Right up until last fall, practically every alternative investment conference this side of the date line had at least one panel of experts discussing and debating the elusive search for alpha, and how to capture and augment a traditional or even non-traditional portfolio by finding managers that were truly capable of generating non-beta returns.

And then the black swan-poop hit the fan.

Nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished. It’s more about earning a return – period – than earning a return above and beyond what the rest of the market is looking for.

Along these new lines has emerged a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.

From market-timing and late-trading to illiquid valuation techniques and 20:1 levered bets to discrepancies in share pricings between markets and indices to the growing popularity of super low-latency flash trading, these pundits, who wish to remain both nameless and faceless for fear of being drawn and quartered by their bretheren, argue that alpha can’t be obtained legally.

Of course, for every one individual who might dare argue that alpha can’t truly be obtained, there are hundreds who will vehemently argue that it can: that alpha in of itself can be created simply by allocating to a non-traditional portfolio or basket, which in turns makes it a non-beta play.

Dig more deeply, though, and true alpha generation begins to look a little more difficult to come by: now-defunct hedge fund Galleon promised alpha, as did a host of alternatives shops before it, Lancer Group, Beacon Hill and many other notorious shops who claimed by definition to produce alpha through their various methodologies and abilities, most of which weren’t, at the end of the day, on the up and up.

From an academic perspective, the question of whether alpha exists and can be obtained is actually nothing new. Roger Urwin and Gerard Roelofs of Watson Wyatt produced this presentation back in early 2006 that questioned whether pure alpha or even pure beta exists.

And from this report published by Dr. Lars Jaeger, a partner with Swiss-based asset manager Partners Group, alpha, if it can be obtained at all, is steadily diminishing.

Which begs the philosophical question: What exactly is alpha? Is it a tangible and quantifiable concept, a true risk-adjusted measure of the so-called active return on an investment in excess of the compensation for the risk borne? Is it an ideal that many lay claim to but that can’t actually be obtained? Or is it simply the first letter in the Greek alphabet?

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha.

According to Montreal-based Castle Hall Alternatives, which maintains a comprehensive database of frauds, blowups and other hedge fund misnomers, some 300-plus hedge fund frauds and / or implosions have taken place over the past decade or so. While difficult to figure out which of those frauds and blowups claimed to run an “alpha” strategy, complex, illiquid, levered or some combination does permeate as a theme.

So is alpha simply an alternative to beta, in which case by definition anything not part of the mean of generating non-correlated returns? Or is alpha in fact plain-vanilla alternative beta? Or is alpha something that is indeed non-correlated and above and beyond what the rest of us mere mortals can produce, but not in a legal or perhaps ethical fashion?

As our name suggests, we believe in the ability to generate alpha, and we believe there are many bright minds and quantifiable alternative strategies that can and so produce it in a perfectly legal and compliant way.

However, there likely does lurk a group of managers and traders who aren’t following the rules when it comes to generating it. From a due diligence perspective, the key is trying to figure out – and stay ahead of – those who might be taking the low road to getting it.

Some food for thought for the US Thanksgiving weekend.

Investment consultant Hewitt Associates said last week that the majority of active long-only managers underperformed their passive benchmarks last year.  This is particularly poor given that the cash holdings and inherent business caution of many mutual fund managers generally results in a lower volatility than the market (along with commensurately lower losses in bad years and lower gains in good years).

Hewitt blamed the usual culprits: management fees and trading costs.  But the firm also pointed to an active bet that went sour for many of the world’s managers: an overweight position in financial right before the debacle known as Q4.

The result, says the firm, is that “some pension funds are already considering switching to passive management, as a way of generating growth through cutting costs.”

“Market Adjusted Alpha”

But the performance of some managers may have been even worse if you use a performance metric proposed by Al Ehrbar in this P&I article.  Ehrbar is credited with popularizing Economic Value Added (EVA).  So it may be prudent to check out what he has to say about measuring “alpha” in down markets.  (We put alpha in quotes since he uses a simplified version of our favorite Greek letter – one that may be more commonly used in practice than, say, Jensen’s Alpha.)

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Despite begin caught with their hands in the beta cookie jar last quarter, hedge funds had one of the best relative performances ever in Q3 – beating equity indices by a country mile.  Most industry participants acknowledge that various “alternative betas” and even, as we have recently seen, traditional betas have found their way into hedge fund returns.  And some now attribute hedge funds’ returns since 2003 as simply repackaging beta and selling it at alpha prices.  While countless reports of abysmal hedge fund performance have included the caveat that they have still beaten the S&P 500 handily this year, the industry remains in the cross hairs of the mainstream media for what it alleges was “promising absolute returns in good times and bad”.

Despite the marketing power of the “absolute return” moniker, its adoption by the hedge fund industry is now coming back to haunt it.  Although we know very few hedge funds naive enough to make such promises, the tacit endorsement of the term by the industry at large has obscured the benefits of old-fashioned relative performance.

Institutional investors have largely adopted hedge funds not because of their performance, but because of their diversification properties – as indicated by their low market correlation.

A survey conducted last year by French business school Edhec shows that virtually all performance measures used by European institutional investors are essentially relative, not absolute.

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Michael Jensen

Jesse Isidor Straus Professor of Business Administration, Emeritus, Harvard Business School.  Founded the Journal of Financial Economics.  Past President of the American Finance Association.

Bio (Wikipedia)
Homepage (Harvard)
Contact Information (Harvard)
Research (SSRN)
Relevant Postings (AllAboutAlpha.com)
     

Industries dominated by fixed costs tend to experience a lot of price competition.  You don’t have to look any further than the airline industry to find evidence of this economic axiom.  In fact, price competition is often even more fierce in growth industries where price cuts are enabled by economies of scale.  For example, the Model T Ford had a price tag of $850 when it was launched – blowing away most rivals priced in the $2000-$3000 range.  Within a few years, the Model T MSRP was around $300 – illustrating to the world the new economics of scale.

But price competition seems to have bypassed one particular fixed-cost business – the money management business.  This, according to an article in the Journal of Investing that was made available for free recently.  The paper by John Haslem of the University of Maryland, Kent Baker of the American University and David Smith of SUNY at Albany has the benign-sounding title “Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios”.  But don’t be fooled.  The authors rail against what they see as a lack of price competition in the US (and by extension the global-) mutual fund industry before examining the relationship between fees and performance.  They even name names – highlighting the US mutual funds with the highest relative fees in the land.

In their words:

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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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Regular readers may remember our two part review of “A Demon of Our Own Design“, a fascinating account of the recent history of risk management by hedge fund manager Richard Bookstaber.  As you may recall, the book was released just in time for August’s hedge fund melt-down making it exceedingly timely and propelling Bookstaber into the international limelight.  In fact Forbes recently instructed its readers to “Run off to your nearest bookstore and fetch yourself copies of Richard Bookstaber’s engrossing A Demon of Our Own Design…”

To keep you, our loyal readers, on the cutting edge of asset management trends, AllAboutAlpha’s Alpha Male will be conducting an in-person interview with Bookstaber (along with two other asset management commentators Tris Lett – see related postings and John Ilkiw – see related posting) this Tuesday, January 8th.  But in the spirit of interactivity that underpins all we do at AllAboutAlpha.com, we are asking you to submit the questions that you would like him to ask.  If you’ve read his book and have a follow-up question or just have a query about something on his blog, please drop us an email at alphamale(at)allaboutalpha(dot)com.  The interview is scheduled for Tuesday evening, so you have until 5pm Tuesday to send us your questions.

By: John Ilkiw, SVP Portfolio Design & Risk Management, Canada Pension Plan Investment Board
Published: Winter 2006 Canadian Investment Review

Yes, you read the title of this article right.  It was Michael Jensen, not William Sharpe, whom actually used the terms “alpha” and “beta” for the first time in 1967’s now famous paper with the catchy title, ”The Performance of Mutual Funds in the Period 1945-1964“.  According John Ilkiw of the US$90 billion Canadian Pension Plan, Sharpe actually used the terms ”A” and “B” instead of “alpha” and “beta”.  Thank goodness for Michael Jensen, since if it weren’t for him, you would be reading AllAboutA.com right now.

But Ilkiw’s historical findings don’t end there.  He reports that one of the first people to make serious money off the more-marketing-friendly term “beta” was Dennis Tito who in 1970 published a “beta book” for an LA brokerage firm and soon after founded Wilshire Associates to package and sell beta.  Thirty years later (in 2001) Tito became the first-ever civilian to visit the International Space Station (yes, that Dennis Tito), proving that in the long-run Beta will go to the moon – or at least part way.

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By: Tim Price, CIO, Global Strategies, UBP
Published: January 4, 2007

Tim Price lives at an intersection.  Only his intersection doesn’t show up on Google Maps.  As the CIO, Global Strategies for one of the world’s largest hedge fund & private equity investors, he has his finger on the pulse of the alpha-generation industry and on his clients’ growing demand for alpha.  In other words, he lives at the intersection of supply and demand for alternative investments – an intersection that is becoming one of the busiest in the world.

As a result, his monthly commentaries can be thought of as a traffic report delivered from his own living room window.  This month’s commentary illustrates how private equity is as fundamentally disruptive as hedge funds and ETFs.

Price contends that the global economic freight train is rolling down the tracks at full speed – “the best of times”.  But certain sub-sectors of the asset management business are being tossed out the train’s window to reduce weight – “the worst of times” (for those sub-sectors at least):

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By: Greg Jensen, Noah Yechiely, Jason Rotenberg, Bridgewater Associates
Published: May 24, 2005

Excerpt:

“Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it).  This is clearly inefficienct, as the two decisions need not be linked. Instead, investors should decide which asset classes they want to be in and then overlay on top of these asset classes the best alpha managers they can find, no matter which asset class they get their alpha from.  This is alpha overlay, and it is a better way to run a portfolio.  Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy.”

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