Why catching alpha in the US feels like chasing unicorns

Most debates on active vs passive investing very quickly land on American soil, with parallels drawn or inferences made to conclude that Indian active managers will also find it hard to generate alpha since American managers have struggled over time.

While I agree America is the mecca of finance and the investing world, I don't think it's that far behind in terms of being the Kashi of marketing, either.

We are always told that American public equity managers struggle to deliver alpha because markets are efficient and institutionalised. What we are not told is that while markets are institutionalised, institutions put two-thirds of their money into alternate investments like venture capital funds, private equity growth funds, buyout funds, cross-over funds, etc., and not into public markets where listed equity stocks are traded.

In the last 25 years, the number of listed stocks in US markets has declined from over 7,000 to just around 4,000. Imagine if you are a fund manager for listed equity funds and what you have seen happening to your playfield. Over the years, your corpus has grown manifold, but your investment universe would have shrunk to nearly half, and what is left for you to generate alpha from would be predominantly large and mega-cap companies only. In the USA, the number of micro, small, and mid-cap companies has been declining for years now. Companies are being bought over and privatised, and the corpus of buyout funds in the USA has gone from nothing to nearly $2 trillion in the last three decades.

Before coming to IPO, companies in the USA spend an average of 15 years in the private equity cradle and by the time they come for listing, their market capitalisation is in the tens of billions of dollars, and they are well-discovered mature businesses. When Uber comes for listing at $75 billion market capitalisation after a decade-plus of history, who captures the alpha? The dry powder or investible corpus available with private equity funds in America till a year back was nearly $1 trillion. Private equity investors have a larger, more diverse set of companies to invest in than ever before, while the universe of public companies is increasingly concentrated, with much of the market performance coming from a few large companies. In terms of the growth of the asset base, private equity is outstripping public equities.

The marketing angle

All this is high finance, but what's the marketing angle? Leave actively managed public equity mutual funds aside, and bear with me for a moment. Let's say I have been supplying Coca-Cola to the market over the years. I suddenly realised that there was a better way; I could market more quantities and at much higher margins, too. To the cost-sensitive low-ticket buyers, I start to say Coke is not good for you - neither for your health nor for your pocket - it contains just too much sugar and costs you a lot, just doing unnecessary damage to your health. You are better off drinking plain soda water, tonic water or soda water with some lime squeezed into it occasionally. And you will get this at a 90 per cent discount on the cost of the Coke. On the other hand, I have identified some rich institutional-grade and high-paying customers to whom I go and ask, why do you want to buy Coke and pay for the whole thing? It's 90 per cent water in any case. I will just sell you the concentrate for a premium (2/20) and soda water separately for a minimal charge. Buy the concentrate and consume it in whatever format you wish. Why buy litres and litres of Coke to get so little concentrate and a lot of soda water?

What do you think I have done? It's not that there is no alpha or concentrate available in American markets. It's just that a combination of alpha and beta - read actively managed public equity mutual funds - which are meant to beat the benchmark and hence provide benchmark plus alpha returns has been replaced by the beta (benchmark) being sold separately for cheap and the alpha (excess returns) being sold separately for the benefit for the rich and the institutional investors.

The ordinary mutual fund investor has been sold the idea that alpha is elusive and injurious to their health and pockets. The rich man has been sold what a rich man wants: exclusive access to the concentrate and its much-vaunted formula. Sound financial advice or gaslighting?

India: A different story

In terms of market construct, is India in this space? Do we have a lot of institutions investing in equity markets and looking for high alpha? Do we have private markets of such comparable size and vintage? Do we have large institutions like pension funds investing a lot in private equity funds? Do we have buyout funds or funds that buy out and privatise listed companies? Are the number of listed companies in India shrinking or rising multi-folds with the passing years?

We are in a market where the private equity concept is still in its first decade or two and only raising awareness; institutionalisation is nascent, and buyout funds do not even exist. The bulk of our economy has yet to come into the markets, and companies are still finding their way into them. Sev bhujiya and potato wafer walas and Coca-Cola bottlers are still getting listed and made available Coca-Cola to us in abundance before we get to first-world problems whereby we must segregate the soda and the concentrate for health and wallet-related considerations or purely for sophistication...not so much of the finance element but sophistication in marketing.

Aashish P Somaiyaa spearheads WhiteOak Capital Asset Management Limited as their CEO.

Also read: Markets, mindsets and the India story