According to the widely accepted Efficient Market Hypothesis (EMH) there are two kinds of securities markets: efficient markets and inefficient markets. An efficient market is one in which all the relevant information on each stock (or bond) is widely available; in such a market, the information has already been factored into each stock’s (or bond’s) price, and it is, therefore, virtually impossible for any analyst or portfolio manager to gain an edge in forecasting market movements or in picking which securities will rise faster than others. Examples of highly efficient markets are large-cap stocks and investment-grade bonds. Although it is not practical to expect to “beat” an efficient market, it is relatively easy to earn a return that closely parallels the market’s return. Such a return is called “Beta.”
A cost-effective way to capture Beta is through inexpensive passively managed investments that are based on market indices. In markets that are deemed efficient we do what many institutional investors do; rely primarily on indexing to capture the markets return. This relatively inexpensive "passive" style of investing doesn’t try to determine which stocks will outperform others, instead the goal is to participate in the historical upward bias of efficient markets at a very low cost. Inefficient markets are those where the relevant information on each security is much less widely available. Investment professionals have an opportunity to “beat the market” by utilizing specialized expertise and rigorous process. Examples of inefficient markets are small-cap stocks, emerging markets, and high-yield bonds. In the inefficient markets, we also do as institutional investors do: turn to talented, experienced active money managers, whose job it is to distinguish which securities will have higher rates of return than the overall market.
These active money managers have the potential to outperform--and, not surprisingly, their services cost more than the low asset management fees of indexed investments. “Alpha” is the excess return a skilled money manager can generate over and above the return of the market. Alpha is conditional; it depends on the presence of market inefficiencies and a portfolio manager having the skill to exploit them. We believe the key to capitalizing on those skills lies in giving that portfolio manager the freedom to both determine his or her own style and to act independently and quickly. To summarize, we don’t pay for value where it doesn’t exist (i.e., we don’t use active management in efficient markets), but will pay for value where it can be achieved (i.e., we do use highly skilled active money managers in inefficient markets). That way, we make sure we aren’t paying Alpha-level fees for Beta-level results. Our approach can enhance returns and help accelerate the wealth-building process.