Illegal alpha

By Felix Salmon
December 1, 2009
Christopher Holt has been talking to some anonymous types:

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Here’s an interesting twist on the efficient markets hypothesis: if you can’t generate alpha in an efficient market, then all excess returns must be illegal! Christopher Holt has been talking to some anonymous types:

Along these new lines has emerged a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.

From market-timing and late-trading to illiquid valuation techniques and 20:1 levered bets to discrepancies in share pricings between markets and indices to the growing popularity of super low-latency flash trading, these pundits, who wish to remain both nameless and faceless for fear of being drawn and quartered by their brethren, argue that alpha can’t be obtained legally…

Now-defunct hedge fund Galleon promised alpha, as did a host of alternatives shops before it, Lancer Group, Beacon Hill and many other notorious shops who claimed by definition to produce alpha through their various methodologies and abilities, most of which weren’t, at the end of the day, on the up and up.

And of course a lot of the Madoff investors were convinced that they were getting alpha precisely because he was illegally front-running trades from his broker-dealer.

My feeling is that the CAPM in general, and alpha in particular, are of limited usefulness and should be largely jettisoned as tools except for in very specific circumstances. This is if anything a move in the other direction, using perceived alpha as an indicator of possible illegal behavior. Yikes! That’s pretty scary, when it’s very hard to distinguish true alpha from what you’d get by chance alone.

4 comments

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Perhaps it makes sense to use alpha as a red flag; indeed, a lot of the hindsight argument that people should have suspected Madoff was up to something is based on his Sharpe ratio.Taking either of these, though, as more than a suggestion as to where to direct some portion of law enforcement attention would be a bit of an overextrapolation, and would in fact be, if I may say it, an overreliance on an at-best imperfect model.

alpha is another word for alchemy. stay in yr passive indexes, buy a house you can easily afford, keep cash on hand and work hard.

Posted by lucretius | Report as abusive

CAPM is of limited usefulness? For evaluating individual investments, yes. But for understanding investment strategy, it’s powerful and very useful – more to understand what not to do, and what won’t work.While I wouldn’t suggest that alpha is evidence on its own of illegal activity, I certainly don’t feel sorry for anyone who did lose money when they were promised alpha.

Posted by Homechef | Report as abusive

Markets are largely driven by sentiment, enabling stocks to be bought at too-low lows. Nothing illegal in that.

Posted by Phox | Report as abusive