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Charles Ellis is a master story teller. When Ellis served on Yale University’s investment committee from 1992 to 2008, his colleagues, who included David Swensen, went so far as to call the advice and wisdom he imparted through his stories “Charley’s parables.” So when I decided to research whether alpha — investment returns above what a plain old index fund would give you — was just a fairy tale that the investment industry told itself at bedtime, Ellis was my guy. I asked the author of Winning the Loser’s Game and the man who wrote the foreword to Swensen’s landmark book on portfolio management to talk to me for a video series we were filming on the murky topic of why institutional investors rarely beat the market. It isn’t a new problem (Ellis first wrote about it in 1972), but it has been getting steadily worse, and I believed I might be writing alpha’s obituary — not good when your job is writing for a publication named Institutional Investor.

When the indefatigable Ellis called me back on a dreary day at the end of March, he graciously said no to the video, assuring me I would never want to interview him on film, as he doesn’t know how to speak concisely. We then spent an hour talking about what prompted him to write “Murder on the Orient Express: The Mystery of Underperformance,” a short, Agatha Christie–inspired piece in the Financial Analysts Journal last year in which he lays the blame for the inability of pension funds, endowments and others to invest well at the feet of the “usual suspects.” Everyone is guilty in Ellis’s estimation: money managers who overpromise, investment committees operating under bad governance structures, consultants who want to protect their franchises and poorly paid, thinly staffed institutional investors.

But the 75-year-old Ellis is polite, perhaps to a fault. He assures me that all these people sincerely believe they’re doing the right thing and that it’s hard to identify the “son of a bitch” (well, maybe not polite to a fault) who is truly responsible for the colossal failure to find alpha. To make his point, Ellis takes me on a long and often touching detour to explain how we can be part of the problem even as we are oblivious to the specifics of the role we are playing. He enlists the movie The Help, in which young, card-playing white women are blind to the tragic effects of segregation around them, to make his point that people in the investment industry are doing their best, even if inexorable forces are preventing them from delivering their promised product.



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Ellis, who founded consulting firm Greenwich Associates in 1972 to provide strategic advice to financial services firms, warns me he is going to stop talking, tells me how much fun he is having and asks how he can be of help. I tell him I want to know why the aggregate amount of alpha — a measure of risk-adjusted excess return — seems to be drying up. Why is it that investors can collectively discover and then quickly wring out all the value from an investment idea? Ellis has pointed to a lot of mistakes that investors make, like dumping funds at the worst possible moment; I ask him why a small-cap stock manager might have a harder time today picking stocks that will beat the average than he or she did in the 1980s.

I had evidence that it was happening. A few months earlier, before he landed at Credit Suisse in New York as head of global financial strategies, Michael Mauboussin had shown me statistics he had prepared for a Columbia University class on security analysis that he was teaching, illustrating that the margin of outperformance — that is, alpha — of U.S. large-cap mutual funds has been steadily shrinking for 40 years. “The difference between the best and the average manager is narrowing, so the results get narrower,” says Mauboussin. “We saw it at the Olympics: The gold medalist wasn’t that much faster than the athletes who won the silver and the bronze. That’s also happened in investing.”

I became interested in how alpha had gotten harder to find during the 2007 quant crisis. Traditional asset managers, which I had been covering since 1998, always tell investors and reporters the same thing when markets fall: Markets can be irrational at times, so keep your head down, keep dollar-cost averaging, and your portfolio of equities and bonds will work in the long term.

In August 2007 investors discovered that a huge number of quantitative long-short hedge funds had been using the same supposed secret algorithms to trade a handful of big stocks. When all these hedge funds got a sell signal from their algos at the same time, the markets cratered. To Andrew Lo, a finance professor and head of the Laboratory for Financial Engineering at the MIT Sloan School of Management, the quant crisis was a surprise and the first sign that something was different. There were no new big investing ideas. Every trade was crowded, and alpha might be dead.

“No corner of the financial market was undiscovered country,” says the peripatetic Lo, talking to me on his cell phone from the back of a cab.

I wanted to know how that had happened and what institutional investors were doing about it. I examined how innovations like target date funds — which automatically divvy up investments among different types of equities and bonds — had fueled blind demand for small-cap stocks. The investment spigot had been turned on for these stocks regardless of perceived value and driven prices up and expected returns down. I talked to investors who were looking for untrammeled corners of the investing world that could provide additional diversification and new sources of alpha.

But when Lehman Brothers Holdings filed for bankruptcy a year later, exploring the concept of too many investors’ running good investment ideas into the ground seemed laughable. Once the financial crisis was unleashed in its full fury, I dropped the subject of whether alpha was dead and reported instead on how the financial services industry could survive.

The crisis turned out to be a watershed moment in investors’ struggles to find excess returns. What had become common wisdom and the science of markets suddenly didn’t work. One case in point was the endowment model, made famous by Swensen: It stresses diversification into all types of equities and employs huge allocations to alternative investments like private equity and hedge funds. The model, which had produced stellar long-term investment returns for Yale, failed during the crisis. The mix of all those asset classes did not provide any cover from the losses in the public equity markets, and investors had to scramble to access other sources of cash once they got a real taste of what it meant for their funds to be locked up in illiquid investments. The research that went into the endowment model looked threadbare in the face of postcrisis structural changes like global deleveraging and unprecedented monetary policy by central banks around the world, not to mention the demands of aging populations for their assets to work harder.

Hoping to make sense of what had happened, I recently reached out to Suzanne Duncan, the 40-year-old global head of research for State Street Corp.’s Boston-based Center for Applied Research. I first met Duncan seven years ago, when she was a rising star at the IBM Institute for Business Value. She always has a counterintuitive insight when I call her about an idea I want to explore. When asked about alpha, investors’ copying one another and the effect of the 2008–’09 meltdown, she tells me that the financial crisis has forced the industry to rethink basic assumptions of Modern Portfolio Theory, such as normal distributions, market efficiency and risk-free rates of return. “Investors and providers alike are recognizing inherent weaknesses in these assumptions, which they have come to realize are not so basic at all,” she adds.

Duncan is excited about my research on alpha. She cites a joint paper from the Center for Applied Research and the Fletcher School of Law and Diplomacy at Tufts University that found that less than 1 percent of 2,076 U.S. mutual funds tracked between 1976 and 2006 achieved superior returns after costs. She also refers to a working paper from the University of Maryland that reports that before 1990, 14.4 percent of equity mutual funds delivered alpha, whereas in 2006 only 0.6 percent of the managers could say the same thing. The authors define funds that produce alpha as those having stock-picking skills sufficient to provide a surplus beyond recovering trading costs and expenses.

Duncan relishes telling people what they don’t want to hear. When I met her in ’06, she was presenting the findings of her research on how transparency and speed would destroy the value of traders, at a time when Wall Street was still making record profits. Now she’s saying that transparency and speed have destroyed alpha.

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