Today, we bring you the first in a series of exclusive interviews with key players in the world of alpha-centric investing.  Approximately once a month, we’ll pick someone from the pages of AllAboutAlpha.com or from the alternative investment industry in general and pose 7 topical and straightforward questions.

By Andrew Saunders, CAIA (AllAboutAlpha.com Editorial Board)

Roger Ibbotson, Ph.D., is the Chairman and Chief Investment Officer of Zebra Capital, a role he has held since the firm was founded in 2001.  However, many of you will know Roger as the founder and former Chairman of Ibbotson Associates, which he founded in 1977. (He sold his interest in Ibbotson Associates to Morningstar in 2006 and is no longer an executive with the company.)

Roger is also a professor in the Practice of Finance at the Yale School of Management.  His book with Rex A. Sinquefield, Stocks, Bonds, Bills and Inflation serves as the standard reference for information on investment market returns.  He also co-authored two books with Gary Brinson, Global Investing and Investment Markets, and in 2001 completed an investments textbook with Jack Clark Francis, Investments: A Global Approach.  Roger also recently published the Equity Risk Premium with William Goetzmann and Lifetime Financial Advice with Chen, Milevsky, and Zhu.

As regular readers are aware, Ibbotson conducts research on a broad range of financial topics, including investment returns, mutual funds, hedge funds, international markets, portfolio management and valuation. He is a regular contributor and editorial board member to various trade and academic journals and has received several awards, including the Review of Financial Studies Award (Best Paper in 1992) and the Graham and Dodd Scrolls (6 times).   His publications are regularly listed in the Top Ten Social Science Research Network Download lists.

He has also served as a consultant to many companies in the financial and investment industry and has managed bond portfolios, traded equity securities, and managed asset allocation accounts.

Q1: Roger, as we approach the second year anniversary of the great quant meltdown of August 2007, how would you characterize investor familiarity, knowledge of and openness to quant strategies?

During the summer of 2007 the risk (volatility) of hedge funds doubled.  It was also a time when many strategies were highly levered and underperforming.  Since most hedged funds targeted volatility, many had to unlever at the same time. Many of the quant funds had similar holdings, which caused the meltdown as they rushed to the same exits.  During the summer of 2008, something similar happened, but this time the cause was the short selling restrictions that the government implemented in an attempt to prop up the most vulnerable companies.  Once again the quant strategies suffered.

In both cases, the quant funds that were able to stick with their strategies were able to quickly recover.  But those who targeted volatility got whiplashed.  Those who kept their leverage intact did reasonably well.  Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.

Q2: Are there questions that investors should ask about quant strategies but do not?

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Could regulation of the hedge fund industry have prevented the Madoff fiasco?  Perhaps.  But likely not the specific type of regulation envisioned in the SEC’s failed attempt to regulate hedge funds back in 2006.

Ironically, Madoff’s investment advisory business “voluntarily” registered with the SEC that year.  That was right around the Commission’s failed bid to have all hedge fund advisers register with it.  Many other hedge funds had already done so when Phil Goldstein’s suit against the SEC eventually vacated the ruling.  However, the surfeit of fund information that resulted from the registration drive provided academics with a unique chance to compare operational risk factors with more traditional investment risk factors.  Stephen Brown, William Goetzmann, Bing Liang, and Christopher Schwarz did just that in this paper called “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration”.  (Brown was recently asked about the topic in this AP piece on Sunday)

The abandoned plan would have seen all hedge fund managers submit a form “ADV” to the SEC containing operational information (see Madoff’s Form ADV here).  According to the authors the form was designed as a “deterrence of fraud”:

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Climate researchers have long debated the effect of airplane contrails on the average ground temperature.  They theorized that contrails prevented sunlight from hitting the ground and warming the lower atmosphere.  But while each individual contrail could, in theory, create a slight shadow over a wide area, it was impossible to really gauge the effect of these ubiquitous clouds on the overall climate unless people literally stopped flying for several days.

Of course, this is exactly what happened during the week of September 11, 2001.  And researchers subsequently discovered that contrails did affect climate after all.  As CNN reported at the time, the average temperature volatility in the US actually rose significantly:

“During the three-day commercial flight hiatus, when the artificial clouds known as contrails all but disappeared, the variations in high and low temperatures increased by 1.1 degrees Celsius (2 degrees Fahrenheit) each day, said meteorological researchers.”

The recent moves by the SEC and FSA to curtail shorting of financial stocks provides researchers with a similarly unique opportunity to examine the effect of this equally ubiquitous phenomenon.

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Yale International Center for Finance

Director: William Goetzmann, william [dot] goetzmann [at] yale [dot] edu

From the Institute’s Website: The International Center For Finance at the Yale School of Management provides active support for research in Financial Economics by its fellows and disseminates their work to the world’s academic and professional communities. More about our goals can be found on our mission page. The Center’s fellowship is comprised of leading scholars in and outside of the Yale School of Management who work on key empirical and theoretical problems in Financial Economics. We also support an active doctoral program with a concentration in Finance at the Yale School of Management. At the MBA level, the Yale SOM Security Analysis Workshop provides current student investment research.  More… 

Working Papers

Related AllAboutAlpha content

Subscribers to our monthly email update “Alpha Mail” will notice that one of the top 10 most popular postings last month was one on a research paper by William Goetzmann of Yale University that explores ways that investment managers can potentially “game” their compensation system to generate illusionary alpha.

Now Wharton’s Dean Foster and Peyton Young of Oxford University and the Brookings Institution have added to the manager-as-scammer literature with a new paper entitled “The Hedge Fund Game: Incentives, Excess Returns and Piggybacking“.  In it, they decry the proliferation of “fake alpha” (e.g. selling options and using the wrong benchmark to calculate alpha).  The paper was published in January, but didn’t start making serious waves until mid-March when Martin Wolf, Chief Economics Commentator at the Financial Times wrote a column about it.

Wolf points out the asymmetry inherent in any type of incentive fee and holds up the Foster/Peyton paper as a “beautiful” example of how incentive fees can be gamed.  He says that such a structure bears a resemblance to the used car industry.  Like the used car industry, he says the hedge fund industry “is bound to attract the unscrupulous and unskilled.” [Ed: We're reminded of the famous Forbes cover story on hedge funds in May 2004 "The Sleaziest Show on Earth"]

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You may recall that Morningstar launched its “Star Rating” for hedge funds last month.  Given the myriad of differences between hedge funds and mutual funds (non-normality, illiquidity etc.), you may have been a little skeptical that the firm’s methodology was well suited to alternative investments.  We certainly were.  But it appears from recent academic research that the Morningstar Risk Adjusted Rating for mutual funds is actually a pretty flexible methodology for rating both mutual funds and hedge funds since it is “manipulation proof”.

This likely comes as no surprise to Morningstar itself, which said in a recent press release:

“The risk-adjusted return calculation and rating address two issues that are specific to hedge funds. First, unlike many other risk-adjusted performance measures such as the Sharpe ratio, the Morningstar hedge fund rating does not assume that funds have returns that follow the normal bell curve distribution. Second, the rating addresses the fact that some hedge funds invest in illiquid securities that are infrequently priced.”

While previous versions of its mutual fund rating system had “characteristics similar to those of an expected utility function” (see this paper by Sharpe in 1998), Morningstar revamped it in 2002 to include the asymmetrical utility of gains and losses experienced by investors (download PDF of the methodology).

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Last week both Ford and Delta got off their deathbeds to hand out goodies to many of their employees.  Response was swift as bloggers and columnists asked why a company like Ford that lost $12.7 billion last year was in a position to hand out anything at all.  “What a waste!”, bloggers wrote.  “It’s all so hopeless”, “Nothing ever changes!”.

Hedge funds of funds face a similar problem nearly every year.  Typically, a single hedge fund charges a 2% management fee and a 20% performance fee.  A fund of funds then adds a further 1% management fee and often a 10% performance fee of their own.  So on the surface, the nickname ”fees of fees” may seem appropriate to some.

But the effect of dual fee layers is more complex than it looks on the surface.  An article by Mark Hulbert in last weekend’s New York Times (reprinted here in Friday’s IHT) fees refers to an MIT study on the “deadweight” fees paid by hedge fund of funds investors.  The paper explains that an end-investor in a fund of funds often ends up paying performance fees even if their fund loses money because some underlying managers are always bound to produce positive returns.  Ironically, the source of this problem is the very reason funds of funds exist: diversification.

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