Q. So we’ve certainly talked a lot about alpha– the outperformance of managers — in the past. But what is “active alpha”?
A. “Alpha” — sometimes called “Jenson’s Alpha” was developed out of modern portfolio theory, and involves the idea that if a manager outperforms a benchmark — without taking more investment risk to do it– then he’s creating something really special that’s worth paying up for. And the way you measure “risk” for this purpose is to look at the volatility of the portfolio, which requires lots of market performance data for the manager’s portfolio and his benchmark.
Q. So the idea does not translate well into the world of less liquid investments, where comparative statistics aren’t so readily available.
A. Exactly. The other day, a professor on a panel with me actually asked how one computes alpha for PE investments, apparently on the theory that if alpha can’t be measured, the investment can’t be put into modern portfolio terms it wasn’t worth doing…
Q. So I’m guessing that the idea of “active alpha” addresses this point…
A. You’re so good. Yes, people have taken to calling the value created by active management — the sort Howard Morgan does — “active alpha”. You can’t measure it in MPT terms, but it’s the extra return a VC or PE management team creates by delivering talent, expertise, and relationships into an investment — the non money aspects. And you see from the performance dispersion numbers– the best VCs far, far outperform the worst– that this is a crucial element of private company investing.
Q. Seems like a very fair point… but why call it “alpha” at all, since it really doesn’t related to the stock picking skills like the word usually does?
A. The common denominator to me is: both are really hard work. You know how hard it is to create alpha in liquid securities when so many talented people and computers are picking against you. Well, a different kind of hard investment work is being done by PE and VC managers — but its more than picking the company, its “active alpha”, the hands-on work of improving corporate performance. In either case, if a manger is delivering classic alpha or active alpha, he’s worth paying for.