07/05/2011 05:54 pm ET Updated Sep 04, 2011

Three Sources of Negative Alpha

Much of the information in the financial media is wrong or misleading. It can be difficult to separate fact from fiction, especially when the source of the information is someone with apparent credibility.

Recently, Pat Dorsey gave an interview to Morningstar. The interview was titled: Three Sources of Alpha. Dorsey was formely Morningstar's director of equity research. He is now with Sanibel Captiva Trust, a division of The Naples Trust Company, where he is Vice Chairman and Director of Research & Strategy. He is the author of two books on investing.

According to a press release, "Dorsey's investment approach strikes a chord with investors looking for capital preservation combined with returns that can outpace the market indexes."

I am curious about his methodology for beating the markets. His interview with his former employer gives us some insight into his investment strategy. He has a three pronged approach:

1. He seeks an "informational advantage" which he describes as "knowing more than the other guy." I wonder how he will get this advantage. Sanibel is a long way from Wall Street. Is it possible Dorsey can uncover information about publicly traded companies that is not instantaneously known to millions of traders around the world? He concedes this is not likely except for small caps, where he believes you can get an "informational advantage" if you "work hard", because small businesses "are not very well followed by Wall Street."

Really? This will come as news to the sophisticated fund managers of more than 600 small cap mutual funds, some of whom probably work really hard in an effort to beat their benchmark. According to a Standard & Poors study, for the five year period ending 2010, 72% of Small Cap Growth funds, were outperformed by their index. 51% of Small Cap Value funds, and 60% of Small Cap Core funds met the same fate. You have to wonder why Mr. Dorsey believes he can succeed where these fund managers failed.

2. He notes the possibility of an "analytical advantage" and uses as an example a "quant model" that processes data better than anyone else. However, he concedes that "like an information advantage, analytical advantages are also pretty hard to come by."

With two prospective sources of "alpha" pretty much eliminated, he discusses the third one.

3. He calls this a "behavioral advantage" which is "simply acting a little bit more rationally than everyone else." He has more confidence in this factor, which he believes is "pretty achievable given how irrational the market can be."

He has a point, but he reaches the wrong conclusion. Markets don't act "irrationally". They are random and unpredictable. Instead of trying to achieve "alpha", investors need only accept the fact that capitalism works. The ultimate "behavioral advantage" is capturing the returns of global markets, using low management fee index funds in an asset allocation suitable for you. Pursuing "alpha" is the essence of irrational investor behavior.

If Mr. Dorsey really wants to give his clients a "behavioral advantage", he will tell them to read books by Burton Malkiel, John Bogle, William Bernstein, David Swensen and many others, including my Smartest series of investing books. Armed with the overwhelming research in these books, his clients will abandon the quest for alpha, which usually yields "negative alpha" for everyone except those who claim they can deliver it.

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