Alpha Bets: Alpha or Beta, Which Are You?

The investing world is bifurcating into two camps: those generating alpha and seeking uncorrelated returns, and those focusing on beta and capturing index- based returns. Which camp you are in makes all the difference in the world.

The alpha camp, typically hedge funds, attempts to develop strategies that generate profits that are not aligned with market indices. Many alpha strategies attempt to lock in price dislocations against various asset classes, capital structures, trading styles and information sources. The beta camp tends to be comprised of "follow the crowd" investments that track an index, commodity (such as gold) or market sector.

The goal of a beta investment is to minimize tracking error, or the return differences between the fund and the index benchmark. To the extent that you can minimize execution risk andcost, your fund will perform better.

Increasingly, the beta camp is represented by exchange-traded funds (ETFs), which have a few advantages over traditional index funds: ETFs typically have lower fees, can be valued in real time and traded like stocks, and can be created and redeemed at will. ETF composition also offers little, if any, investment choice - the ETF maintains the same asset balance as the index. Little research is needed, and portfolio manager insight is limited; costs therefore are low.

These advantages, in conjunction with the difficulty actively managed funds face in beating an index, are pushing investors to migrate their holdings from traditional actively managed funds to ETFs. From January 2007 through August 2011, U.S. equity mutual funds bled more than $300 billion in assets, according to ICI. Meanwhile, U.S. ETFs added more than $500 billion in assets from 2007 through the first quarter of 2011, according to Strategic Insight's Simfund database.

We are seeing a shift in the market in two directions: For alpha, investors are turning to high-cost platforms, which attempt to insulate the investor from index volatility; and for beta, investors are moving to low-cost and more-relative-performance ETFs.

As this shift continues, it will place pressure on the whole investing value chain. The advice channel, which had been focused on the traditional manager, will shift toward alternative managers, who, by nature of their higher fees, will be able to pay more for ideas. Conversely, as ETFs gain share, cost (execution and commission rates) will outweigh insight as their prime business driver.

In addition, competition will force traditional funds either to provide a more similar return structure to ETFs or to offer more alternative and higher-fee structures. Competition also will push traditional funds to consolidate, which will increase operational efficiencies, distribution capabilities, economies of scale and the broker leverage a larger commission pool drives.

It will take decades for retirement accounts to modify their heavy reliance on mutual funds, but times are changing. Funds are consolidating, fund complexes are developing ETFs and traditional managers are creating hedge funds.

In addition, brokers are refocusing on low-cost electronic execution.

While the fund industry is long from moribund, increasingly it will become difficult to remain in the middle. Firms either will need to develop high value alpha or provide efficient and inexpensive beta. Unfortunately, the actively managed mutual fund will be increasingly hard to defend.