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Book Review: The Quest for Alpha

It's said that no man is more religious than a convert, and for proof of that theory, you would need look no further than MoneyWatch's own Larry Swedroe.

In a previous life, Larry was vice chairman of Prudential Home Mortgage, and senior vice president at Citicorp -- prototypical Wall Street jobs, in which Larry embraced the prototypical Wall Street approach to investing, spending an enormous amount of time and energy in an attempt to outperform the markets.

But like Saul on the road to Damascus, Larry eventually saw the folly of his ways, realizing the futility of active management. And ever since then, Larry has been one of indexing's most outspoken proponents, touting the benefits of a low-costs and passive investing in columns, on internet message boards, at investor conferences, and in 11 books, including his most recent, The Quest for Alpha.

Readers who are even just passingly familiar with Larry's work are likely struck -- as I often am -- by the breadth and depth of his knowledge of the academic work that's been done in the fields of finance and investing. (I imagine Larry working in a bookshelf-lined office, which is bulging at the seams with papers and articles written on every investment-related topic imaginable.)

And in his excellent new book, Larry harnesses that work to slay every possible canard about the utility of active management.

In chapter after chapter, Larry puts to rest the notion that persistent alpha -- i.e. benchmark-topping returns -- can be found anywhere in the investing world. In the book's first six chapters, he meticulously presents the academic and real world evidence that mutual funds, pension funds, hedge funds, private equity funds fail in their quest to beat the market. And lest the reader think that they can either trade their way to market-beating returns, or harness the work done in the field of behavioral finance to outsmart their fellow investors, Larry documents just why that isn't likely, too.

As compelling as the academic evidence is, perhaps most convincing is Larry's use of the confessions of the investment world's practitioners who, in fits of candor, admit the terribly long odds they face in their attempts to outperform the markets. In the chapter on mutual funds, for instance, Larry quotes fund managers Ralph Wanger, Bill Miller, and Douglas Dial -- among others -- acknowledging the dispiriting realities they face in their own quest for alpha.

Those admissions resonate because they stand in contrast to the active management industry's traditional message, which Larry documents and undresses in Chapter 9, Whose Interests Do They Have at Heart? In many ways, an understanding of the financial industry's motivations is the bedrock upon which individual investors can build a successful portfolio. Understanding that the industry's interests and yours are in direct conflict provides a powerful lens through which to view their claims of expertise, and Larry does a fine job of helping the reader focus their view.

In the final chapter, Larry provides the payoff, showing the reader how to harness the power of passive investing. In it, he walks the reader through six passive portfolios -- each slightly more diversified than the last -- which demonstrate both the benefits of diversification and rewards reaped via a low-cost portfolio of passively-managed mutual funds.

Finally, in his conclusion, Larry highlights a point that I've seen him make many times over the years, one that I believe is the most often overlooked benefit of a passive approach to investing: It frees you. Trying to outperform the markets -- whether via mutual funds, stock picking, or any other method -- requires a tremendous amount of time and effort. Should I buy this fund, or that one? Has the recession bottomed out, and if so, how should I position my portfolio? Is the bull market run about to peter out? Even if the answers to these sorts of questions were knowable -- which, of course, they're not -- divining them consumes an enormous amount of time that, as Larry notes, could certainly be put to more productive use. And because a passive approach to investing eliminates these sorts of decisions, its adopters have more time for the more important things in life. Higher returns with less effort -- it's the closest you'll ever get to a free lunch in the investment world.

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 wonderful addition to that effort, and investors will be well-rewarded by reading it and acting upon its wisdom.

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