What Investors Get Wrong About Alpha

Conversations about investment returns tend to collapse everything into a single question: did the manager outperform? The answer is treated as evidence of skill, and skill is treated as the reason to invest. This is too simple.

In reality, the returns an investor experiences are shaped by at least four distinct forces: the risk taken, the scale of the fund, the manager's genuine skill, and the cost of access. These forces interact, and they are frequently confused with each other. A fund that takes more risk will, on average, generate higher returns. That is not alpha. A fund that has grown too large may show declining returns despite unchanged skill. That is not bad management. An LP that pays higher fees will experience lower net returns than a larger LP in the same fund. That is not about performance at all.

The point is not that alpha does not exist. It does, in some markets and for some managers. The point is that most discussions about returns fail to separate these components, and as a result, investors make allocation decisions based on a number that blends things together that should be analyzed separately.

1. Risk: The Largest Driver by Far

In efficient markets, differences in returns are largely compensation for differences in risk. The Fama-French three-factor model explains about 97% of daily stock price movements. What looks like outperformance is, more often than not, exposure to a risk factor that has not been accounted for.

In less efficient markets, such as private equity or venture capital, things are more nuanced. Information asymmetries are larger, and the relationship between risk and return is less transparent. Small-cap buyouts deliver higher average returns than large-cap buyouts, but they also come with significantly higher dispersion. Venture capital is the extreme case: a small number of funds deliver exceptional returns while many others destroy capital. The average looks attractive. The variance is enormous.

The uncomfortable implication: much of what the industry labels as "alpha" is actually compensation for risk that has not been properly measured or benchmarked. A fund that invests in small, leveraged companies in cyclical industries will, on average, generate higher returns than one that invests in large, stable businesses. That difference is not skill. It is risk. And any honest discussion about returns must start by separating the two.

2. Scale: The Paradox of Success

When a manager demonstrates the ability to generate attractive returns, capital flows in. Assets under management grow. And this creates a well-documented paradox: more capital means higher revenues for the manager, but it also constrains the ability to generate high relative returns.

Berk and Green (2004, JF) formalized this insight. ¹ In their model, skilled managers attract capital until the expected return to investors equals the competitive rate. The manager captures the rents from skill through fees, not through excess returns to LPs. This is a rational equilibrium, not a market failure. But it means that observing a manager's past performance tells you less about future investor returns than you might think.

Our own research with Tim Jenkinson and Daniel Urban confirms this in private equity. ² We find that while relative returns (IRR, MOIC) decline with fund size, net present value (NPV) persists and increases. Skilled managers deploy more capital and generate more absolute value, but the returns per dollar invested decline. Approximately 40% of NPV is attributable to internal capital allocation decisions that direct more resources to skilled individuals. The skill is real. But it manifests in NPV, not in the return metric that most LPs focus on.

For investors, the implication is direct: a manager with genuine skill may not deliver high percentage returns if the fund has grown beyond a certain size. The manager may be optimizing for total value creation rather than return on capital, because their compensation is more closely linked to the former. This is rational for the manager but not necessarily aligned with what the LP expects.

On the positive side, larger funds tend to exhibit more stability and lower risk. So while absolute returns may decline with size, risk-adjusted returns can remain competitive. For investors who care about consistency, large funds may still be attractive, but the reason is risk reduction, not alpha.

3. Skill: Real, but the Residual

After accounting for risk and scale, what remains is genuine skill: the ability to identify, execute, and exit investments better than a randomly selected manager with the same risk profile and fund size.

There is empirical evidence that such skill differences exist, particularly in less efficient markets. Research shows persistent outperformance by certain individuals, both in mutual funds and in private equity. The question for LPs is not whether skill exists in principle, but whether they can identify it reliably before committing capital, and whether it will persist into the next fund.

Two things make this harder than it sounds. First, in more efficient market segments, the opportunities for skilled managers to consistently outperform shrink. The more capital chases an opportunity, the smaller the edge becomes. Second, the way managers choose their benchmarks can obscure the picture considerably. A manager who compares returns against an underperforming index will look skilled even when the returns are entirely explained by factor exposures.

The bar for evidence should be much higher than a track record that looks good against a convenient benchmark. Identifying genuine skill requires deal-level data, factor-adjusted benchmarks, and statistical testing that separates signal from noise. Without these tools, the LP is essentially guessing.

4. Cost: The Silent Erosion

Whatever returns are generated through risk, scale, and skill, costs determine what the LP actually receives. This is the most underappreciated component of the equation.

Skilled managers command higher fees, and investors are willing to pay as long as net returns remain attractive relative to alternatives. In principle, this is rational. In practice, there is significant disparity in what different investors actually pay for the same gross returns.

Large investors with substantial commitments and long track records wield considerable bargaining power. They secure lower management fees, reduced carry, and co-investment rights that allow them to deploy capital at near-zero incremental cost. Smaller investors pay full fees for the same fund. Two LPs invested in the same vehicle can experience meaningfully different net returns, not because of anything related to risk or skill, but because of the terms they negotiated at commitment.

Recent research by Begenau and Siriwardane (JF) documents the magnitude of these cost differences systematically and shows how they affect the distribution of net returns across LP types. ³ The disparity is particularly stark in private markets, where fee structures are complex and opaque, and where the bargaining dynamic between GPs and LPs varies enormously with LP size and reputation.

The Bottom Line

Chasing alpha by picking the best fund manager has its merits. But it addresses only one of four return components, and arguably not the most important one.

A more complete evaluation would start with risk : am I being compensated for the risks I am taking, and are those risks appropriate for my portfolio? Then scale : has this manager's fund grown to a size where the returns I can expect have structurally declined? Then skill : is there statistical evidence of genuine outperformance after controlling for risk and scale? And finally cost : what am I actually paying, and how does that compare to what larger investors pay for the same exposure?

Investors who structure their thinking around these four dimensions will make better decisions than those who look only at headline returns and call it alpha.

Prof. Dr. Reiner Braun holds the Chair of Entrepreneurial Finance at TUM School of Management and is co-founder of QFT Capital GmbH, an LP analytics platform for private markets.