Practical analysis for investment professionals
07 August 2013

What I Believe, But Cannot Prove: True Alpha Does Not Exist for Individual Investors

Posted In: Drivers of Value

I believe, but cannot prove, that true alpha does not exist for individual investors. There are too many conflicts of interest and “frictions” in the system for an individual investor to enjoy market-beating results. I believe this is the case regardless of whether individual investors invest on their own or with the help of an investment professional. Although I don’t think that investment advisers can help an individual beat the market, I do believe that most individuals will enjoy superior results with the help of an investment adviser.

Although it is not exactly shocking that an investment adviser believes that individuals are better off hiring an investment adviser, this was not an easy conclusion for me. The track record, dating back almost 100 years, of investment professionals is not exactly stellar:

  • Alfred Cowles found evidence that professionals underperformed a buy-and-hold investment approach back in the 1920s and 1930s.
  • John Bogle’s senior thesis at Princeton University found that 75% of professional investors underperformed the S&P 500 Index from 1945 to 1975.
  • Charles D. Ellis, CFA, found that 85% of professional money managers underperformed the S&P 500 from 1962 to 1974.
  • Mark Carhart studied the period 1962–1993 and found that most money managers underperformed their benchmark by about the amount of the fees they charge. He also found a lack of persistence in performance.
  • Eugene Fama and Ken French found that between 1984 and 2006, only 3% of managers exhibited enough skill to cover their costs.

These are just a few of the many studies showing that professional investors have largely failed to deliver on the promise of market outperformance. Why is this the case?

I believe a lot of it has to do with the structure of our business. Conflicts of interest are rife. There are many players within the industry that all purport to provide the same service. Brokers, bankers, insurance professionals, financial planners, and registered investment advisers all look the same to regular investors, yet there are material differences. Many of these parties are dominated by sales professionals rather than by investment professionals.

Vanguard’s founder, the legendary John Bogle, has described the investment industry’s shift from profession to business, in which revenue generation trumps the client’s best interest. The repercussions have been largely negative. It is not unusual for us to see new clients with investments in such illiquid investments as annuities and private REITs. Although these investments may be “suitable,” they clearly are not in the investors’ best interests. Rather, I believe these investments are used mostly because of the generous commissions they pay and because they help retain clients by putting up barriers to exit. This is just one example of the many conflicts of interest that exist in the investment industry that impair the individual investor’s odds of realizing superior performance.

There are also significant “frictions” in the system. Most notably, this includes costs and taxes. There can be many layers of costs in the investment process, and often the end investor is not aware of the hurdle they present to realizing outperformance. Advisory fees, mutual fund expense ratios, sales loads, 12B-1 fees, and bid–ask spreads are just some of the costs investors may face but not understand. All of them siphon money away from the investor and result in performance that very likely will fall short of expectations.

Even if an investor can find an adviser to provide market-beating performance after costs and fees, taxes all but guarantee subpar net performance. Active trading in the mutual fund and investment management industries results in a serious headwind for taxable investors. The lower qualified dividend and long-term capital gains tax rates help, but they still result in a significant “give back” of returns. An article in the Journal of Portfolio Management in 1993 titled “Is Your Alpha Big Enough to Cover Its Taxes?” discussed the impact of taxes on investment returns. The conclusion was that actively managed investment portfolios are highly unlikely to deliver market-beating results after the impact of taxes.

Clearly, the odds are stacked against investors working with professional investment advisers. The quest for alpha is effectively futile. So, in the face of all this, why would anyone waste their money by hiring an investment professional? Because, despite the poor results provided by the investment industry, the results of individual investors have been even worse.

Professors Brad Barber and Terrance Odean studied returns of individual investors and found their trading acumen sorely lacking. In fact, those who traded most actively realized the worst investment returns, lagging the stock market by more than 6.0% per year.

There is a relatively new concept called “adviser’s alpha,” which describes the value investment advisers bring to a client relationship. Most of this is self-serving for the investment industry, but there are some important points surrounding this concept. Individual investors strive for the highest returns possible but do not necessarily think about process, efficiency, or discipline. These are all areas in which a professional investment adviser can help.

Setting up an asset allocation plan, or getting the right mix of risk and return, is important. However, maintaining this balance over time is equally important. Regular rebalancing and having a process in place to invest methodically through time are rare among individual investors.

Tax Efficiency

Asset location, tax swapping, holding out for long-term capital gains, and methodically selecting which tax lots of a stock to sell can all have real economic value by controlling the amount lost to taxes.


The discipline to stay in the market, rather than selling out at market bottoms, is probably the most important role of a good investment adviser. Any market timing can be damaging, but abandoning discipline at market extremes (peaks and valleys) can be all but impossible to recover from.

I remember seeing a chart in one of John Bogle’s presentations several years ago that showed the average return of the stock market at 16%, the return of the average mutual fund at 13%, and the return of the average mutual fund investor at only around 5%. Clearly, individual investors had been chasing performance rather than investing with process and discipline. The chart data are out of date, but I suspect the concept holds true today.

Individual investors can go to a low-cost mutual fund provider, construct a balanced portfolio, and rebalance annually or with cash flows that they dollar-cost average into the portfolio. This approach is simple, efficient, and should provide competitive returns. However, I believe it is rare for investors to take this route. The vast majority will be tempted by “hot tips” and media stories that encourage more active trading.

Working with a professional may not produce market-beating returns net of fees and taxes, but it should help avoid many of the behavioral traps individual investors fall into. Professionals have a wider knowledge of portfolio construction, customary fee levels, and tax-minimization techniques and often bring much-needed discipline to the investment process. So, although I can’t prove it, I believe most investors would be better served with a little professional help.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Mark Armbruster, CFA

Mark Armbruster, CFA, is president of Armbruster Capital Management, Inc. (ACM), a boutique wealth management firm serving high-net-worth individual and institutional clients. ACM uses index funds, exchange-traded funds (ETFs), and other investment vehicles to build portfolios designed to reduce investment-related costs and taxes in order to maximize net returns. Previously, he worked in equity research on Wall Street, following the aerospace and defense industries at Smith Barney. Armbruster also worked in the equity strategy group for Salomon Smith Barney’s Chief Equity Strategist. He also started an investment advisory firm, where he served as chief investment officer. Armbruster has served on numerous nonprofit and for-profit corporate boards. He also consults on and provides expert testimony for investment-related legal disputes. Armbruster has been quoted on investment matters in several investment publications, including the Wall Street Journal and Investor’s Business Daily. He frequently gives talks on investment matters to professional investor groups. Armbruster has served as president of CFA Society Rochester. He holds a degree from the University of Rochester.

12 thoughts on “What I Believe, But Cannot Prove: True Alpha Does Not Exist for Individual Investors”

  1. Patrick Lanaghan says:

    Excellent work!

    I believe this article can be best summarized by the first and last sentences :
    “I believe, but cannot prove, that true alpha does not exist for individual investors. . . So, although I can’t prove it, I believe most investors would be better served with a little professional help.”

    Thank God we have faith!

  2. Nat says:

    There’s a recent paper showing that individuals investing in low cost index funds do underperform due to bad market timing decisions.

    1. Mark Armbruster says:

      I had not heard about this paper…thanks for the tip. It provides nice empirical support for what Jack Bogle has been saying all along about ETFs (though interestingly, it extends to index funds as well). He uses the analogy of a shotgun: it can be a powerful tool in the right hands, but you can also blow your head off with it. I think passive funds (both mutual funds and ETFs) are great tools, but perhaps there is room for professional guidance even when using these fairly basic investment vehicles.

  3. Kyle Felciano says:

    Great summary, really articulated many items I have suspected to be true. Inherently the average returns of individuals are below the market due to all of the fees and taxes. Similar to a poker game at a casino the more skilled players struggle to make enough to beat the rake and 80% of the players are losing. Hopefully the industry can shift more focus on to the needs of the client instead of fee generations.

  4. Matthew Feda says:


    I sincerely agree with the hypothesis made in your article. But you’re right, measuring an advisor’s effect on an individual’s overall financial well-being is difficult to quantify.

    Check out David Blanchett’s (Morningstar) paper on gamma (a measure on the effectiveness of a financial planner). It’s a simple model, but I believe it could be expanded upon to include more factors.

    Again thanks for the article, it was an interesting read.

    1. Mark Armbruster says:

      I’ll take a look at that…thanks. There is supposed to be another paper in the works on “advisor alpha”. I’m guessing it will be fairly self-serving for the industry, but hopefully it will continue to build upon these ideas and provide some new insights.

  5. Patrick Lanaghan says:

    Excellent work!

    I believe this article can be best summarized by the first and last sentences :
    “I believe, but cannot prove, that true alpha does not exist for individual investors. . . So, although I can’t prove it, I believe most investors would be better served with a little professional help.”

    Thank God we have faith!

  6. George says:

    Based on this assessment, I don’t see why one would hire an investment adviser at all.

    Assuming the investor has a typical goal (e.g.retirement savings), they could just buy and hold indexes (in an IRA perhaps, if they can get their employers to match their contributions), allocating from riskier asset indexes to less risky asset indexes over time.

    For asset allocation they could consult a flat fee financial planner for generic asset allocation strategies that correspond to each stage of their lives (or better yet just find them online via numerous sources), trade for themselves via Scottrade, and avoid an investment adviser completely.

    Finally, if they are particularly risk averse they could manage risk (and effectively buy peace of mind) with various forms of insurance beyond health insurance (disability perhaps).

    As far as discipline is concerned, hiring an investment adviser is not necessarily going to make someone more discipline. If they tell you to buy XYZ stock at whatever valuation because they like it, or to sell ABC annuity because they need the cash for something they don’t really need, sure you have the fiduciary obligation to tell them it’s a bad move, but in the end, it’s their money and they make the calls about how to allocate it.


    1. Mark Armbruster says:

      You are absolutely correct that an investment advisor is not at all necessary for those willing to do a little research and spend a little time tending to the portfolio each year. However, in my experience, most people are unlikely to do that. It seems the data bear this out as well. Despite having great tools at their disposal, most investors fail to use them or to use them appropriately (see the paper referenced in Nat’s comment above).

      We keep our clients disciplined by having discretion over their accounts. We make the trades, rather than recommending trades. That way, we know things get implemented. Clients do always have ultimate control, as they can fire us and do what they want with their money. However, for those who stick around, we do instill a significant amount of discipline to stay the course, rebalance, and make smart tax decisions.

  7. Agnes says:

    What I have found useful is reading alot of history like some investors suggest. I see a movement in price, I dig up the older papers and try to understand where this is leading the stock and then try and join the dots and act. Often i do not agree with my investment advisor, whose reference frame is current news.

  8. Agnes says:

    Also, say something about inertia. The tendency to remain motionless. This happens when one gets into the market and then the stock dips. The period where one watches for positivity steals an investor’s valuable time as they await recovery?

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