Finding Alpha: The Search for Alpha When Risk and Return Break Down »

Eric Falkenstein, PhD, developed the RiskCalcTM, the world's leading scoring tool for evaluating private firm default risk, while at Moody's Risk Management Services. The celebrated tool is used by banks worldwide, as well as by regulators and Moody's own CDO group. He was head of capital allocations and quantitative modeling at KeyCorp prior to joining Moody's and later was with Deephaven Capital Management where he developed and managed a long/short equity strategy. Between 1996 and 2002, Falkenstein formed his own investment company, the Falken Fund, which had returns of 16.0% versus 3.8% for the S&P500. His hedge fund activities are ongoing and, by law, proprietary. He is a consultant and a member of CapRock Advisors LLC, a hedge fund advisor.

In 1992, a long-established finance theory was turned upside down when researchers published a paper in the Journal of Finance—later cited in the New York Times—which documented that the main empirical implication of the Capital Asset Pricing Model (CAPM) was untrue: that is, that "beta" was not positively related to stock returns. The article, later corroborated in many subsequent studies, was to be one of the most heavily cited Journal of Finance articles in its history. The basic model of risk and return that academics had taught for decades was shown to be empirically useless, and subsequent extensions have been successful only by redefining risk merely as anything with a high average return. Since that groundbreaking article was published, practitioners have been left asking: So how do we find alpha if we can't measure risk?

Finding Alpha offers a new approach to finding alpha, backed by current empirical evidence and grounded in the notion that risk and return are not necessarily correlated. Author Eric Falkenstein offers a serious criticism and counterproposal to current financial theory on risk and return that is comprehensive yet understandable to the average person. He argues convincingly for replacing the old assumptions with new ones, primarily replacing greed and introducing another factor—the innate human desire for hope and certainty. Falkenstein clearly shows that once one understands that "risk adjusting" returns, in the sense of adjusting for a priced risk factor, is a red herring, one can search for alpha more productively.

The author brings his theories down to earth with practical applications of alpha-seeking strategies that he developed through his own experience at Moody's Risk Management Services and with his own investment company. But ultimately, as the author shows, alpha is about finding a comparative advantage, both in the financial markets and in life. This means sticking to things you are good at, things you enjoy doing, because those are the things where making that extra effort is costless because it is something you like to do. That is the risk-taking that leads to greater returns. Maximizing your alpha should provide you with not merely a way to maximize your income, says Falkenstein, but also give you the greatest satisfaction, and the most meaning, in your life.

Chapter 1 Risk Uncorrelated with Returns 1

The Response: Return (Risk (Return)) 4

Failed Paradigms 6

You Minimize Some Risks, Pay to Take Others 9

Chapter 2 The Creation of the Standard Risk-Return Model 15

The CAPM 17

Pillar 1: Decreasing Marginal Utility Means Risk Aversion 18

Pillar 2: Diversification Means Not All Risk Is the Same 21

The Arbitrage Pricing Theory (APT) 25

The Stochastic Discount Factor (SDF) 27

Adding Non-Normality 32

The Uncertainty Revival 34

CAPM: A Special Case of the Stochastic Discount Factor Model 36

Chapter 3 An Empirical Arc 39

The Beginning of the End of CAPM 44

APT Tests 50

Fama and French Put a Fork in the CAPM 52

Saving the Standard Model 55

Serial Changes to APT 58

Skewness 61

Analogy to Business Cycle Forecasting 63

Summary 68

Chapter 4 Volatility, Risk, and Returns 69

Total Volatility and Cross-Sectional Returns 70

Beta-Sorted Portfolios 72

Call Options 75

Small Business 76

Leverage 77

Mutual Funds 79

Futures 79

Currencies 82

Lotteries 84

Movies 84

World Country Returns 84

Corporate Bonds 85

The Long End of the Yield Curve 88

Distress Risk 91

Sports Books 92

Total Volatility and Expected Equity Index Returns 93

Uncertainty and Returns 95

IPOs 96

Trading Volume 96

Volatility as Shorthand for Risk 97

Chapter 5 Investors Do Not Mind Their Utility Functions 99

Behavioral Violation 1: Investors Trade Too Much 101

Behavioral Violation 2: Too Many Funds 102

Behavioral Violation 3: Underdiversification 102

Behavioral Violation 4: No Fundamental Analysis 103

Behavioral Violation 5: Buy Recommendations Exclude Firms with Merely LowRisk 104

Behavioral Violation 6: Agents Do Not Agree 104

Behavioral Violation 7: The Home Bias 105

The Rotten Core: The Utility Function 106

Absurd Extrapolations 106

Easterlin's Paradox 108

Summary 112

Chapter 6 Is the Equity Risk Premium Zero? 113

Geometric versus Arithmetic Averaging 115

Surviorship Bias 116

Peso Problems 117

One-time Effect of an Anomalous Post-Depression Period 118

Asymmetric Tax Effects 118

Market Timing 119

Transaction Costs 121

Summary 124

Chapter 7 Undiminished Praise of a Vacuous Theory 127

Chapter 8 Why Relative Utility Generates Zero-Risk Premiums 135

Benchmark Risk 136

Why Relative Risk Leads to No Risk Premium 137

Chapter 9 Why We Are Inveterate Benchmarkers 143

Typical Economic Assumptions 146

Virtue of Selfishness 147

Why Envy Is Virtuous 149

Why Economists Dislike Envy in General 150

Chapter 10 Alpha, Risk, and Hope 153

The Search for Safety 154

Most Financial Risk Takers Are Foolish 156

Two Types of Priced Risk 156

Uncertainty in Innovation 157

Why Risk Taking Hurts 158

Confusion of Risk and Gambling 160

Standard Alpha Contradiction 163

Why We Take Risk Anyway 165

Experiments, Risk, and Alpha 168

Chapter 11 Examples of Alpha 173

Finding the Right Alpha 175

Arbitraging Put-Call Parity 179

Convexity Trade in Futures and Swaps 179

Pairs and Mean Reversion 183

Fund Innovations 186

Convertible Bonds 190

Long and Short Equity Hedge Funds 194

Automating Activities 196

Conclusion 202

Chapter 12 Alpha Games 205

Benign Deception 210

The Favor Bank 214

Managerial Alpha 218

The Alpha in Risk Management 222

A Singular Risk Management Decision 226

Risk Management Like Audit 229

Overpaid Alpha Deceptors 231

Investor Meets Alpha 233

Chapter 13 Alpha Seeking Applications 237

Minimum Volatility Portfolio 238

Beta Arbitrage 244

Investing in Anomalies 248

Safety Investing 250

Hope Investing 252

Relative Risk and Bubbles 253

Capital Finding Alpha Strategies 254

Search for Alpha 262

Chapter 14 Conclusion 265

Notes 271

Index 293