The 3% Alpha Puzzle: Why So Few Institutional Investors Can Solve It

We find that firms with good performance on material sustainability issues significantly outperform firms with poor performance on these issues……”.
FROM THE 2015 HBS STUDY“CORPORATE SUSTAINABILITY: FIRST EVIDENCE OF MATERIALITY”BY KHAN, SERAFEIM, AND YOON

 Is a 3% Alpha Possible? 

Last month’s Letter calculated a real return of 3.6% is now a reasonable long-term expectation for a broadly diversified stock portfolio. This compares poorly with the 1871-2014 realization of 6.7%. So to get anywhere near that historical realization in the decades ahead requires outperforming the stock market by some 3%/yr. Impossible you say? I disagree, and explained why in a trilogy of Letters published in December, January, and April:

• Last December’s Letter was titled “Professor Fama’s Folly: Financial Markets Are Efficient”. It responded to the good professor’s famous observation last Fall that institutional investors who believe they can outperform the market over the long-term “must be from the moon”. The Letter argued that a real world “Inefficient Markets Hypothesis” was a far more plausible construct than the academic “Efficient Markets Hypothesis”, and that there was plenty of empirical evidence to support that viewpoint.

• The January Letter was titled “Active Investing….Three Possible Paths”. It laid out three mutually-supporting strategies available to institutional investors who have taken the time to understand them, and are also capable of actually implementing them. The dominant strategy at the individual institutional investor level is to design and implement “a comprehensive active long-term investment program”.
• Finally, the April Letter titled “Focusing Capital On The Long-Term: From Talking To Walking” documented my own 45-year journey of understanding the essence of actually implementing such a program. It progresses from John Maynard Keynes (α=8%/yr. for 25 yrs.), to Benjamin Graham and David Dodd’s 1934 text “Security Analysis”, to Warren Buffett (α=13/yr. for 35 yrs.), to David Swensen (α=5%/yr. for 20 yrs.), to a small group of investing institutions that had been implementing a coherent long-term approach to investing for a long-enough period of time that the resulting material alphas were very unlikely to be due to chance (α ranges from 5% to 2%/yr.). Conclusion: generating a 3% alpha over the long-term is indeed possible.

One of the cited supporting academic studies in the April Letter was a 2014 Harvard Business School (HBS) study “The Impact of Corporate Sustainability on Organizational Processes and Performance” by Eccles, Ioannou, and Serafeim.  The quote at the top of this page is from a 2015 sequel to that study by Khan, Serafeim, and Yoon titled “Corporate Sustainability: First Evidence of Materiality”. I summarize its important new findings in this Letter.