Discretionary trading and the search for alpha

Abstract

Investment managers focus much of their attention on the process of searching for alpha. This paper presents a model which shows that this search for alpha is likely to generate undesirable effects for clients, leading to a loss in portfolio value that reflects an increased variance. This loss in value is unrelated to transaction costs. The greater the potential alpha and the more confidence the manager has, the greater the potential loss to the client. This effect is exacerbated if the manager sells short or if the portfolio is leveraged. Thus, searching for alpha is not just a harmless activity that leads to either positive alpha or nothing; it will almost surely lead to a loss in value, even if the manager is expected to capture positive alphas half of the time. Highly speculative portfolios such as hedge funds are likely to have an even greater loss in value.