Pat Dorsey, previously the director of equity analysis at Morningstar, was interviewed by his old colleagues on the “three sources of alpha,” in other words, the competitive advantages that certain fund managers have that allow them to consistently outperform their benchmark. The three sources of alpha outlined by Pat are the following:
- Informational advantage – knowing more about a company than the broader market does. This is perhaps the hardest advantage to come by because, generally speaking, information is widely available to the public and is synthesized quickly. However, information dissemination is less efficient in certain areas of the market, like small and micro-cap stocks, which gives some fund managers the ability to profit from information that is not yet factored into the underlying stock price.
- Analytical advantage – being able to develop quantitative models that synthesize information faster and more accurately than the market. Analytical advantages are also very hard to come by and often short lived because people are constantly searching for these models and are quick to copy others, which erodes their effectiveness.
- Behavioral advantage – being able to behave more rationally than other market participants. According to Pat, and we would agree that this is probably the most common advantage we see. For this reason, we tend to invest with older more experienced managers that understand their emotional biases well and have taken time to develop specific processes to protect themselves from these biases.
The “three sources of alpha” are particularly relevant to our job as we are always looking for fund managers that have a definable competitive advantage, also known as an “edge” within the industry. If you are interested in learning more, please see the interview with Pat Dorsey or the academic research performed by Russell Fuller.