I Do What I Do

by Raghuram G. Rajan

there are only a few sources of alpha for investment managers. One comes from having truly special abilities in identifying undervalued financial assets – Warren Buffet, the U.S. billionaire investor, certainly has these, but study after academic study shows that very few investment managers do, and certainly not in a way that can be predicted before the fact by ordinary investors. A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage, and an idea into a full-fledged profitable and professionally managed corporation is creating alpha. A private equity fund that undertakes a hostile corporate takeover, cuts inefficiency, and improves profits is also creating alpha. So is a vulture investor who buys up defaulted emerging market debt and presses authorities through various legal devices to press the country to pay more. A third source of alpha is financial entrepreneurship or engineering – investing in exotic financial securities that are not easily available to the ordinary investor, or creating securities or cash flow streams that appeal to particular investors or tastes. Of course, if enough of these securities or streams are created, they cease to have scarcity or diversification value, and are valued like everything else. Thus this source of...