The following two letters were received in response to last week’s letter/article entitled Coin Flipping and the Search for Alpha:

Dear Editor,

Just a quick observation regarding Mr. Kam’s mutual fund:  According to the Morningstar data his article links to, his Marketocracy Master 100 fund underperformed its benchmark by 1.66% and ranked below average among its peers over the past five years.  As a firm supporter of passive investment management, this comes as no surprise to me.  Does Mr. Kam have an explanation for why his active manager selection process seems not to be adding alpha over the past five years?  If not, here’s a couple: efficient markets and expenses.

Regards,
                                   
Ian A. Post, CFA
Principal
Post Asset Management LLC
New York, NY

Dear Editor:

Ken Kam’s letter to the editor opens an important and quite frankly little discussed need to differentiate money manager skill from luck.  While I applaud Mr. Kam for revealing his process, it also reveals the flaws in Modern Portfolio Theory (MPT), the Capital Asset Pricing Model and alpha as indicators of skill or success.  Advisors must know graduate level statistics and math in order to utilize the tools necessary to discern skill from luck.

Understanding Alpha’s Shaky Foundation

When Markowitz published Portfolio Selection in the mid 1950s, he alluded to the fact that the mean-variance method (measuring volatility around the average or mean return) upon which his theory was based was not the best option.  Instead Markowitz concluded that semi-variance (measuring the propensity to underperform a set objective) was a far more accurate procedure.  However, unlike today, he did not have access to a 2GB DELL laptop with Excel 2007.  Such calculations were simply too time consuming to add value for the investor before the advent of the micro processor.

In order for MPT to have any validity without a solid mathematical foundation, two important assumptions are needed:

1. Investment returns are symmetrical – that is an investor should be equally rewarded against a 10% drop in the value of their investments with a 10% rise. 
2. All investors have a singular goal – to beat the market (known more accurately as the Capital Asset Pricing Model).

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