Alpha is ESG!
Alpha is an ESG concept. Alpha is the returns above the benchmark. If the S&P 500 delivers 5% in a year and say for example the Exceptional & Rich U.S. 500 delivers 15% using the same 500, at a similar annual turnover and volatility, for the same period, the Alpha is 10%. How can this additional 10% Alpha have anything to do with Environment (E), Social (S), and Governance (G)?
Governance
Even if we assume that underperformance or lack of alpha (9 out of 10 asset managers underperform their benchmark) [1] is just an accidental misfortune that asset managers are suffering despite their brilliance, there is a Governance issue that the industry needs to address, which is survivorship bias. Asset managers and asset management companies more than occasionaly close underperforming funds and issue new funds. This is a legal misrepresentation that is poor Governance because survivorship bias overstates good performance by more than 50% [2] and understates poor performance. And by the way, we don’t want to discuss the fairness in defining a benchmark in the first place. If we get there, we might find more skeletons in the closet and capital market integrity might stand further compromised as investors continue to pay fees for underperformance, subsidize incompetence while foregoing significant profits, year after year.
In a fair world (which does not exist), survivorship bias is a breach of ethical conduct if it manipulates performance reporting. The asset managers in plain speak lie about their already dismal performance. Why there is no punishment for such misconduct may not be so difficult to explain. Since 9 out of 10 asset managers underperform, it is from the 90% of underperforming managers that survivorship misrepresentation is likely to happen. How do you think the regulator should punish when the majority is at fault.
There is so much mediocrity in the industry that the regulator might be better in accepting that the asset manager is maybe trying his(her) best to do the impossible which is to beat the market. Hence, there is no Governance issue, it’s simply a job hazard. If Alpha was doable there would be no Governance issue in the first place. Hence Alpha is connected with the G of ESG in investment management.
Social
There is a pension crisis or pension time bomb [3], which means there is an increasing likelihood that when you retire, your pension fund may not have the money to pay for your pension. The incompetence of the G is amplified when asset owners rely on the asset managers, who can’t deliver Alpha, closing underperforming funds, creating new funds, and pushing them back using marketing machines. Add to this currency devaluation, indebted state, economic recession, inflation, increasing interest rates and you have a bigger worry than global warming. Because the climate will kill you slowly, lack of pension is an instant heart attack. Hence, Alpha is connected to the S of ESG in investment management. Let’s not even talk about the under-serviced, unbanked masses, who don’t have the risk capital to invest and participate in the next bull run, whenever that will start.
Environment
The reason Alpha is missing from the G and S in ESG is a consequence of how the society generates, interprets and maintains information which does not produce any Alpha. We do what the textbooks teach us. We don’t question, why should I continue to do what I have been doing for time immemorial and expect something new to happen. If we would ask this question, we may start wondering, what is the carbon emission from this vain process.
We have so many issues with crypto mining but rarely do we wonder about the carbon emissions related to running a $100 trillion non – alpha-generating investment management ship. I can tell you without a doubt that the information machine is the most polluting element of our Environment today [4].
A smart machine that can generate alpha, in a computational light, cost-effective way, without the desire to bring opacity and without a need to close underperforming funds is an ESG solution for Investment Management. Such a machine would prove that Alpha is at the heart of ESG. If there is no Alpa, we will never succeed in ESG.
Bibliography
[1] M. Pal, “9/10 Fail Logic”, January 2022
[2] “Why worry about survivorship bias?”, Dimensional Funds, October 2020
[3] Pension Crisis, Wikipedia
[4] M. Pal, “The Conceptual Age”, March 2022