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By Christine Benz | 10-18-2012 07:20 AM

Bernstein: How Overgrazing Ruins Alpha

As more investors flock to the hottest alternative asset class, the more its alpha will shrink toward negative territory as expenses overwhelm the returns, warns financial specialist Bill Bernstein.

Christine Benz: Hi. I'm Christine Benz for Morningstar. I recently traveled to the annual Bogleheads event, where I had the opportunity to sit down with asset-allocation expert and author Bill Bernstein.

Bill, thank you so much for being here.

Bill Bernstein: My pleasure.

Benz: Bill, some of your latest research looks at the growth in alternative-style investments, let's start by talking about why that concept of some asset class that's going to diversify away from stocks and bonds is so appealing?

Bernstein: Oh, it's like looking for Santa Claus. An asset class that has a low correlation with other risky asset classes, that has high returns, it's the Holy Grail of portfolio theory. It's what everybody is looking for in their portfolio, but unfortunately there is no Santa Claus.

Benz: You note that there are some practical impediments to alternatives being worthy additions to investors' portfolios. Let's talk about the central thesis there. You call it overgrazing. Why does that happen, that investors all glom on to a single asset class at the same time?

Bernstein: Well, we're talking about two separate phenomena. Let's talk about the first phenomena, about the return side of it. There is only so much alpha, excess returns in a given asset class whether you're talking about the whole market or a sub portion of the market, and if there is only a single manager grazing that asset class, they’ll generate this much expenses in transactional costs moving the market around charging fees, and they'll do just fine because there is an enormous amount of return left over.

But if you have 1,000 managers following that asset class and dealing in those markets, then there comes a point where the alpha disappears and becomes negative when the expenses, the aggregate expenses, overwhelm the excess alpha. And I think we're well past the point where that's happened now with the major alternative asset classes.

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