I'd don't quite understand this, so I'd appreciate help interpreting this graph for me. A few reflections (that may not be correct) to indicate where I get lost:There was discussion in the podcast on this point, but it went over my head. Can anyone help bring it down to earth for me? Here is the relevant quote:If passive investing creates inefficiencies in the market, there will always be people and computer algorithms at the ready to exploit them, and make the market more efficient.
"Ben Felix: One of the other big measures is active manager performance. How does this situation affect the ability of active managers to beat the market?
Mike Green: Perversely, what it does is it creates a drift in the marketplace that penalizes holding cash or being “safe,” maintaining the optionality of cash. But it also perversely corrupts measures like the Sharpe ratio or alpha in its behaviour. Again, jumping to a slide, and this one has to be a little bit interactive. I apologize to your listeners. If you jump to slide 25 in my deck, this is titled, ‘When time becomes a proxy for passive penetration, alpha vanishes for active management’. What I'm pointing out here is that the historical model of how stock prices behave or how markets behave, is that there is a central tendency, equities return 8% a year and then there's cyclical variation around that.
When you introduce something like passive, this is the pale blue line, the convex curve that you see. When you introduce something like passive, it pushes valuations up over time. It actually changes that underlying return function from a flat line to a convex line. Now, this is where it gets really tricky, and I apologize for your listeners if there is math involved. The solution sets that we use in finance, we're all very good at math. But alpha is actually just the intercept on a linear equation. The behaviour of your portfolio is equal to its beta times the market return, plus some idiosyncratic measure we call alpha. Y equals MX plus B.
If you use a linear solution to a curved surface, over time, mechanically, your alphas get pushed lower. It's just math. It's a function of the fact that we're really not as good at math, as we like to talk about being. We're just using the wrong metrics. So then, if you flip to the next slide, you can actually see the impact that this has. The theoretical model, you're looking at alpha in this context, and the impact of passive, is identical to the empirical data.
* t0 shows return at year 0. The historical model in which the portfolio returns, which include the excess return generated by active manager's alpha, stays around a given level (say 8% as mentioned in the text above). The returns are explained by a flat line.
* As passive pushes up prices and valuations over time, the returns at year 1" and 2 get pushed lower, because our model still assumes a flat line and that flat line must be adjusted to an ever increasing return.
But I have a hard time understanding this mechanic intuitively. What are some other ways to explain the diminishing levels of alpha as passive pushes prices (and thus valuations) up over time?
Statistics: Posted by sinus — Sat May 18, 2024 11:08 pm — Replies 151 — Views 14800