A common misconception in finance is that abnormal returns are a direct result of informational inefficiency or a manager's exceptional ability to pick stocks. However, recent research suggests that this may not be the case.

Cochrane's AFA 2011 Presidential Address on Discount Rates shed light on this issue. In it, he argues that most active management and performance evaluation can be explained by beta, rather than alpha. This challenges the traditional view of the capital asset pricing model (CAPM) and its reliance on informational inefficiency.

The Beta-Alpha Dichotomy

The concept of alpha has been a cornerstone of modern finance for decades. However, Cochrane's work suggests that this may be an oversimplification. Instead of distinguishing between alpha and beta, perhaps we should focus on understanding the different types of risk that investors face.

For example, a value-growth, momentum, currency, and term carry strategy can replicate many active management returns. This is not to say that such strategies are necessarily "passive" or "mechanical," but rather that they can be understood within a framework of systematic risk premia.

The Commoditization of Risk Premia

The evolution of financial markets has led to the commoditization of risk premia. What was once considered alpha is now seen as beta. This shift has significant implications for investors, particularly those relying on traditional active management strategies.

For instance, consider a portfolio that includes IEF (iShares 20+ Year Treasury Bond ETF), C (Citigroup Inc.), GS (Goldman Sachs Group Inc.), BAC (Bank of America Corp.), and GOOGL (Alphabet Inc.). In such cases, investors may find that their abnormal returns are more a result of beta than alpha.

The Limits of Alpha

The concept of alpha has been tied to the idea of informational inefficiency. However, Cochrane's work suggests that this may be an oversimplification. Instead of relying on alpha as a measure of performance, investors should focus on understanding the different types of risk they face.

This is not to say that active management has no value. Rather, it suggests that investors should approach their investment decisions with a more nuanced understanding of beta and its various components.

Practical Implications

So what does this mean for investors? In short, it means that abnormal returns may not be as abnormal as they seem. Instead, they can often be explained by systematic risk premia or beta.

This has significant implications for portfolio construction and management. Investors should focus on understanding the different types of risk they face and how to manage them effectively.