exhibit 1

As evidenced by their high fees, stock pickers still are coveted in investing. Conventional wisdom attributes much of alpha to the skill of investment managers finding the best businesses at the right price. However, the mysteries of what creates positive alpha — or outperformance — have been chipped away over time. And not in the favor of conventional wisdom.


It may be helpful for some to recall that the strange but common use of Greek letters in investing — in particular beta and alpha — comes from the capital asset pricing model (CAPM) theory developed by William Sharpe in the 1960s, which provided the foundation for modern finance. The theory goes that beta, related to volatility, explains variation in stock returns. Higher beta means higher expected returns, and vice versa. Except that beta didn’t explain everything. The unexplained part of Sharpe’s model is referred to as alpha, commonly meant performance versus a benchmark.

While the model offers no insight into the source of alpha, conventional wisdom has attributed it to the ability of the portfolio manager. Managers who consistently generated positive alpha were thought to have superior stock-picking abilities.

However, the advent of multi-factor pricing models has changed this dynamic. As the explanatory power of multi-factor models increased, unexplained active manager alpha necessarily decreased. This introduced the possibility that manager skill could be explained by other systematic factors.

This topic was thoroughly explored in the landmark paper by Mark Carhart (1997), in which he examined the performance of more than 1,800 mutual funds between 1962 and 1992. Initially he found strong persistence in active returns, supporting the notion that managers with superior insights can consistently generate positive alpha. However, after the returns were subsequently adjusted for style factors, the persistence disappeared. More importantly, after adjusting for style factors, alpha was found to be negative, indicating that manager “skill” actually decreased returns on average.

Carhart is by no means the only academic to find persistence in manager returns, nor was he the first (or last) to attribute persistence to style factors. Bollen and Busse (2001) confirmed all the findings of Carhart, as did Daniel, Grinblatt, Titman and Wermers (1997). A number of other studies that were published during this time period drew similar conclusions.

Exhibit 1: Hypothetical Performance of Factors vs. Market
Portfolios that represent equity factors outperformed the market index, based on Russell 1000 Index data from 1980 to 2018.

SOURCE: Northern Trust Asset Management, Russell. Hypothetical factor performance represents the top 30% of stocks sorted by each individual factor (bottom 30% for low size and low volatility). Portfolios are capitalization weighted and rebalanced quarterly. For illustrative purposes only. Please see important information on hypothetical returns at the end of this presentation. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.


The interest in style factor investing should not be surprising given its appeal to both passive and active investors. Style factors offer a systematic, diversified and transparent source of return, but with the added benefit of higher Sharpe ratios. Like traditional active investing, style factors offer the ability to outperform the market, but in a more reliable and cost-effective manner.

Read Northern Trust Asset Management’s new paper Foundations in Factors for a detailed analysis on the evolution of factors, implications for investors, the perils of cyclicality, and diversity within and across factors.

By Northern Trust Asset Management
Michael Hunstad, PhD, Head of Quantitative Strategies
Northern Trust Asset Management

IMPORTANT INFORMATION. This material is provided for informational purposes only. Information is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice.

All material has been obtained from sources believed to be reliable, but the accuracy, completeness and interpretation cannot be guaranteed. The opinions expressed herein are those of the author and do not necessarily represent the views of Northern Trust. Information contained herein is current as of the date appearing in this material only and is subject to change without notice.

Excerpts reprinted with permission from Northern Trust Asset Management. Read the full article, Solving the Mysteries of Alpha, and important disclosures at: www.pointofview.northerntrust.com

© 2019 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.

Northern Trust Asset Management
Northern Trust Asset Management

Northern Trust Asset Management is a global investment manager that helps investors navigate changing market environments, so they can confidently realize their long-term objectives.
Entrusted with more than $999.1 billion of assets,¹ we understand that investing ultimately serves a greater purpose and believe investors should be compensated for the risks they take — in all market environments and any investment strategy. That’s why we combine robust capital markets research, expert portfolio construction and comprehensive risk management to craft innovative and efficient solutions that seek to deliver targeted investment outcomes.
As engaged contributors to our communities, we consider it a great privilege to serve our investors and our communities with integrity, respect, and transparency.
¹ Assets under management as of September 30, 2022.

Chris Doell, CFA, CIA
Director—Insurance Practice

50 S LaSalle St
Chicago, IL 60603

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