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The Quest for Alpha


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Table of Contents

Acknowledgments xi Introduction xiii The Holy Grail xiv The Quest Begins xvi Chapter 1 Mutual Funds: The Evidence 1 When You Wish upon a Morningstar 2 Focus Funds 4 Active Management of Bond Funds 6 Skill versus Luck 8 Who Cares about the Average Fund? 12 With Active Managers, How Long Is Long Enough? 12 Advice from Professional Investors and Academics 15 Admissions from Industry Practitioners and the Financial Media 17 Chapter 2 Pension Plans: The Evidence 23 Counterproductive Activity 25 The Value of Consultants 27 The Performance of Funds Offered by 401(k) Plans 27 Fund Selection Skills 29 Please Don't Do Something, Stand There 30 Advice from Professional Investors 30 Admissions from an Industry Practitioner 31 Chapter 3 Hedge Funds: The Evidence 33 The Problems with Hedge Funds 36 Advice from Professional Investors and Academics 40 Chapter 4 Private Equity/Venture Capital: The Evidence 43 Characteristics of Private Equity Returns 46 Bias in the Data 48 Advice from a Professional Investor 49 Chapter 5 Individual Investors: The Evidence 51 Investment Returns versus Investor Returns 54 Advice from Professional Investors and Academics 56 Admissions from Industry Practitioners and the Financial Media 59 Chapter 6 Behavioral Finance: The Evidence 61 There Is Smoke, but No Fire 62 The Tyranny of the Efficient Markets 63 Further Evidence 64 The Failed Quest 65 The Value of Behavioral Finance 66 Even Smart People Make Mistakes 66 Admissions from Industry Practitioners 68 Summary 69 Chapter 7 Why Persistent Outperformance Is Hard to Find 71 The Quest for Alpha Is a Game Played on a Different Field 72 Successful Active Management Sows the Seeds of Its Own Destruction 74 Closet Indexing 76 Concentration and the Role of Trading Costs 77 The Role of Trading Costs 78 Drifting Out of Small Caps 79 Encore Performances 79 Who Gets the Money to Manage? 81 The Value of Economic and Market Forecasts 83 The Value of "Expert" Judgment 86 We All Want to Believe 89 The Value of Security Analysis 90 Buy, Sell, or Hold? 92 The Hurdles Are Getting Higher 93 Advice from Professional Investors and Academics 94 Admissions from Industry Practitioners and Academics 96 Chapter 8 The Prudent Investor Rule 103 The Prudent Investor Rule 106 The American Law Institute 106 The Uniform Prudent Investor Act 108 Chapter 9 Whose Interests Do They Have at Heart? 113 Advice from Professional Investors 114 Admissions from Industry Practitioners and Academics 115 A Triumph of Hope over Experience 120 The Arithmetic of Active Management 121 The Math Is Always the Same 123 The Costs of Active Investing 124 The Cost of Cash 126 An Expensive Quest 127 Summary 129 Chapter 10 How to Play the Winner's Game 133 Indexing Is More than the S&P 500 Index 135 Does Passive Investing Produce Average Returns? 140 Enough 141 Needs versus Desires 144 Pascal's Wager 145 Conclusion 147 The Yale Endowment Fund 148 The Way to Win Is Not to Play 149 The Quest for the Holy Grail 150 The Winner's Game 151 Appendix A: Rules of Prudent Investing 153 Appendix B: Doing It Yourself 159 Notes 165 Sources of Data 176 About the Author 177 Index 179

About the Author

LARRY E. SWEDROE is a principal and the Director of Research for the Buckingham Family of Financial Services, which includes Buckingham Asset Management and BAM Advisor Services. He has also held executive-level positions at Prudential Home Mortgage, Citicorp, and CBS. Swedroe frequently speaks at financial conferences throughout the year and writes the blog "Wise Investing" at CBS


?As I noted recently, success in investing is somewhat counterintuitive, and requires most investors to set aside their pre-conceived notions of how to build a portfolio that will allow them to reach their goals. The task is made all the harder because the vast majority of the participants in the financial services industry spend hundreds of millions of dollars annually reinforcing the myth of active management. Fortunately for investors, experts like Larry Swedroe are hard at work pointing out the fallacies of those myths, while also detailing the undeniable logic and mathematics that underpin a passive approach. The Quest for Alpha is a wonderful addition to that effort, and investors will be well-rewarded by reading it and acting upon its wisdom.? ? Nathan Hale,, March 2011

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