April 14, 2024
Understanding 'Alpha Decay': Past Returns and Future Predictions

What is ‘alpha decay’ in finance, and do past returns indicate future returns? originally appeared Quora: a place to gain and share knowledge, empowering people to learn from others and better understand the world.

Answer By Julien Penasse, Associate Professor of Finance at the University of Luxembourg Quora,

In finance, ‘alpha’ refers to the ability of a strategy to outperform the market, taking into account the level of risk. Simply put, if an investment approach consistently delivers strong returns, it is said to have ‘alpha’. Value investing is a prime example of such a strategy. This approach involves buying stocks that are priced lower than their earnings and selling stocks that are priced higher than their earnings. Historically, this method has been effective in delivering better than average returns.

Investing in the stock market involves significant risk, and returns from long-short strategies are often volatile. Many strategies struggle to maintain strong returns over extended periods. This variability in performance can be attributed to chance or the inherent risks associated with these strategies. Additionally, the effectiveness of many strategies diminishes once they become widely known. A notable example of this phenomenon is the ‘size effect’, first identified by Rolf Benz in 1981. This effect, which initially suggested that smaller firms outperformed larger firms, appeared to dissipate in the United States after the publication of Benz’s research.

Many widely used investment strategies experience a similar decline in effectiveness, a phenomenon known as ‘alpha decay’. The term refers to the diminishing returns of strategies over time, especially after they become public knowledge. Alpha decay appears to be a widespread issue in finance. A 2016 study conducted by David McLean and Jeffrey Pontiff showed that on average, returns from popular stock market strategies are reduced by 58% after details of them are published.

This is not necessarily surprising. In the world of finance, it is wise to view claims of high risk-adjusted returns with skepticism. This is reflected in the commonly seen disclaimer, “Past returns are not indicative of future returns.” Alpha decay can usually be detected for two main reasons.

The first cause of alpha decay is “data snooping”, which reveals that the alleged alpha never actually existed. With the vast range of ways to manipulate data, it is not surprising that some strategies appear to provide alpha. Reason two is crowd. Initially profitable strategies may lose their edge as they become more widely known and adopted. As more investors adopt the same strategy, its profitability decreases. An example of this is the size effect; After several funds were set up to capitalize on this phenomenon, it disappeared, leading many to believe that its disappearance was due to overcrowding of the strategy.

You may be tempted to believe that a strategy is genuine if it continues to work well soon after it becomes public knowledge. However, this is a misconception. In my research, I have shown that the crowd effect can be misleading. It is possible for a strategy to remain highly profitable immediately after going public and yet turn sour later on. This incident highlights the subtle and often delayed effects of crowding out in financial strategies.

Consider the following example: Your investment strategy focuses on buying small stocks that are relatively cheap and shorting larger stocks that are relatively expensive. Initially, this approach generates alpha. However, as other investors begin to adopt your strategy, they inadvertently influence market dynamics. Their collective actions drive up the prices of the smaller stocks you are investing in and drive down the prices of the larger stocks you are shorting. This results in a temporary increase in the returns of your strategy. This uptrend only continues until market prices adjust down, at which point the alpha generated by your strategy effectively disappears.

The magnitude of this impact could be substantial. In my analysis, I propose that for a typical strategy, every one percent decline in alpha results in a three percent increase in returns. This significant variation may lead to the false conclusion that a strategy is profitable when in fact it is not. Take the size effect as an example: After Benz’s paper was published, returns remained remarkably high for about two years. This represents an important lesson for investors: past returns can predict future performance, but this relationship can end suddenly. Caution is advised not only with respect to data espionage, but also in terms of ‘honeymoon returns’ following the public release of a strategy. These returns, which often appear exceptionally promising, may ultimately prove unsustainable.

For more in-depth and technical details on this topic:

Julien Penasse (2022) Understanding alpha decay. Management Science 68(5):3966–3973.

this question originally appeared Quora – A place to gain and share knowledge, empowering people to learn from others and better understand the world.

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