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Excerpts from Alpha
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Since recorded time, storytellers have used illustrations to express themselves. The written equivalents of pictures - anecdotes and respites - are used frequently in Searching for Alpha.
Anecdotes are useful because they connect the everyday with the esoteric. It is my hope that these narratives make the task of investing seem as fascinating and challenging as it is in real life.
From Chapter 8
The Case of the Converging Correlations
Winston Smith gazed contemplatively at his glass of 1986 Chateau Lafite Rothschild. The vintage wine was a gift from one of his first clients, and Mr. Smith chose a momentous occasion – the adjournment of a tense meeting with this same client – to pop the cork. Great Bordeaux is a combination of three distinct grapes – cabernet for complexity and elegance, merlot for smoothness and consistency, and cabernet franc for acidity and fragrance. The great wine house of Lafite Rothschild, whose origin dates back to 1755, earned a reputation based on its skill in blending these varieties of grapes into a product greater than the sum of its parts. It was this skill that Mr. Smith needed now more than ever.
It is November 1998. The financial carnage of the last several months has taken an onerous toll on a number of Mr. Smith’s best investment managers. The collapse of the Russian debt market and the ensuing panic from the disintegration of Long Term Capital Management did particular damage to convergence strategies – those that buy and sell similar securities simultaneously in the hope that their prices will intersect in an orderly fashion. As a result, Mr. Smith was contemplating the first losing year of his multiple-advisor ‘fund of funds’, an investment he feverishly touted as market neutral – able to profit in any market condition.
Winston Smith, our protagonist, must determine why his supposedly "market neutral" hedge fund was not immune to the Asian currency crisis of 1998. How does he do it? Read the book!
From Chapter 9
Monkeys display remarkably human-like behavior. But despite their innate intelligence, they are surprisingly easy to capture. Monkey-catchers start with a gourd, in which a small hole is drilled and baited with rice. When a monkey plunges his hand in the hole to retrieve the prize, he quickly realizes that the hole is too small for him to remove his rice-filled fist. The monkey thus finds himself in a dilemma – he can either continue his quest for a full stomach, or simply recognize the trap for what it is and run to safety. Unfortunately, most monkeys choose to ignore the long-term consequences of their actions and instead focus on the short-term, ending up either as a meal or a weekday special at the local pet shop.
Such is the case with both investors and investment managers regarding taxes. Although there has been considerable effort spent by both academics and practitioners in seeking to create more efficient portfolios, these efforts have largely ignored the long-term effects of taxes on total return. Taxes are frequently the largest expense that many investors face – surpassing both commissions and investment management fees – yet there have been fewer than a dozen published studies that examines its effects on investor wealth. Richard Brealey, a professor at the London Business School and one of the few commentators on the subject, remarks that "return is likely to depend far more on the risk the fund assumes and more on its tax liability than on the accuracy of analyst’s forecasts."
How can you get the tax monkey off your back? Read the book!