Aurora Borealis
1 August 2009 CFA Institute Journal Review

Five Principles to Hold Onto (Even When Your Boss Says the Opposite) (Digest Summary)

  1. Frank T. Magiera

The authors investigate the effectiveness of using Fed monetary policy shifts as a rotation indicator variable in a sector portfolio. They provide evidence that suggests this indicator could be used to significantly improve investment performance

The authors describe the environment that MBA graduates and CFA charterholders enter when they begin their jobs in the investment management industry. They are often told to forget the theoretical nonsense and use street wisdom, and the industry appears to be resistant to the tenets of modern portfolio theory. The authors describe the features of theories and concepts that can be used to improve the practice of investment management. Their basic message flows from the market model of Sharpe and the idea of return components being attributable to alpha and/or beta. In this vein, they discuss five principles to improve investing practice.

The first principle suggests that investors should think of any investment in terms of alpha and beta contributions to risk and return and not forget fees and costs. The second principle is that alpha is a zero-sum game and that alpha bets are typically expensive and only valuable if the manager has exceptional skill. Beta is valuable but mostly “free.” The third principle recognizes that the criteria for making alpha and beta decisions are very different, as are the rewards for correct decisions. The fourth principle states that alpha consistently delivered by a truly skilled manager is very valuable, and depending on the manager’s skill level, a high fee may be a bargain. The fifth principle states that it is desirable and usually possible to separate alpha from beta and that fees paid for each should be appropriate.

The authors believe that managers following these principles will take a giant step toward the use of science in making investment decisions and will become better investors who earn higher returns with less risk and lower costs.

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