Is it worth the time, effort, and cost to try and beat the market (aka to seek alpha)? Or is it better to try and capture the market return (aka to seek beta)? That is the question I’d like to address today. Like most aspects of investing, the question is simple but the answer is complicated. I believe that there is an answer for every investor, if they are willing to put forth the effort to figure it out.

The warring camps

In the ongoing debate about the relative merits of active vs. passive investing, it occurred to me that the entire premise is flawed. Framing the active vs. passive debate as an either-or proposition, with warring factions representing each side, may cause investors to lose sight of what really matters for achieving their goals. The approach, strategy, and tactical plan they choose must offer the best odds of success, given their specific investing goals.

What’s the right strategy for you?

Finding the strategy that’s right for you is no easy task. For starters, investing goals are hard to define for most of us. The default goal seems to be some variation of “I want to make as much money as I can, as fast as I can, so I can retire young and Live the Dream.” You would be surprised to learn how many investors think like that, and never put any more thought into developing a realistic, practical strategy.

What this investor type usually ends up with is a hodge-podge of randomly chosen stocks, bonds, mutual funds, and ETFs. Most of these holdings came from schemes that were touted by hucksters and charlatans. There is no rhyme or reason to the portfolio they end up with. And to make matters worse, they often get impatient when things don’t pay off as quickly as they wanted, so they abandon the strategy-of-the-month and move on to the next one.

Ad Hoc investing

I call this the Ad Hoc style of investing. No defined goals, no cohesive investment philosophy, no plan, no stable strategy, no method for measuring progress, and no discipline. But here’s the good news. These Ad Hoc investors, as a whole, produce negative alpha. And since alpha is a zero-sum game before costs and a negative-sum game after costs, these misguided souls are unintentionally offering up the alpha that astute investors are seeking. Without the underperforming Ad Hocs, there would be no alpha.

Other sources of alpha

The latest S&P Index vs. Active (SPIVA) 2016 scorecard for US active mutual fund managers was just released. Once again, the professional alpha-seekers did not do very well. In 2016, 66% of large-cap, 89% of mid-cap, and 86% of small-cap managers underperformed their respective S&P benchmarks.

The results are even worse when performance is evaluated over the last five years (see Fig. 1). It’s been more than 30 years since a majority of active equity managers consistently outperformed their benchmarks.

The Yale model

At the other end of the alpha spectrum, there are astute investors who are the beneficiaries of the poor performance described above. Take, for example, Yale University. According to their recently published annual endowment report, active investing can in fact add significant value. The endowment has been very successful with active management and will continue to use it. They captured 9.5% annual outperformance in international equities, and 3% annual outperformance in domestic equities, over the last ten years.

The Alpha (and The Truth) is out there

Generating alpha is increasingly more difficult, as the SPIVA results make clear. The challenges that active managers face arise from both market efficiency and from managers’ incentives to take risk.

Equity markets have become too efficient for most managers to consistently beat their benchmarks. Doing so requires regularly identifying mispriced stocks relative to their fundamentals and risks. But the combination of more “smart” investors with cheap and easy access to much better information, computing power, and capital than ever before has made this task very difficult. Markets are simply doing a much better job of incorporating all information into stock prices.

Poor incentives may explain some of the closet indexing and herding behavior that’s rampant in the active world. Active managers have an incentive to hug the benchmark if a couple of underperforming quarters trigger fund withdrawals.

In the final analysis, the goal of investing is to achieve a desired outcome. Devoting time, energy, resources, and expenses to argue over the relative merits of active vs. passive can result in missed opportunities.

Asset allocation, for instance, is significantly more important than security selection. The same can be said for asset location (holding the right assets in the right accounts) and active portfolio management (rebalancing and loss harvesting). Ultimately, after-tax, after-fee performance is what matters most, and for the majority of investors, a range of active and passive implementation within their portfolio will help achieve their goals.

Yes, Virginia, you can beat the market

There are many strategies for capturing alpha, if that’s what it will take to achieve your investment goals. There’s the time-tested Value strategy (Buffett), the growth-at-a-reasonable-price strategy (Lynch), moving average crossovers, swing trading, contrarian, small cap, long/short, and so on. The list is long, and there is no such thing as a “perfect” strategy.

But in order for any strategy to work, it has to fit the investor’s skill level, emotional temperament, risk preferences, and decision-making style. A great strategy in the wrong hands simply won’t work. Think of it this way. Suppose you wanted to take up the game of golf because you figured it would be good for your career if you could entertain clients on the golf course. What’s the first thing you would do? Take golf lessons, of course.

The golf analogy

So you go to your local public golf course and sign up for 3 lessons with the resident golf pro. The first thing he does is ask you who your favorite pro golfer is. You say Jordan Spieth. O.K. he says, I’ll teach you how to hit the ball like Jordan Spieth.

Wrong! You do not have the muscle tone, coordination, flexibility, body mechanics, vision, or endurance of Jordan Spieth. So trying to emulate him is a huge mistake. You are doomed to frustration and ultimate failure. So you fire this coach and go to a private club, and hire their pro for three times the cost of the public pro.

The first thing he asks you is “do you mind if I video tape your swing so we can analyze it together?” Wow. That makes so much sense. So you do the taping and then sit down with the pro and look at the film. He goes over everything you’re doing right, and everything you’re doing wrong. But most valuable of all, he makes an assessment of your natural swing mechanics and which aspects of your swing he can improve the most.

He then designs a coaching plan that will take full advantage of your natural strengths and weaknesses. He pushes you to improve in ways that you are capable of achieving. He will not waste your time or his trying to get you to do something that you’re not physically capable of doing.

This is how a novice golfer learns to hold his own and not embarrass himself with clients. A goal oriented, custom-tailored strategy that fits comfortably with the natural abilities of the golfer.

How my clients invest

Roughly 55% of my clients are index investors. They are satisfied with capturing the market return because it accomplishes their investing goals. The other 45% of my clients are seeking alpha. Some are pure stock-pickers, doing their own research and designing their own portfolios. Others are value investors, trying to emulate the success of the Warren Buffetts of the world. I also have swing traders, day traders, and hedge-fund wannabes.

But my clients who are at the top of the performance scale are the ones who combine active and passive in a way that works for them, and takes advantage of each approach. Typically, they have a core portfolio of low-cost index funds or ETFs that represent 50% to 80% of their investable funds. The rest is invested in factor-based strategies that are designed to capture significant alpha.

Factor-based investing

Factor-based investing has proven over many years to be a successful strategy, but it’s not for everyone. For one thing, it requires regular monitoring and rebalancing, as opposed to a buy-and-hold strategy.

It also requires a fairly substantial investment of time and effort up front to set up a robust methodology. But once that’s out of the way, it doesn’t take a lot of time to keep it running efficiently.

It does take discipline and consistency, first to codify the procedures involved, then to translate the procedures into trading rules. But again, this work is done up front and only requires occasional tweaking after implementation.

The trading costs involved are higher than a buy-and-hold strategy. There is more portfolio turnover. But the alpha that can be captured far outweighs the additional costs of implementing a factor-based strategy. How much alpha are we talking about, exactly?

My clients’ results speak for themselves

I set up my factor-based strategy in early 2005. Over the 12 years it’s been “live”, the alpha captured by my clients has averaged 11% per year, relative to the S&P 500. It has only had one year, 2011, where it produced negative alpha (-9.21%). When that happened, about a quarter of my clients bailed out of the program. That turned out to be a mistake because every year since then the alpha has been positive. In 2013, the alpha was 35.9% over the S&P 500.

Here’s the hard part, and it goes to my earlier comment that any strategy must fit the investor’s natural style. On a monthly basis, the performance can be volatile. There are many months where the alpha is either small, or negative. So it takes courage and patience to stick to the system. The “good” months tend to be very good, and the “bad” months tend to be just slightly bad. This is the price one has to pay in order to capture 11% of annual alpha.

How to design a simple factor strategy

The truth is that anyone is capable of creating their own successful factor strategy if you have the time and patience to do the work. The first thing you’ll need is a factor screening engine. There are some decent free versions out there, but they aren’t as robust as the professional models which can cost $2,000 or more to purchase. Here are a few free ones you can check out:

Motley Fool’s stock screener

Google Finance stock screener

Finviz stock screener

There are others you can find at Morningstar, Zacks, FactSet – if you can afford to pay the licensing fees.

Here is a simple value-with-growing earnings factor strategy that has produced annual alpha of 5.8% since 2000.

Step 1. Screen the universe of 8,000 to 10,000 stocks (depending on the size of your engine’s database) to exclude penny stocks (stocks trading for less than $2 per share.

Step 2. Exclude stocks with less than 50,000 shares per day of trading volume.

Step 3. Exclude stocks with a price/cash flow greater than 20x.

Step 4. Exclude stocks with a forward P/E that’s greater than the median P/E for its industry group. If you can’t get that metric, limit the P/E to the current market P/E.

Step 5. Exclude stocks with a price/sales ratio of 2 or more.

Step 6. Exclude stocks with a price/book ratio of 3 or more.

Step 7. Exclude stocks with a PEG ratio greater than 2, or greater than the median PEG ratio for the industry.

Step 8. The final, and perhaps most crucial step is to exclude stocks that have declining earnings or earnings estimates. They can be flat, but not declining.

What you end up with is a list of candidates for further consideration. I don’t spend a lot of time on this because I trust the screening engine to catch the weak stocks for me. But I do want to know what the company does, and whether there is any hint of accounting issues or investigation by industry regulators.

After they clear these hurdles, I buy the remaining stocks in equal weight, limiting the portfolio to 10 names or less.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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