Thinking of starting a business in the asset management industry?  Say, a company that develops methods for constructing investable hedge fund indices?  Or maybe an outfit that lends money to asset managers in exchange for a share of its revenues?  Well, you can forget about it.  This week, U.S. patents were awarded to companies that have developed somewhat novel ways to do both.

Royal Bank of Canada, the world’s tenth most profitable bank locked up the patent rights for a long list of business processes relating to the management of investable hedge fund indices and the structured products built upon them (see patent).  In typically passive and arcane language, the patent itself reads like a case study in excessive patenting:

“What is claimed is:  A computer implemented method for balancing an index of a plurality of hedge funds, the method comprising: calculating, by a computer system, a hedge fund weight for a hedge fund included in the index; determining, by the computer system, if the calculated hedge fund weight exceeds a hedge fund weight maximum, the hedge fund weight maximum corresponding to a maximum proportion of the total index that can be allocated to a particular fund; determining, by the computer system, if the calculated hedge fund weight is less than a minimum hedge fund weight, the minimum hedge fund weight corresponding to a ratio of a required capacity or exposure to the net exposure of the index; and adjusting the percentage of the index allocated to the particular fund if the calculated hedge fund weight exceeds the hedge fund weight maximum or is less than the minimum hedge fund weight…”

In other words, RBC Capital Markets now owns the rights to use a “computer system” (?) to calculate hedge fund index weights.  Yet many of the claims stated in the patent document sound remarkably similar to an index methodology white paper.  For example…

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Rob Arnott

Chairman, Research Affiliates.  Outspoken advocate of Fundamental Indexation.

Research Affiliates
Bio (Research Affiliates)
Fundamental Indexation
Relevant Postings (AllAboutAlpha.com)
 

Rob Arnott, the outspoken proponent of “fundamental indexation” might want monitor what’s being said in Paris this week.  Arnott is the owner of the patent for “non-cap-weighted indices” (see related posting).  But IPE reports that Alain Dubois, the head of Lyxor Asset Management a SocGen subsidiary, told a conference audience:

“It could create a market phenomenon, like reduction of very high market caps, and could lead to performance of these indices just because everybody invests in them…It is an interesting trend, but should be arbitraged as soon as possible.”

Piling on was Tomas Franzen, head of AP2, one Sweden’s national pension funds who apparently added:

“…it is the market-cap-indices that are flawed and not necessarily the alternatives that are, per se, intelligent.”

Arnott might not actually disagree with this assessment since he has often referred to fundamental indexation as simple common sense (see related posting).  In either case, the value of his patents is probably doing just fine.

The term “portable alpha” is still a relatively new addition to the popular lexicon.  As we’ve written on these pages, the term itself seems to morph on a regular basis to encapsulate the literal “porting” of alpha between asset classes to the combination of hedge funds and swaps.  Issues like active management fees, regulation, risk measurement, and market efficiency seem to weave their way in and out of the various definitions of portable alpha.

Now someone has finally brought many of these concepts together in one place.  “Portable Alpha: Theory and Practice” (US link) edited by PIMCO’s Sabrina Callin has just hit bookstores.  If you read Peter Bernstein’s “Capital Ideas Evolving” (see related posting), you may recall that PIMCO is considered to be one of the early pioneers in portable alpha strategies.

Naturally, we’re working our way through it right now and are so far impressed with the holistic nature of the content (including contributions by Rob Arnott, Bill Gross and several PIMCO managers).

Yesterday, AAA media partner HedgeWorld ran an interview with Callin for its premium subscribers.  With permission from our friends at HedgeWorld, we have re-printed the interview in its entirety below.

But before you read the interview, here’s a quick footnote.  It appears that Portable Alpha has a lot of fans in the UK and Singapore.  A Google search of this book returns the publisher’s country-specific websites in the following order: UK, Singapore, US, Germany, Canada.  A flagrantly un-scientific observation for sure.  But curious nonetheless…

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When Credit Suisse and S&P both recently announced 130/30 “indices”, we struck a note of skepticism.  Wasn’t such an active index an oxymoron?  Doesn’t a short-extension simply leverage a manager’s pre-existing alpha?  And if so, isn’t such an index just an arbitrary benchmark based upon the underlying alpha-generation model?

Andrew Lo provided some arguments in favour of such an index in his December 2007 paper “130/30: The New Long-Only“.  In it, he acknowledges:

“our proposal to put forward an algorithm or dynamic portfolio as an index is a significant departure from the norm. Existing indexes such as the S&P 500 are defined as baskets of securities that change only occasionally, not dynamic trading strategies requiring monthly rebalancing.  Indeed, the very idea of monthly rebalancing seems at odds with the passive buy-and-hold ethos of indexation.”

According to a paper published in the January 2008 edition of the Journal European Financial Management, the “passive buy and hold ethos of indexation” ain’t so passive after all.  The paper (earlier version available here), finds that most indices are chalked full of active biases – making a truly passive index a rare animal indeed.  This, of course, is the central argument made by proponents of fundamental indexation (see related posting, “Arnott: Does My Beta Produce Alpha?”)

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During the final months of 2007, Credit Suisse and S&P both launched what they called “130/30 indexes”.  CS didn’t say much about their methodology at the time, but S&P published the entire index construction approach online.  After reading that approach on November 20, we wrote the following:

“…here’s the thing we don’t quite get: why would you want to benchmark yourself to another active manager? There is no common risk factor underlying these funds that can serve as a benchmark. There is no 130/30 beta. In fact, all a 1X0/X0 program aims to accomplish is to lever pre-existing alpha for greater returns if alpha is already positive or greater losses if alpha is negative. As IPE reports, a speaker at a recent conference referred to 130/30 as just a prescriptive technique. How do you index a ‘prescriptive technique’?”

Clearly anticipating such a line of questions, the developer of the Credit Suisse index, AllAboutAlpha Hall-of-Famer Andrew Lo of MIT, addressed this question head-on in his December 11 paper on 130/30 indexation (”130/30: The New Long-Only”).  The paper has generated quite a bit of chatter recently (the subject of this Pensions & Investments story today and a column in the Economist this week.)

Say Lo and co-author Pankaj Patel:

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As you probably know if you are a regular reader, The Institute for Quantitative Research in Finance” (or Q-Group for short) is one of the world’s foremost communities of quant rock-stars from the academic and practitioner communities.  In his video interview for the American Finance Association’s “History of Finance” project, William Sharpe tells of how he was actually at a Q-Group annual seminar when he learned of his Nobel Prize.

Well, no one won a Nobel Prize at last spring’s meeting.  But the 17 pages of session summaries, now available here, are well worth a read.  Here is a selection of what you’ll find:

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Visitors to our Events Section may have noticed that many of the world’s leading conferences on portable alpha, 130/30 and hedge fund replication are organized by Terrapinn or one of its subsidiaries.  Terrapinn’s events in this area have featured industry leaders such as Harry Kat, Bill Fung, David Hsieh, Rob Arnott, Thomas Schneeweis, Nassim Taleb, Laurence Seigel, Paul Wilmott, Angelo Calvello and others.

So we recently jumped at the opportunity to become the “official blog partner” of Terrapinn’s line-up of alpha-centric events from Toronto to Tokyo and from Sydney to Santa Monica.

One of the first projects to be undertaken jointly by AllAboutAlpha.com and Terrapinn is a survey of attitudes toward 130/30 investing.  We encourage you to take this brief 5 minute survey before August 24th.  In exchange for your time, you can expect to receive the summary results along with a reduced fee for a number of Terrapinn’s North American events.

As this partnership takes shape, you can also expect to hear from members of Terrapinn’s excellent speaker line-ups here at AllAboutAlpha.com in the form of guest postings and special contributions.

We hope you will agree that this partnership represents the perfect marriage between a physical community (a conference) and a virtual community (a blog).

Continuing the proud tradition of the “Rumble in the Jungle” and the “Thrilla in Manila“, Financial Planning Magazine hosted what it called the “Fundamental Indexation Smack Down” last month between the inventor of fundamental indexation Rob Arnott (the Patent King of Pasadena) and Gus Sauter, CIO at Vanguard.  The entire 15 rounds was just released in a 60-minute webcast – and there’s no annoying $30 pay-per-view charge. (see entire video here, audio here)

It’s actually a pretty interesting 60 minutes.  (Thankfully, even more exciting than the 60 minute SEC meeting we watched earlier this week.)  However, if you’re pressed for time, you will find that both Arnott and Sauter make their key arguments in the first 25 minutes (but you will miss Arnott’s taunt in Round 7 when he pointedly asked Sauter, “Why are you so scared of this?” – not quite Jack Nicholson’s “You can’t handle the truth!”, but a high point nonetheless).  Whether you make it to the end or not, you will find it’s a great way to get up to speed on the arguments for and against fundamental indexation without having to reading mind-numbing academic papers.

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Well, maybe not retirement per se.  But Ibbotson (now under the Morningstar umbrella) recently convinced examiners at the US Patent Office that adjusting a retirement portfolio based on the amount of time until a worker retires was patent-worthy.  According to the US Patent Office website, the patent was awarded on May 8, 2007.  But it wasn’t until last Friday that the firm released a statement saying “Nyaaa, nyaaaa!  We gotta a patent!” (we paraphrase here).

This patent reminds us of Research Affiliates’ recent patent on fundamental indexation (see related posting, “The Patent King of Pasadena“).  Both make liberal use of the terms “machine-readable medium…” and “processor performs the steps…” to differentiate their “inventions” from generic and broadly-understood concepts.  Says Ibbotson’s statement:

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Lawrence Carrel at TheStreet.com writes about the “Godfather of Fundamental Indexing” last week.  Rob Arnott, founder and CEO of Pasadena-based Research Affiliates not only invented fundamental indexing, but he apparently also patented the idea.  As Carrel discovers, however, critics are quick to point out that fundamental indexing bears a remarkable resemblance to simple old-fashioned value-investing.

In fact, Carrel points out that ETF manufacturer WisdomTree never even sought permission from Arnott before launching their own ETF based on the same concept.  Says Carrel:

“It was also a challenge to Rob Arnott, the godfather of fundamental indexing. Arnott’s investment firm, Research Affiliates, had licensed the first ETF based on a fundamental index a year earlier and filed a patent application for all indices based on fundamentals. But WisdomTree didn’t seek Arnott’s blessing for its new products. In essence, the firm was saying that fundamentally weighted indexing isn’t the property of Research Affiliates but of the entire world.”

The patentability of business processes came to the fore late last century in the froth of the tech bubble.  In fact, Alpha Male himself even applied for provisional patent protection on an e-business process that he thought would someday make him a rich man (he still thinks it’s a cool idea).

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Rob Arnott isn’t afraid to go against the grain.  His “fundamental indexing” methodology ignores price and value-weighted indices and instead uses fundamental business metrics such as sales and revenue to construct investment benchmarks.  He says this avoids the propensity for indices to overweight temporarily overvalued stocks and underweight temporarily undervalued stocks.

But the idea has always had its skeptics – many of whom argue that fundamental indexing amounts to value investing in disguise.  After all, they say, it simply amounts to overweighting high book-to-price stocks and underweighting low book-to-price stocks.  Arnott is well aware of such criticisms and apparently plans to launch a counter-offensive soon.  According to P&I, that counter-offensive will involve none other than Harry Max Markowitz, father of modern portfolio theory.

P&I reports on a paper in the works by Harvard professor Andre Perold called “Fundamentally Flawed Indexing”.  Apparently, those who have seen it say it makes a lot of sense.  Eric Sorensen, president and CEO of PanAgora (see posting: “King of Quants“) tells P&I that fundamental indexation assumes “large-cap stocks are overvalued, and you don’t know that”.

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Apparently it’s open season on Fama & French’s 3 factor model. Yesterday on these pages, researchers argued that the value premium was largely explained by transitional distress, not fundamental (”structural”) value. And today we receive word via John Mauldin’s weekly newsletter that Dresdner Kleinwort’s James Montier has leveled an attack on the model’s alleged small-cap outpeformance – leaving 3F proponents taunting us with cries that “it’s only a flesh wound!”.

In this week’s edition of “Outside the Box”, Montier shows how small cap did indeed outperform large cap prior to 1981. But after that time, the outperformance of small cap stocks has been negligible. He chalks this up to the fact that capitalization is a factor of stock price – and stock prices fluctuate. So the capitalization factor implicitly integrates two components: valuation and actual firm size. He cites fundamental indexation guru Rob Arnott’s research that shows the “small cap factor” is dramatically less predictive when it’s based solely on a fundamental metric like sales, as opposed to the traditional market capitalization metric. Apparently, Montier’s own research on European stocks corroborates this observation.

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Active managers – particularly hedge fund managers – are notoriously inconsistent. This fact is often held up as proof of efficient markets. The assumption: all managers eventually “revert to the mean”, “hot hands don’t last”, and “what goes up must come down.”

As a result, endless resources have been poured into the quest to find some way to predict manager performance other than to simply rely on historical returns. Naturally, such a finding could be lucrative for advisers – particularly those who benefit from the performance of other managers like, say, funds of hedge funds.

The latest attempt to do this has some intriguing possibilities. In a paper published in this month’s Journal of Finance, Marcin Kacperczyk of the University of British Columbia and Amit Seru of the University of Michigan propose a new metric called the “Reliance of Public Information” (RPI) to measure the extent to which a manager’s performance is correlated – not with the markets – but with “public information” (captured by consensus sell-side analyst recommendations).

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“CAPM is CRAP, or, The Dead Parrot Lives”

By: James Montier, Dresdner Kleinwort
Published: January 29, 2007, John Mauldin’s “Outside the Box”

John Mauldin is a big fan of James Montier, the 34 year old Dresdner Kleinwort economist who literally wrote the book on behavioral finance.  Montier also wrote a chapter in Mauldin’s 2006 book “Just One Thing” and Mauldin re-printed Montier’s musings a couple of times on his website last year.  Montier seems like an interesting guy and we enjoy his irreverent take on modern finance – like this one…

In this comprehensive yet very readable article Montier rails against the CAPM, calling it “(C)ompletely (R)edundant (A)sset (P)ricing”.  While his facts are irrefutable, their interpretation leaves room for disagreement.  In other words, the exact fecal count of CAPM remains unknown.  But whether you agree with his conclusion or not, you will probably find this essay an interesting read.

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