If You’re Going to be Cheap…be Cheap

My hometown has a locally owned pizza place that’s been a staple of the community for almost 40 years; I even worked there for a stint in college. The pizza they serve is pan style and both the dough and sauces are made fresh daily. Even the toppings are scrutinized for freshness throughout the day. The owner’s life has been dedicated to improving the customer’s experience with the quality of their product. For example, as a delivery driver I wasn’t allowed to chew gum, because “the first thing the customer should smell is our pizza, not your gum.” It’s the kind of food that transcends the body’s basic necessity of fuel and feeds your soul, makes you happy, and causes you to pause, if only for a second, to reflect on the complexity of the flavor.

One block away, there is a chain pizza place that also has a market niche. Its niche is about as far away as you can get from the ‘ultimate-consumer’ pizza experience as you can imagine, but it’s cheap. And guess what? My favorite hometown parlor is expensive—not even expensive on a relative basis—it’s just plain expensive. The reason is obvious: quality. The hometown hero is obsessive about being the best—from the quality of the ingredients, to the actions of its employees.

The big question is does any of this “pay for quality idea” translate to the world of active management? Our answer is an emphatic yes…but you have to do your homework. The good news for any advisor is that the homework is not overly complex.

The answer lies in Alpha.

Investopedia defines Alpha as a measure of performance on a risk-adjusted basis. Here is the basic idea. Alpha = the investment’s return – the investment’s beta-adjusted expected return. (Note, for simplicity in this blog, we are deliberately leaving out risk-free rate and other factor returns, but even with those things added in, the concept remains the same.)  Let’s say an investment has a Beta of 1.5. If the market return was 10%, the expected Beta-adjusted return would be 15%. Now, if the investment’s return was actually 16%, then the Alpha would be…1% (16%-15%). (All of these calculations are done on a net basis.)

Here’s an example of why alpha is so important, and much more so, than simply the fee. Consider this scenario with two distinct long/short equity funds. We are not going to name either fund, so we’ll refer to them as “Fund A” and “Fund B”. Fund A charges 1.09% (remember these are long/short funds, so this is considered a lower fee for the category) and Fund B charges 1.69%—which is more expensive relatively speaking. In this case, the advisor already owned Fund A, so the question is whether or not to entertain switching funds based on fees alone…at first glance, not a chance.

But let’s talk about Alpha.

Over the same time period, Fund A, aka the less expensive fund, had an Alpha of -1.2%. Why is this a big deal? Because the investment with a negative Alpha carries a Beta of 0.63, and only realized 43% of its benchmark’s return!

If cost is the main objective, this advisor could simply move 63% of this allocation to a 10 basis point ETF and 37% to cash. It would have performed better with the same risk exposure and for a tenth of the cost—hence the title of the blog, “If you’re going to be cheap, be cheap” (i.e., just know that the desired outcome goes beyond simply screening on expense ratios).

By the way, the more “expensive” choice, aka Fund B’s, Alpha was 4.64%—realizing its benchmark’s return (net) with a Beta of only 0.43 over the same time period.

Bottom line. If the main objective is to achieve compelling risk-adjusted returns, then the choice becomes easy—just like my choice in pizza venues when visiting my hometown.

Learn more about Defining Alpha…It’s Skill Not Excess Return