“Past performance does not guarantee future results.” It is a common disclaimer used by asset managers, wealth planners and other finance professionals to inform their clientele of the uncertainty of investing. However, the textbook method of studying investment strategies doesn’t account for the market effect that this often-used phrase embodies, what analysts refer to as “alpha decay”, or the reduction in abnormal expected returns (relative to an asset pricing model). In fact, financial textbooks often state the opposite: if the excess returns associated with an investment strategy continue after the strategy has become public, then the strategy should remain profitable in the future.
With the monograph publication in Management Science, “Understanding Alpha Decay,” Julien Pénasse, Associate Professor with the Department of Finance at Faculty of Law, Economics and Finance of the University of Luxembourg, seeks to overturn the assumption that investment strategies will display a constant long-term excess return. Using common examples from asset pricing literature, Prof. Pénasse finds a discrepancy between the true alpha and measured alpha of around 1.4% per year. He proposes a simple formula, which can be used by practitioners and academics alike, to correct for this bias and check if an investment strategy is losing its performance power over time, even if alpha decay is occurring very gradually.
Prof. Pénasse finds that in the short run, alpha decay leads to counterintuitively positive repricing returns, as prices adjust in reaction to arbitrage activity of investors. However, he cautions against assuming because an investment strategy has performed better than expected in the past, it will continue to yield positive results in the long run. The paper calls for more prudence and skepticism when examining investment strategies, especially when it comes to new and popular investment products such as ESG funds, which may show artificially high initial performance rates.