E301: Why Generating Alpha is So Hard

0:00Curtis Pierce:I'm Curtis Pierce. For those that don't know me, I'm David's co-founder and business partner. You're one of the most prolific interviewers of the world's top institutional investors. Today, we're putting you in the hot seat to explore some of the most important lessons that you've learned over 300 interviews over the last two plus years. You recently made the comment to me that alpha is not what people think it is. How do people traditionally think about alpha and what do they get wrong? Experienced CIOs implicitly grasp this, but alpha is in the hard and the boring. I recently had dinner with the chairman of Jeffries who founded a firm called Lucadia.

0:36His name's Joseph Steinberg. And he won't even jump on camera. He doesn't believe in doing press. He's very much focused on his business. We spent three hours together. I asked him to really, like, what determines what he's interested And he said, it has to be hard or boring and ideally both. Alpha, as portrayed in movies like The Big Short or on TV or in YouTube shorts or TikToks, is this like stroke of genius. You're in the shower and you get this genius idea. Let's short the mortgage crisis. Nothing could be further from the truth. Alpha is about doing the things that people don't want to do.

1:18there's this well-known entrepreneurial meme which is if you want to get rich you start a garbage disposal business the same lessons apply to investing it's focusing on the things that people don't want to do and focusing in the areas that people don't want to focus on

1:36Curtis Pierce:would it be accurate to say based on that description that alpha is more about avoiding these trades, these stroke of genius ideas, and more about finding the consistent compounding areas or factors that lead to true outperformance consistently over time. I interviewed Bill Brown, episode 253, who actually did the Big Short trade. He wasn't the main investor, but at the Stern family office, they did a sizable trade. They knew all the parties, the guy who's portrayed in Big Short from Deutsche Bank and all these characters. and even that even the most famous most sexy trade of all time wasn't the stroke of genius it was a lot of work it was talking to a lot of people talking to all the different banks figuring out the unknown unknowns like what are we missing in the trade building conviction and then it was a lot of execution and trading and recalibrating so even the most extreme example of alpha being the stroke of genius was not actually a stroke of genius that being said 99 of investments are not the big short, 99.999%.

2:41If you take a 50 ,000 square foot view, alpha is much more about portfolio construction than these stroke of genius trades. In fact, there's a famous pension fund study that 90 % of returns at pension funds could be predicted by their portfolio construction, not by their manager selection. So figuring out how to construct your portfolio, which sounds extremely boring, not sexy, is actually where alpha is more so than picking the trade or picking the manager that's just going to outperform.

3:09Curtis Pierce:I really like that concept of the dichotomy between manager selection and portfolio construction. I want to double click on that in a little bit. But first, just to touch on the big short, because you took it there, there's an interesting thing I want to explore, which is this concept of prestige. And it's actually interesting because in hindsight, it was a prestigious trade have been a part of, It was this brilliant thing that only certain people saw in advance. But at the time, actually in real time, you were sort of crazy to short the housing market. It was something that had never gone down before.

3:48Curtis Pierce:So I'm actually curious what your thought is on how much does prestige or lack thereof an ability to maybe suffer low status or low prestige at a point in time play into this concept of being able to achieve alpha over time? That's such a good point, which is prestige always follows returns, but it doesn't work in reverse. In other words, the highest returning trades are not prestigious at time. Bill Brown talked about this. He was left out of rooms. A lot of people thought that it was a silly trade. It would never work. Other people thought that even if it did work, they wouldn't get paid out.

4:21So there was a lot of naysayers, which is why there were such high returns on big short specifically. this idea of being able to tolerate low status behavior for many years in every realm of business is one of the most underrated aspects of business that is where the alpha is if you're seen as doing something really smart really contrary capital c contrarian and genius a lot of people want to be seen as that that's that doesn't differentiate you as investors, there's no alpha in that trade, but if you're doing things that people think are dumb, are not scalable, are not sexy, or as I mentioned before, just take a lot of work.

5:03One of the biggest sources of alpha in asset management is actually doing the work. And there's different derivations of that. But on the status thing, it's not just being able to deal with low status behavior for a month or a quarter or a year. Oftentimes the best trades require you to have steady hands for many years, which requires a lot of conviction and also a lot of, paradoxically, status within the organization to them.

5:35Curtis Pierce:And how practically should people think about overcoming this dynamic? One interesting parallel you could make is the startup entrepreneur. When they start, everyone is telling them they're crazy, they're going to fail. They have to suffer this low status for a long period of time, sometimes for many years, until they achieve that product market fit, until it becomes obvious. They get that brand name VC, and then they're a genius. Whether you're a startup entrepreneur or a mid-career investor, how do you overcome these status games?

6:12it's the million dollar question so i don't think you overcome the status games i think you find other ways to gain meaning and joy from what you're doing outside of status so taking down to neurobiological level your neurons might not be firing on status like people looking up to people thinking you're smart but it might be firing on you're working with people you really want to work with you're focusing on things that really matter in the world oftentimes these low status trades are things that no one else is doing which is another way of saying you're actually changing the world it's like the most trite thing but if you were building nuclear reactors or nuclear startups three to five years ago you were actually helping build the future of u.s energy policy low status super high impact also you just have to have it's like the second marshmallow test you have to have the capacity to avoid positive reinforcement for a long time in fact we've talked about this before i've had seven billionaires now on the show the one thing they all have in common it's really only one thing that i've seen is they're able to do things for many years that are low status and they're able to go against the consensus which is another way of saying low status and not only are they going in an opposite direction of consensus they're oftentimes running in the opposite direction a couple examples of that lawrence calcano i capital he was a decade ahead of the retail trade and they were just running they were just growing and they insulated them from the outside world and they they didn't let naysayers and quote unquote institutional investors tell them anything else ryan's her hands another great example Today, Ryan Serhan is one of the highest status people, certainly on a show, but in society, he's a top 10 on YouTube.

8:02He has his own Netflix show. In 2013, when he sold his first house on YouTube, people thought he was a joke. They thought he was literally ruining real estate. Real estate was a conservative industry. But he was a decade before that. And he literally looked like a clown. He was jumping in pools and doing all these things. And yet, that is why he has that advantage today, because there's network effects when it comes to media. So he has this 10-year head start on everyone. So cultivating the ability to be contrarian, lower seat contrarian, not seen as being contrarian, right, but doing things that other people think are dumb or low status is one of the most important skillset that you could have in business and all of business, including investing.

8:42Curtis Pierce:I agree with that. And I think it dovetails into something that we talk a lot about, which is structural alpha. Going below the surface and trying to find other ways to be consistently good or consistently find meaning if you want to stretch a little bit. So maybe for the audience, how do you define structural alpha? And give me some specific examples. One of the hardest things of investing is seeing what's shifting before everyone else does. For decades, only the largest hedge funds could afford extensive channel research programs to spot inflection points before earnings and to stay ahead of consensus.

9:18Meanwhile, smaller funds have been forced to cobble together ad hoc channel intelligence or rely on stale reports from sell-side shops. But channel checks are no longer a luxury. They're becoming table stakes for the industry. The challenge has always been scale, speed, and consistency. That's where AlphaSense comes in. AlphaSense is redefining channel research. Instead of static point-in-time reports, AlphaSense channel checks delivers a continuously refreshed view of demand, pricing, and competitive dynamics powered by interviews with real operators, suppliers, distributors, and channel partners across the value chain.

9:51Thousands of consistent channel conversations every month deliver clean, comparable signals, helping investors spot inflection points weeks before they show up in earnings or consensus estimates. The best part, these proprietary channel checks integrate directly into AlphaSense's research platform trusted by 75 % of the world's top hedge funds with access to over 500 million premium sources. From company filings and brokerage research to news, trade journals, and more than 240 ,000 expert call transcripts. That context turns raw signal into conviction. The first to see wins, the rest follow.

10:25Curtis Pierce:Check it out for yourself at alpha-sense.com slash how I invest. If you look at what LPs are trying to do, you'll oftentimes hear Rahul Mugdahl on the show and he says, it's not about the returns. And oftentimes people say it's not about the returns. I actually disagree. I think it is about the returns, but it's about sustainable returns. And LPs are always looking at, okay, great returns. How do you sustain these in a risk-adjusted manner? How do you continue to get these returns over and over? The implicit question there is, are you lucky? Is it a time and place? is there's not enough demand in this industry and the sub strategy.

11:03But there's also a question of, did you get lucky? This is the most pronounced in venture where you might have one portfolio company driving a return. So it's also important to understand the quality of your returns, how diversified, how consistent. But structural alpha is one of those things that consistently delivers alpha, so much so that's literally in the structure of the investment. What does that mean? A couple of examples. Professor Steve Kaplan, arguably the leading researcher in the private equity space, University of Chicago. And he created this Kaplan-Shore index, which found that the 2 in 20 that investors pay GPs translates to 600 basis points in fees per year.

11:47That's the bad news. The good news is that there's still roughly 300 to 400 basis points of alpha in private equity and still a lot of alpha in venture capital if you're in the right funds. But 600 basis points. Said another way, there's an issue if you're one of these large LPs in the network. Your Alaska permanent, I think today, is$70 billion. Your UTEMCO, University of Texas. Your CalPERS, your CalSTRS. How do you sustain alpha deploying so much capital? It's a serious problem. And one of those answers is structural alpha. What does that mean in this case? It means co-invest. If you think half of your portfolio is going 2 and 20 and half of it is not, that half that's not, you're getting 300 basis points of alpha.

12:31Is that 1 ,000 basis points is a 10 %? No, but it's 3 % predictably, both historically and forward-looking. It makes sense. It's intuitive. Why paying lower fees? That is a source of alpha. That's a form of structural alpha. In a high net worth space, you now have tax loss harvesting. An entrepreneur has a$100 million exit, puts it into a tax loss harvesting vehicle, which right now there's two major players, AQR and Quintino. You could wipe away that tax. Year one, you get$100 million tax loss harvesting. That is the equivalent if you're in New York, roughly 35 % in capital gains. So that's the equivalent of 35 % return in year one of structural alpha.

13:12That means the return, let's say that the investment does 8 % or 12 % or 10%, 35 % is layered on top of that, that's structural alpha. So together you might get a 40 plus percent turn. As far as I'm concerned, I don't think those returns exist outside of structural alpha. I don't think anyone's consistently beating the market, at least anyone with open funds. So I think structural alpha is extremely underrated. Again, it's not very sexy. If you use the proverbial cocktail party test, you're sipping your cocktail and someone says, what's your best tray? and you say, I structured it in a tax-efficient way, no one's going to be very impressed by that.

13:46And yet, it is one of the most sustainable and most predictable sources of alpha in all of investing.

13:54Curtis Pierce:Maybe that's a heuristic to think about. The investments you want to brag about at the country club or at the cocktail hour are maybe those that are more difficult by definition because of their sexiness, their prestige, to actually achieve alpha consistently, and those that you would rather not talk about because it's going to be perceived as boring or uninteresting, those are the places that alpha is more likely to be found and where you should really be spending your time. Is that the right takeaway? Yeah, let's call it the cocktail cringe test. If the other party will not cringe while you're talking about it, there's probably not structural alpha.

14:28By the way, the opposite is true too. You invested in OpenAI's latest round at a$500 billion valuation. Probably not going to get 10X on that at least before it goes properly. And you also did it on three layers of SPVs. So to use the Kaplan short index, you're paying 18 % a year in management fees. One eight.

14:46Curtis Pierce:Also known as negative alpha. Yeah. That is the definition of negative alpha. And yet you go to a cocktail party and you could tell people legitimately without lying, I invested in the latest open AI round. If I would refine the cocktail cringe test, which I like, we should coin that phrase. If I would refine it though slightly, I would say it applies at the point in time in which the investment was made. So if you were a seed investor in OpenAI, it wouldn't have been brag worthy at the time because no one had ever heard of OpenAI. ChattyPT had never been launched. So mentioning at the cocktail party would have been a shrug as so what?

15:26Curtis Pierce:I've never heard of that. it's the relevant point is that it's the point in time the investment is made. Sure, some investments that don't pass the test at the point in time of investment will in hindsight be, you know. I'd also further refine it in that it depends what cocktail party you're at. As you know, we have a very specific archetype that we make the podcast for. We make it for CIOs of large institutions and family offices. We also make it for people that find structural alpha sexy. that if you were to explain to them this tax-ass harvesting or the co-invest, they would be like, oh, that's actually really interesting.

16:02That's really sexy. So it's a very specific cocktail party. So it really depends also who's at the cocktail party. But a generalist audience and a generalist population should not find it sexy and should not find it interesting.

16:15Curtis Pierce:Shifting gears lightly, what parts of the market have the greatest opportunity for Alva today? if you're asking for a specific asset class or sub asset class i think lower middle market pe is one of the most interesting parts of the market for a couple of reasons one is if you buy the thesis that large buyout has too much dry powder which is empirical you just raise too much capital and you think of just the second order effects you don't have to go far where are they going to deploy this dry powder, they're going to deploy it into companies that get bigger, lower middle market. It's this whole idea that companies get re-bought over and over by private equity funds.

16:56It's absolutely a true idea. So second order effects, going back to my definition of alpha, which is hard and boring. Is lower middle market hard? Yes. There is no Blackstone of lower middle market. It's a paradox. Lower middle market, by definition, is highly fragmented. By definition, no one's really heard of these funds unless you're in the space. So you really have to do your diligence. You really have to do your team. It's a lot of work to get up to date on the lower middle market. Not to mention there's more PE funds today than there are McDonald's. So there's just so many to diligence. Similarly in venture, almost no venture fund of funds could talk to all 3 ,000 funds.

17:40It's just not a practical reality. So it is very hard. It's very time consuming. and to most people it's very boring it passes the cocktail cringe test if i say i invested in abc 200 million dollar private equity fund it's not going to be impressive but the opposite will be impressive i invested in blackstone i got access to abc venture you know 10 billion dollar manager that sounds very impressive are there returns there probably is there alpha almost definitionally no. On top of that, the incentives are completely misaligned in the institutional investing space between principals and agents, in terms of principals being these pools of capital endowments, pension funds.

18:23There's a 2022 University of Pennsylvania paper that found that the average CIO at a pension fund, their tenure was 6.33 years, so six and a third years. and it doesn't sound great in general but what makes it even worse is in most asset class especially the liquid from the very beginning that they make the investment so assuming that they make the investment on day one the returns of that investment are unlikely to be materialized certainly not much dpi before they leave in other words their incentive from a purely dollars and sense and career aspect are not aligned with the investments that they're making.

19:07And in fact, are misaligned.

19:09Curtis Pierce:You said a lot there, and I want to break it down into a few different points because I think they're all interrelated and they all tie back to a lot of the points you've already covered today. So in the lower middle market, you have a double layered or maybe even a triple layered brand friction, which is the companies themselves are not branded. They don't have general awareness. The funds investing in the unbranded companies have low brand on a relative basis to the largest players in the industry. And so you are overcoming the sort of double brand friction versus if you invest in KKR's latest fund, they're probably buying a company you've heard of and everyone's heard of KKR in the space.

19:44Curtis Pierce:So you have the opposite of that. The third layer, if there is one, is this brand friction between the individual making the investment decision and their governance structure. So they're trying to overcome this lack of brand in the companies and in the funds. And maybe they themselves may not have a strong brand within the organization, especially because there's this long lag time between the point at which the investment is made and the decision is made. And when the returns will be realized or be able to be more easily assessed, which ties into your point around the principal agent conflicts that exist.

20:23Curtis Pierce:So let's double click on that piece of it. how can institutional investors balance these factors when they need to make good investment decisions, but these conflicts exist and they're also trying to manage their careers, ensure that they don't get fired in the worst case and in the best case have better career opportunities ahead of them. How do people think about and manage these conflicts? When you want more, you start your business with Northwest Registered Agent. They give you access to thousands of free guides, tools, and legal forms to help you launch and protect your business all in one place.

20:59With Northwest, you're not just forming an LLC, you're building your complete business identity from what customers see to what they don't see, like operating agreements, meeting minutes, and compliance paperwork. You get more privacy, more guidance, and more free resources to grow the right way. Northwest has been helping founders and entrepreneurs for nearly 30 years. They're the largest registered agent LLC service in the US with over 1500 corporate guides, real people who know your local laws and help you every step of the way. What I love is how fast you can build your business identity with their free resources.

21:30You can access thousands of forms, step-by-step guides, and even lawyer-drafted operating agreements and bylaws without even creating an account. Northwest makes life easy for business owners. They don't just help you from your company. They give you the tools you need after you form it. And with Northwest, privacy is automatic. They never sell your data because privacy by default is their pledge. Don't pay hundreds or thousands of dollars for what you could get from Northwest for free. Visit northwestregisteredagent.com slash invest free and start using free resources to build something amazing.

22:02Curtis Pierce:Get more with Northwest Registered Agent at northwestregisteredagent.com slash invest free. CIO is asking him or herself, how do I balance the needs for returns in my organization with preserving my reputation and the longevity of my career in the seat? They've already lost. They're at the wrong institution. So the short answer to what you're saying is you've picked wrong if the institution is not aligned with this. Because this is not something you could change just in time at an institution. What does that mean? And that means, first of all, you need to, even ahead of who the IC is, who really runs kind of like the board of directors of the institutions, two different entities, but similar idea in that you need to know how they're chosen.

22:52In the majority of pension funds, you have non-industry professionals on the IC on the board, which sounds great. You have police and firemen on the board and union members, all those things. There's nothing against them. It's just that they're not investors and they're going to make mistakes when it comes to investing, not understanding the nuances. It's just like having an investor be on the board of a brain surgeon trying to do the best brain surgery. It doesn't mean that that investor is not best in class. You could put Cliff Asness, one of the greatest investors on brain surgery, and they're not going to do a good job.

23:32They just don't have the experience. Same thing happens on the IC of certain institutions. There's also a principal agent aspect there where oftentimes it's not their money. Oftentimes they don't even have a dollar and there are underlying capital structures. So when you have a 12-person IC and one person is really being the table, like, we need to invest in Blackstone, we need to invest in KKR, like, I don't know what these funds are. The other 11 people on that committee, they may disagree, but ultimately it's not their money. So there's only so much they're going to fight. So you have these principal agent problems at every part of the organization.

24:09And the most forward-looking organizations, regardless of ask class, have solved this at the point of inception at corporate governance. another thing that you won't bring up at a cocktail party corporate governance is probably if you think of portfolio construction as the main driver of returns corporate governance is upstream of portfolio construction and you'll see this for example alaska permanent the cio can invest up to one percent of the entire capital discretionary we had uh john skirvin from urs same thing there giving the investor team the discretion to make investments doesn't mean that you take off all governance and doesn't mean that you allow them to put 50 % of their money in Bitcoin, even though that might technically be a smart strategy.