Redefining Alpha

An implication of factor-based investing is that what was once legitimately deemed "alpha"—excess returns attributable to skill—has morphed into "beta" (or a factor) once researchers identify a simple strategy that replicates the alpha. For instance, certain hedge fund managers in the 1980s and 1990s pursued then-exotic strategies such as merger arbitrage that produced excellent returns uncorrelated to the market. However, once researchers identified how the arbitrage strategies worked and created mechanical replications, the managers' alpha became beta.

This has implications for the meaning of "skill"

A consequence of this process is that the hurdle for being declared a truly skilled manager has risen over time. In the 1980s, it was good enough to beat your benchmarks. These days, studies looking for evidence of skill in equity mutual funds control for exposure to size, value, and momentum factors. In other words, if your excess returns come during times in which value, smaller-cap, or momentum stocks outperform, the procedure will adjust your "excess" return to zero.

If you believe the excess returns of value and momentum strategies reflect risk, then it's a reasonable adjustment. If you believe value and momentum produce excess returns because of market inefficiency, then it's not—what you've done is redefine outperformance.