Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week we’ll be looking back through our archives to cull posts on the topic of CAPM/Alpha Theory…

How Hollywood, lotteries and mutual funds show that all risk is relative
Since the birth of the CAPM, empirical evidence has been uncooperative – showing that high risk investments produce lower returns, not higher ones.  Now one author looks beyond equity markets and finds even more evidence against the vaunted CAPM.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history?

More…

This week marks the publishing of our 1,000th post at AllAboutAlpha.com.  We’ve seen a lot over the past 3 years.  And despite its recent travails, the hedge fund industry remains approximately the same size now as it was back when we thought WordPress was a new type of laser printer and that blogs – like Pet Rocks and Cabbage Patch Kids before them – were another sign of the End of Times.

To celebrate this milestone, we thought we would highlight some popular posts in each topic area covered by AllAboutAlpha.com.  So throughout the summer, we’ll be pouring through the archives so you don’t have to.

(If you are a paying subscriber or a member of the CAIA Association and can’t remember your password, just hit “forgot password” at the right and we’ll have one of our army of overworked interns send you an email.)

This week, we’ll start with one of our favorite topics at AAA – CAPM/Alpha Theory.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history?

More…

A few days ago, we reflected in the rationality of closed-end hedge fund pricing.  And with markets swooning – then recovering this year, the topic of overall market rationality (or lack thereof) is firmly back on the front pages.   It seems the “wisdom of crowds” is being called into question these days.

The academics who brought us the Efficient Market Hypothesis (EMH) were recently  questioned for the website of one of their clients (Dimensional Fund Advisers).  In response to an op-ed in the Wall Street Journal by alpha-generator extraordinaire George Soros, Eugene Fama and Kenneth French argue that hedge fund managers are unqualified to comment objectively on efficient markets since they represent “a threat to their existence.”

Here’s an excerpt of what Soros had to say:

“Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge.”

But Fama and French don’t buy it.  They argue that markets make “mistakes”, but they still efficient price all available information.  If their March 2009 paper on “luck vs. skill” in mutual fund management is any indication, then they’d probably also argue that Soros’ returns are a statistical aberration that is bound to crop up every now and then by chance.

Meanwhile, author Justin Fox writes a summary of his new book “The Myth of the Rational Market” (Amazon, book review) for Time Magazine this week.  Says Fox:

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In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image.  Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher.   We’re not graphic imaging specialists.  But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.”  Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors.

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In an Alpha magazine article published today, Clifford Asness (founder of AQR Capital) and colleague Adam Berger launch a spirited defense of quant funds – saying they are not “black boxes” or reincarnations of the HAL 9000 from the movie 2001: A Space Odyssey.  The article is full of other colorful analogies that have become Asness’ trademark and it’s well worth the read (here – available without a login right now).

In “We’re Not Dead Yet” Asness writes:

“It’s not hard to see why people might think quant strategies are dead.  Recent performance, fears of overcrowding and the current market environment could easily lead one to question the viability of these strategies…we don’t think these concerns hold water.”

Asness and Berger base much of their argument on the belief that investors are irrational and that there are “fundamental, deep-seated, flaws in the way most investors make decisions.“  These result in trading opportunities (such as momentum and value a la Fama & French) which are likely to endure well into the future – regardless of the short term health of the hedge fund industry.

As the duo puts it:

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Clifford Asness

Co-founder, AQR Capital.  Was Managing Director and Director of Quantitative Research for the Asset Management Division at Goldman Sachs.  Ph.D. in Finance from the University of Chicago. Eugene Fama’s student and teaching assistant.

Applied Quantitative Research
Bio (AQR Capital)
Research (SSRN)

It seems to have become a financial axiom that actively managed mutual funds fail to justify their fees.  Ergo, index funds are often proposed as the best way to lose the least amount of money.

But what if the underperformance of actively managed funds has been driven by their underlying strategy, not their stock-picking buffoonery?

Beneath the complexity of their recent paper on benchmark indices, that’s the question posed by Martijn Cremers and Antti Petajisto of Yale and Eric Zitzewitz of Dartmouth. (You may recall the names Cremers and Petajisto from their paper on active share – a new metric to measure active management.  See related posting.)

The researchers found that academic models aimed at isolating manager skill by adding new variables to the CAPM (such as the Fama/French and Carhart models) are a substantial weakness.  Instead, they propose using actual indices as variables in an equation to reveal manager skill.

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Kenneth French

Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business, Dartmouth College. President Elect of the American Finance Association, a Research Associate at the National Bureau of Economic Research, an Advisory Editor of the Journal of Financial Economics.

Bio (Wikipedia)
Homepage (Personal)
Contact Information (Personal)
Research (SSRN)
Interview (Fama/French Forum)
Relevant Postings (AllAboutAlpha.com)

Eugene Fama

Robert R. McCormick Distinguished Service Professor of Finance, Graduate School of Business, University of Chicago.

Bio (Wikipedia)
Homepage (University of Chicago)
Research (SSRN)
Interview (Fama/French Forum)
Relevant Postings (AllAboutAlpha.com)

If you’re in the hedge fund industry, you know the name Pertrac.  These are the guys who make the ubiquitous software platform that many hedge funds use to analyse and report performance to their investors.  Last March, the firm compared the performance of large ($500 million+), medium ($100 million-$500 million) and small (under $100 million) hedge funds to see if size determined success in Hedgistan.  They also compared the performance of young (under 2 years old), middle aged (2-4 years old) and seasoned (4 years old +) hedge funds.

Earlier this week, the company announced the updated results of the same study.  It came as no surprise to researchers that last year’s findings were reinforced.  Young funds and small funds did better than their larger and older cousins.  The chart below appears in the firm’s press release:

You don’t need to be a finance Ph.D. to see the parallels between this research and the work of Eugene Fama and Kenneth French on the “small-cap bias”.  Apparently, small cap stocks aren’t the only small things that tend to outperform.

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Faced with a lack of track record for active extension funds, researchers are forced to re-create how these funds would have performed if they had existed for some time.  The idea is to select an “alpha model” (an unfortunate term since alpha cannot technically be “modeled”) and run it back in time using real market data to see how it would have performed.  The model is run once as a long-only portfolio and then again using any number of 1X0/X0 strategies.  Comparing the performance of the models can yield some insight into whether the short extension itself adds value to a given alpha model.

The latest to conduct this analysis are Carl Armfelt and Daniel Somos, graduate students at the Stockholm School of Economics.  Armfelt & Somos selected a set of basic Fama/French factors to create their alpha model and ran it all the way back to 1927.  Here’s what they found:

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Every year, pure random chance dictates that exactly half of all investors will outperform the median and half underperform the median.  The Holy Grail of alpha generation, of course, is to outperform more than pure random chance should allow.  In other words, to produce persistent alpha.

In our monthly column featuring the thoughts of a member of the Chartered Alternative Investment Analyst (CAIA) Association, we feature one academic who may have identified a way to uncover such non-random outperformance.  Daniel Capocci, Ph.D., CAIA, is a senior portfolio manager at KBL European Private Bankers, a lecturer at the Luxembourg School of Finance and a Research Associate at the Edhec Risk & Asset Management Center.

Alternative Viewpoints, powered by CAIA

Special to AllAboutAlpha.com by: Dr. Daniel Capocci, CAIA, KBL European Private Bankers

Three fields exist that examine hedge fund performance. The first includes studies that compare the performance of hedge funds with equity and other indices (some authors conclude that hedge funds are able to outperform these indices, whereas others are more cautious in their conclusions).

The second field of hedge fund performance analysis compares the performance of hedge funds with that of mutual funds (where some have found that hedge funds constantly obtain superior performance to mutual funds, although lower and more volatile returns than the reference market indices considered.)

Finally, the third group of hedge fund performance analysis examines the persistence of hedge fund returns.  Persistence is particularly important in the case of hedge funds because the hedge fund industry has a higher attrition rate than mutual funds.

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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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As outside observers of the academic literature surrounding alpha-centric investing, we always find it curious that the easiest-to-read, most accessible papers and presentations are usually written by some of the field’s most accomplished and technically sophisticated members.  William Sharpe, Eugene Fama, Andrew Lo, Jacobs & Levy…each seems to be able to cast aside the trappings of academia and present cogent arguments in laymen’s terms.

By this standard, Larry Gorman is a name to watch.  The Cal Poly professor has a unique ability to come down from the ivory tower to help the rest of us get our head around the pressing academic issues of the day -  the Fundamental Law of Active Management, 1X0/X0, and the true meaning of alpha, for example.  But don’t take our word for it, Gorman has been named “Most Outstanding Faculty” in the Cal Poly finance department each of the past fours years.

Gorman recently teamed up with professor Robert Weigand of Washburn University to write this relatively easy to digest paper covering some of the roadblocks on the path to alpha-centric investing (called “Measuring Alpha Based Performance. Implications for Alpha Focused, Structured Products”).  Warn the duo:

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