Nerds on Wall Street: Math, Machines, and Wired Markets

Part II: Alpha as Life

Index funds are passive investments; their goal is to deliver a return that matches a benchmark index. The Old Testament of indexing is Burton Malkiel's classic A Random Walk Down Wall Street, first published in 1973 by W.W. Norton and now in its ninth edition. For typical individual investors, without special access to information, it offers what is likely the best financial advice they will ever get: It is hard to consistently beat the market, especially after fees. A passive strategy will do better in the long run.

Of course, no one thinks of oneself as a typical individual investor. That might be your brother-in-law or the guy across the hall. And index funds are just not as much fun as picking stocks. It's called passive investing for a reason. Alpha, outperforming a passive benchmark, is the goal of active investing. Even Malkiel has admitted to actively managing some his own money.^[] Recent additions to the Forbes 400 list include more than a few people who seem unusually adept at finding alpha, and keeping a piece of it.

^[] This surprising admission came in a dinner speech at the Investment Management Network "Superbowl of Indexing" Conference (December 1996, Palm Springs, California). No performance figures were disclosed.

The basic fee structure in the hedge fund world is "2 and 20." Managers are paid 2 percent of assets and 20 percent of alpha. ...