index fund costs around 0.2 pct a year. This fund charged 1.8 for the package. On a Rs 10L holding that is Rs 18000 a year against Rs 2000, for ingredients that were never skill in the first place.

Alpha is whatever is left after every beta has been named. Most funds run out of return before they run out of betas.

Factor models, decoded: