Alpha? ...Or polished beta?

“Core-satellite” investing is often regarded as a precursor to portable alpha and various other modern portfolio construction techniques.  However, the popular definition of the term usually refers to a passive “core” and an active “satellite”.  And as we have argued extensively on these pages, active management too often contains a large amount of embedded beta.  Ideally, in our view, core-satellite would involve a beta core and a (pure-) alpha satellite.

This is essentially the same argument presented in a recent paper by Swiss researchers called “What if alpha is just polished beta?“.  The study was authored by Erik Wallerstein, Nils Tuchschmid & Sassan Zaker – the authors behind a paper we covered last week on the performance of hedge fund replication products.

The trio question whether funds of hedge funds should even be in the high-alpha “satellite” allocation in the first place.  They reason that if funds of funds can be replicated passively, then they should be disqualified from being satellites and should instead be treated as part of the core (beta) portfolio.

They use a simple linear model with 5 factors (the Russell 2000, the MSCI EAFE, the Barclays Agg, the GSCI and the CBOE S&P 500 BuyWrite Index) to replicate the HFRI FoF index.  As you might guess, they find this to be the case.  In fact, check out the tiny tracking error of this simple model (click to enlarge):

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By: Michael Newman, CAIA, AllAboutAlpha.com Editorial Board

In its semi-annual report on the Asset Management and Capital Markets businesses, M&A specialist Jeffries Putnam Lovell highlighted the continued increase in divestitures as a percentage of overall M&A activity affecting the asset management business.  Traditionally, independent buyers and sellers tend to dominate deal activity, but as the report makes clear in numerous charts and tables, divestitures and strategic acquisitions by pure play asset managers have been the primary deal makers as of late.  In doing so, the report raises important questions about the future of the asset management industry and alternative investment managers in particular.

Overall Environment:

The report begins by detailing the dearth of deal activity, which is still significantly below 2008’s already muted levels, by most measures.  As the chart below highlights, transaction activity, as measured by deal value or number of transactions is down significantly.

Outliers:

The report is also quick to remind us that these already low figures are themselves markedly distorted by two major outliers: the Barclays Global Investors deal and the Société Générale deal.  Without these two mega-deals, deal value would have been a pittance as would ‘transacted AUM’ (highlighted in the chart below):

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Today, we bring you Part 2 of Dr. William Shadwick’s proposal to use “extreme value theory” in calculating value at risk (VaR) and its close cousin conditional value at risk (CVaR). (see Part 1).

Shadwick is a highly-regarded mathematician who crossed over into finance a decade ago and has since made his mark on the field of investment performance analysis, developing Omega Metrics® and winning a prestigious award from the Investment Management Consultants Association along the way. He is also the founder of Omega Analysis Limited, a quantitative research firm in London.

Special to AllAboutAlpha.com by: Dr. William Shadwick, Omega Analysis Limited

As I wrote two weeks ago, Extreme Value Theory Conditional Value at Risk (EVT CVaR) can be a very useful measure in portfolio analysis.

In a volatile market, EVT CVaR with a variable Value at Risk threshold (for example the worst loss in the past 250 days) is a useful method for tracking the evolving exposure of a portfolio position.  In fact, it provided accurate estimates of the declining fortunes of shares in companies such as AIG, Bank of America, Barclays Bank, Citigroup, HBOS, Lehman Brothers, Lloyds Bank Group and UBS over the past two years.

In each of these cases, the share price movements prior to severe loss events showed extremely fat tails.  Our implementation of EVT provided warning of the likelihood and severity of subsequent losses well in advance. Thus, while the weakness of these institutions may have come as a shock to their regulators, the prospect of large losses was quite apparent from their share price histories, through our CVaR estimates.

Citigroup’s Share Price Decline 2007-2009

By the end of 2006 the daily returns on Citigroup shares had tails too fat to be consistent with a normal distribution. The Tail Risk Level as measured by the “C-S Character” had been high for several months by the beginning of 2007. Those who followed this indicator after the publication of Omega Analysis’ Primer on Tail Risk on AllAboutAlpha.com in May 2007 received warning of this heightened risk well in advance of the impact of the credit crisis in the equity markets.

At the beginning of January 2007, the worst loss in the previous 250 days was the return of -4.69% on 20 January 2006. According to the normal model, the probability of a return less than or equal to -4.69% was one day in 78,000 years. By contrast, our tail estimate of the probability of such an event was one day in 588.

Table 1 shows Risk Assessment Levels and subsequent breaches, if any, at a monthly frequency.  In this table, we show a Monthly Risk Assessment report on Citigroup. Prior to the first trading day of each month we report: worst loss in sample, estimated probability of exceeding the worst loss, Conditional Value at Risk beyond the worst loss (based on the previous 250 days). The table shows the date and magnitude of any excess losses in the subsequent month.

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Is a thaw coming to the frozen streams of money that built the hedge fund industry?  According this piece in the Wall Street Journal:

“There is little new fund raising going on right now, so much of the activity is in the form of conversations. But some hedgies are beginning to sense a thaw in the market, and potential interest from pension plans that never moved much money to the business.” (our emphasis)

Take It From The Expert

You know how the FBI and CIA like to hire reformed computer hackers to critically evaluate their systems?  Well, we might be able to learn a thing or two from one of the key players in the biggest systemic mishap to ever be propagated by a hedge fund.  Hans Hufschmid, a former LTCM Partner told Reuters this week that he doesn’t think “…a hedge fund today is big enough to pose a systemic risk…”

A Highway to Hell?

…Maybe not for infrastructure funds according to The Economist:

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Back in early 2008, the Economist marveled over the gravity-defying returns of US university endowments.  In early 2009, AllAboutAlpha.com contributor professor Christian Tiu wrote on these pages that “all endowments are relatively unconstrained, tax exempt and large enough to hold different asset classes”.  But what happens when a major driver of returns for these “different asset classes” runs out of gas?  Michael W. Crook, CAIA, of Barclays Wealth examines this issue today.

Special to AllAboutAlpha.com by: Michael W. Crook, CAIA, Vice President, Alternatives Strategist, Barclays Wealth

The revelation last month of serious problems in the Harvard Management Company’s portfolio brings into question the viability of the so-called “endowment model” of asset allocation. Harvard has essentially been forced into a liquidity-driven unwinding of its portfolio, due in part to some specific recent mistakes, but also due to its adherence to the prescriptions of the endowment model.

The endowment model is associated closely with the investment philosophy of David Swensen and the management of the Yale University portfolio. It has been adopted (or imitated) by other endowments around the nation and by some foundations, family offices, and private investors. The main differences between a more traditional asset allocation and the endowment model are:

1. An overweight to equities, typically through private equity,
2. An overweight to hedge funds,
3. Allocations to “new” asset classes (e.g., timber), and
4. Elimination of low volatility liquid assets (fixed income).

These adjustments reflected two fundamental assumptions: that there are additional returns associated with illiquidity and that the returns on private equity, hedge funds, and new asset classes were very stable and, therefore, helped to increase portfolios’ risk-adjusted returns.

The recent period has, however, cast doubt on these assumptions. During periods of crisis the premium associated with liquidity becomes even larger, resulting in negative relative returns for illiquidity. The recent crisis has been unusually severe in this respect and has made it clear that these returns to illiquidity came with an unlikely but potentially devastating downside risk. Additionally, many adherents to endowment model, who didn’t pay enough attention to their actual liquidity needs, are now suffering the consequences. Finally, investors discovered that the relatively steady returns realized by some of the “alternative” asset classes concealed serious “fat-tail” risk.

Liquidity Premium

It has been well documented that liquidity impacts asset prices, and that on average a less-liquid instrument that is functionally similar to a more liquid instrument will be priced more cheaply (implying greater future returns). This can be seen in equity and fixed income markets, among others, by isolating liquidity risk from other sources of risk and then measuring the return over time associated with that risk factor.

We have created a proxy for the illiquidity factor by forming a portfolio that is long off- the-run treasury securities and short on-the-run treasury securities. This creates a liquidity mismatch because off-the-run Treasuries are slightly less liquid than on-the-run Treasuries, even though both have the same underlying credit risk. We hedged interest rate risk by matching duration within the portfolio. Figure 1 shows the cumulative return of this portfolio since 2000.

Figure 1: Cumulative liquidity returns, January 1, 2000 – March 31, 2009

This illustration makes it clear why many endowments oriented their portfolios toward illiquid investments. Illiquidity appeared to provide an additional element of stable, low volatility positive returns to the portfolio. However, the recent period has made it clear that those returns came with a negative fat-tail risk, as the recent negative returns associated with illiquidity more than wiped out over 3 years of gains in less than 3 months.

The Future of the Endowment Investing

Many endowments are now confronted with the question of whether or not they should move in increase portfolio liquidity. For some this will be an easy answer. Portfolios that are either experiencing a forced unwinding of positions or that are not able to provide funding for their institutions should certainly target a higher level of liquidity going forward. For others the answer is less clear. Illiquidity, in this context, should be viewed as a source of risk and return. It simply becomes part of the asset allocation decision. In the same way that managers allocate to equity risk, credit risk, and interest rate risk, they should be consciously and deliberately managing their allocation to illiquidity risk, i.e., by considering both the upside and the downside.

Considering the new information we have regarding the risk and return associated with illiquidity, we believe many portfolio managers will decide to reduce their exposure to illiquidity risk. This likely means that equity risk will move to public equities from private equities, arbitrage hedge funds will be sold in favor of fixed income and allocations to emerging asset classes will be made more cautiously.

A recent academic article also brings into question whether the endowment model really was responsible for outperformance all along. Brown et al found that endowment outperformance should be attributed to an overweighting of their best managers rather than the increased allocations to specific asset classes. That sounds like good advice for all investors.

- M. Crook, May 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or the CAIA Association.

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IRS Circular 230 Disclosure: Barclays Capital and its affiliates do not provide tax advice. Please note that (i) any discussion of US tax matters contained in this communication (including any attachments) cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

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Looks who’s making a return trip to the news after being largely tossed away by the media last year.  It’s alternative beta and 130/30.  As regular readers will recall, these hedge fund relatives seems to have died off last fall.  But this week, several firms announced new funds aimed at resurrecting interest in “hedge fund replication” and “short-extension” strategies.  And who knows, the time may now be right for these quasi-hedge fund instruments.

Clones or Zombies Back from the Dead

Hedge Funds Review reported today that Invesco, the mutual fund giant, launched an alternative beta strategy called “Premia Plus” (not to be confused with Premium Plus, the perfectly flaky cracker from Kraft).  Without calling itself a “hedge fund” (now a four letter word in the post-12/11 environment), the company borrows heavily from the hedge fund lexicon.  According to Hedge Funds Review, Invesco says it has developed a proprietary risk management strategy that “could generate equity-like returns with bond-like risk.”

The magazine also reports that Invesco is emphasizing many of the now de rigueur qualities of liquidity, low price and “transparency”.  (Although we wonder how useful “transparency” really is when the product still uses a “proprietary risk management and rebalancing technique”).

Not content to let Premia Plus steal the headlines, Barclays Capital just launched the “Barclays Alternatives Replication” Index last week.  The index comes in long and short versions called LBAR and SBAR (much like Innocap’s products and T-Rex offered by Socgen).  Barclays says that LBAR tracked the HFRI better than “four main competing hedge fund indexes” last year.  This statement is a refreshing change in a field where companies often seem to compete on the basis of performance, not tracking error.

Why the reincarnated interest in hedge fund replication?  According to Reuters:

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We have moved the cast and crew of AllAboutAlpha.com down the street today from the Metropolitan Club to cover the “Battle of the Quants III“, an increasingly popular event that attracts both financial rocket scientists and mere mortals like your humble scribe.

Ray Kurzweil is billed by Wikipedia as an “inventor and futurist”.  And they’re not making it up.  He invented one of the first music synthesizers, the first flat-bed scanners and the first speech recognition software and has been recognized by three US Presidents, has written 4 best selling books and has several honorary doctorates to his name.  He also runs what he calls “a high frequency quant fund”.  He addressed the crowd of 100 on the topic of “accelerating pace of change” and “21st Century Technology and financial markets”.

Kurzweil is also well known for his views on “technological singularity” – the increasing frequency of so-called “Paradigm Shifts” over the past billion years and the ensuing exponential growth of information technologies.

On technological advancement: “Health and medicine is now an information technology.  The Human Genome is the software.  Now health – like other information technology – will begin to advance exponentially.”

On faxing physical objects: “In the future everything will be an information technology.  Someday, we’ll

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End of the Hedge Fund? Unlikely, according to Washington Post columnist Sebastian Mallaby who writes, “Even if you define Madoff’s investment outfit as a hedge fund, which for various reasons is debatable, there’s nothing in this saga that supports clamping down on the industry.”

Hedge funds return to roots as alpha claim refuted: This prediction of the hedge fund apocalypse tops all others.  Robert McAdie, a credit strategist at Barclays Capital, was quoted by Reuters last week as saying “Eighty percent of the hedge fund sector will not be here in three to four months“.  Check back in April for an update…

Regular readers may recall this post on “hedge fund forum shopping” – the theory that hedge funds search out the least-regulated jurisdictions in which to ply their trade.  AIMA’s Canadian chapter announced last week that the study cited in this post was the recipient of the organization’s annual research award.  If you want to compare jurisdictions side-by-side, this study is the place to start.

Man bites dog!…GLG Partners to buy SocGen UK asset management arm: Here’s an addendum to our recent  post on hedge funds being snapped up by traditional asset managers.  Except this time, the hedge fund is the one doing the buying.

In another twist on the traditional, T. Boone Pickens has reportedly decided to unilaterally relax quarterly redemption and 90-day notice rules on his equity fund – begging the question, why did he have these liquidity rules in the first place?

University endowments may reduce their hedge fund exposure next year, but not for the reason you might think.  Quoting InvestHedge, Bloomberg reports that “Hedge funds might be put ‘on the backburner’ when endowments have to fulfill previous obligations to private-equity managers.”

And here’s another problem faced by otherwise healthy hedge funds…J.W. Henry worries that even strong hedge funds may go under.

Breaking Views reports on “six changes they [hedge funds] need to prepare for” (via IHT).  One is that industry concentration will accelerate.

But Portfolio.com’s Jesse Eisinger has a different view.  Writes Eisinger: “Most hedge fund watchers think the biggest fund managers will only get bigger. But that’s hard to see…”

At least hedge funds aren’t the only ones looking at a huge drop in fees next year.  Thomson reports that “UK unit trusts and open ended investment companies have seen rises in both TERs [total expense ratios] and annual management fees for equity funds for the past ten years.”

We are pleased to present another commentary from the man who first coined the term “alpha-centric”, Angelo Calvello.  Today, Calvello uses examples such as Man Investments and BGI to argue that there is more than one way for asset managers to become truly alpha-centric.

Special to AllAboutAlpha.com by: Angelo Calvello, Ph.D.

Investors, faced with funding shortfalls and stricter accounting regulations, are demanding innovative ways of achieving absolute returns.  In the process, they are challenging the asset management industry to break down artificial barriers and constraints and consider solutions to problems we did not know existed a year or two ago. 

In many cases, these investors are offering those of us who can provide demonstrable value the opportunity to transform ourselves from vendors into partners who share their vision. The common denominator is the concerted focus on finding and generating alpha. The defining challenge for the asset management industry is to create and adopt business models and mindsets that will allow us to succeed in this new alpha-centric world.

Multiple Sources

Institutional investors are already seeking investment solutions beyond narrow, single-source portable alpha strategies.  They are exploring and implementing multi-alpha solutions that provide exposure to multiple asset classes at the portfolio level.

Because alpha is scarce, transitory and capacity-constrained, these solutions need to be structured flexibly so that alpha sources can be changed as they reach capacity or lose their edge. These solutions must also be structured to provide not just the desired return and volatility targets, but consistent positive returns while avoiding large losses.

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Barton Waring

Managing director and head of the Client Advisory Group at Barclays Global Investors.  Previously, head of Ibbotson Associates.

Bio (Yale Alumni Association)
Research (SSRN)
Relevant Postings (AllAboutAlpha.com)

Richard Grinold

Managing Director, Advanced Strategies and Research at Barclays Global Investors. 14 years at BARRA as Director of Research, Executive Vice President, and President; and 20 years on the faculty at the School of Business Administration at the University of California, Berkeley, where he served as the chairman of the finance faculty, chairman of the management science faculty, and director of the Berkeley Program in Finance.

Research (SSRN)
Some guy’s study notes on Grinold’s book, Active Portfolio Management

As the hedge fund industry matures, assets are flowing disproportionately to the larger players in what some have called a “shakeout”.  Taking a page from TV’s “Survivor”, investors are apparently starting to vote smaller players off the (Manhattan) island.

Usually, the term “shakeout” refers to the culling of weaker, smaller players in an industry in favour of the larger and more dominant competitors.  So it’s striking that Business Week this week suggests that the “parade of cave-ins” in Hedgistan included funds managed by major financial institutions (e.g. Citi, UBS, and parade-marshal Bear Stearns).

The ones doing the culling?  Pure play asset managers such as Bridgewater and BGI.  In fairness, JP Morgan (which bought and subsequently grew Highbridge) and Goldman (which today announced its hide was saved in Q2 by its asset management business), buck the trend.  But 8 of the top 10 largest hedge fund managers in Alpha magazine’s listing of the largest US hedge funds last month were NOT run by investment banks or other large financial services firms (we’d say that #9 BGI runs pretty independently of Barclays).  So the question remains, what’s up with the bank-run hedge funds?

Despite a rocky road for some bank-owned hedge funds, size continues to be an advantage.  Reports BusinessWeek:

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