Misguided Rocket Scientists

The failure of portable alpha mandates

RENE LEVESQUE, PRINCIPAL, MOUNTJOY CAPITAL

The following question and answer shall best encapsulate both the implicit and explicit elements that will become obvious before the conclusion of this article.

Question: Why wouldn’t the senior managing director of the bank’s proprietary trading desk rely on a consultant to hire a proprietary trader? Answer: Because the available candidates do not already have $500 million under management and there are no 5-year impeccable track records to rely on.

Pension advisory and manager search
The corporate and government sponsored defined benefits schemes are in a serious mess. The timing could not be any worse. The predicament coincides with a time when a significant part of the population is retiring and corporate balance sheets are stretched. Pension plans are indicating significant actuarial deficits to a point where they may jeopardize numerous corporations as going concerns. Municipal and other government-sponsored pensions pass on these deficits as increased taxes to the population. But these rather “stealth” events have increasingly become as obvious as the problems experienced in the corporate sector. The state of both public and private pensions has been deemed by some economists and authors as the next shoe-to-drop in an already weak economy.

The actuarial consulting firms advising both public and private pensions have evolved in a much similar pattern to that experienced by the accounting firms whose original and core mandate was to verify and certify the accuracy and fairness of financial statements. These accounting firms, already in relationships and well versed in the intimate details of their client’s business, developed and evolved into the consulting business. This consulting business became immensely lucrative, and as history proved, to a point it compromised the accounting industry’s integrity to deploy its original mandate. And this clearly became evident in the Enron scandal.

Similarly, the actuarial firms which have become well versed in their pension clients’ needs have developed a new business targeting investment manager search consulting and advising. Perhaps a sad reality, but the fallout experienced in the Enron scandal that led to the Sarbanes-Oxley guidelines pales in comparison to the potential extent of the financial and social impacts that the projected pension shortfalls may bring.

Independence as ammunition
The consultant’s claim to the status of being independent is often used as ammunition in their corporate strategy. However, the concept of independence does not shield them from the misguided and presumptuous assumptions about their ability to effectively perform a task related to the core business, and remaining free from conflicts of interest. This unregulated industry is perhaps overdue for an element of scrutiny to ensure that any element of perceived conflict of interest, such as the churning of managers and churning of services (on which more later) is subject appropriate scrutiny and safeguards.

Consultants are often sharp and eloquent individuals. Their firms are well staffed, and produce well structured and exhaustive reports, studies and surveys on the current realities throughout the spectrum of investment activities. The extent of these studies has allowed them to claim to be institutionalised experts in these investment areas, and thus better equipped to shape opinion among the somewhat non-informed or ill-informed members of the pension committees who will accept whatever these “experts” will feed them.

As in the medical field, where a general practitioner would never consider the execution of a triple by-pass operation, one may ask the following question: under what circumstances would the consultant assume an expertise in the effective evaluation of a hedge fund manager or hedge fund strategy? Some will argue that they have acquired a certification in a recognized body of knowledge in the area of investment. This article will later demonstrate that this claim in fact further alienates them from the ability to effectively evaluate hedge fund strategies.

In fact, essential elements of effective hedge fund strategies have very little to do (or absolutely nothing to do) with the notions of traditional investing that relies on fundamental investment research. The proof, in part, lies in the way that very sophisticated trading systems have been developed specifically to replicate the thought process of a talented trader that derived absolute returns. And these systems are built with absolutely no consideration to the data points resulting from the fundamental research and due diligence. Many of these systems have proven themselves successful in all market environments.

Manager search and absolute returns
In the traditional long-only asset management world, equipped with the luxury of static benchmarks, the application of quantitative-centric methodologies to evaluate investment managers was perhaps appropriate and became a natural extension of the actuarial firm abundantly staffed with quantitative-centric resources. By virtue of the imposed investment policies and the statement of return objectives that refers to a benchmark, the traditional asset manager is locked into a beta. The manager’s talent is revealed in the ability to effectively tweak the underlying portfolio exposures in reference to the established benchmark. In other words, the manager undertakes an active risk to derive active returns above the benchmark. To justify and validate the undertaking of active risks, the asset manager goes to great lengths to analyze the fundamentals of a listed company, its competitive advantages, quality of management, superior product and marketing channels, etc. Some managers claim to undertake deep forensic-like due diligence to derive informational advantages over other managers that are assigned the very same performance benchmarks. And given the relatively static nature of these benchmarks, the manager has the luxury of time to be proven right and eventually outperform the benchmark and peers.

A dual failure
With the introduction of the concept of hedge funds, whose objective was to generate absolute returns and the protection of capital, the benefit of such strategies (if successful) became obvious to the overall portfolio in the form of diversification and dislocation from broad equity draw-downs. As a natural extension to the existing manager search platform, consulting firms also applied the model to the hedge fund universe.

At this juncture, two critical elements unfortunately became part of the equation that ultimately led to many unfortunate results. First, the appealing hedge fund fee structure attracted participants from the long-only traditional asset management universe. And second, the consulting firms applied a similar (or the same) methodology used in the evaluation of hedge funds that was also used in the evaluation of traditional asset management.

The hedge fund industry thereby became contaminated with managers not familiar with the mechanics of deriving absolute returns and the protection of capital. And these managers were being evaluated by consultants that deployed resources that were also not familiar or experienced with these mechanics.

Segregation and boutiques
On the manager search consulting side, some groups have either segregated themselves from their parent actuarial consulting firm already, or some key members have left those firms to set-up management consulting boutiques that also specialize in manager search services. It is recognized, for the most part, that they all apply the same methodology in the hedge fund evaluation and screening process. This process, mostly relying on quantitative screens biasing top quartile return profiles (churning managers) has resulted in a natural tendency to favor those with significant beta contamination and implicit short gap risk exposures; particularly in extended benign market environments. And for some reason and surprisingly, given their quantitative abilities, they have completely failed to recognise the value in discounting the explicit liquidity premiums imposed by these funds.

For the most part, hedge fund strategies represent the disintermediation between the bank’s proprietary trading desk and the proprietary trader who has now become an entrepreneur. The trader, now labeled as a hedge fund manager, of course still makes use of the bank’s balance sheet to execute the strategy through the negotiation of a prime brokerage agreement.

The concept of absolute returns, along with the relevant trading mechanics, discipline and respect for the overall and overwhelming market forces stem from the bank’s proprietary trading desks who hire traders who are evaluated on a daily basis. The successful trader understands that the market is a collective perception of reality. It is this collective perception that will prove the trader right or wrong, and thus allow the trader to make or lose money, not the truth! On the proprietary trading desk, capital is much too precious to be allocated into positions waiting for the market to realize that he may be right. Successful traders have the ability and discipline to implement and dynamically size individual positions and overall portfolio exposures coherently within the market’s collective perception. They also have the discipline to admit when they are wrong, cut positions and move on with the next idea, even though they may eventually be proven right.

Found within the philosophy adopted by the proprietary trading desk is the methodology vital to the effective evaluation of hedge funds. But this was largely outside of the expertise and methods of traditional asset managers. In turn, the consultants who were perhaps well equipped to evaluate traditional investment strategies and the resulting return profiles, effectively served to alienate investors from the concept of absolute returns and the protection of the capital.

Little did the consultants know, until the severe market disruption of 2008 that these dedicated hedge fund portfolios were in fact traditional investments on steroids, i.e. loaded with leverage within illiquid legal structures and subject to bloated management fees. But, above all, much of the dedicated investment portfolio was in fact leveraged beta exposures. Unfortunately it took the events of 2008 to show many consultants that not all hedge funds deploy appropriate hedge fund strategies. Some will blame the failures on the financial crisis itself. The reality is, if properly executed with hedge fund strategies, real hedge fund strategies, the financial crisis, should have provided a more fertile opportunity set than the related pitfalls in the generation of pure alpha.

Absolute returns and protection
Investors allocate capital to alternative investments to derive alternative returns. In the case of hedge funds this should translate into absolute returns and protection of capital. The disappointment of hedge fund returns leads, of course, to the debate over hedge fund fees, rather symptomatic of the frustrated investor who allocated money to hedge funds but failed to recognize that not all hedge funds use “hedge fund strategies”. And for as long as they fail to do so, they will continue to subsidise and provide a living to those who will ultimately fail investors when a real hedge fund strategy is most needed. Leading up to 2008, there had been widespread implementation of dedicated hedge fund portfolios within the institutional investor landscape, including pensions. Given the extended benign market environment, the concept of portable alpha became increasingly recommended and mandated by the consulting firms who now had another fee-based business to offer.

Absolute returns and portable alpha
The success of a portable alpha mandate dwells on the element of consistent alpha generation, i.e. bets obtained through consistent absolute returns. Hedge fund strategies became a natural solution to portable alpha mandates. Therefore the successful portable alpha mandate is entirely dependent on the effective evaluation and selection of hedge funds that truly deploy hedge fund strategies.

The unfortunate events of 2008 quickly revealed the failures in construction of most portable alpha mandates. In fact, many of the consultants that previously proposed such mandates no longer promote them. Portable alpha is a nearly dead issue among the pension consultants who now offer another fee generating business to the now more than desperate pension client. It is called portfolio immunization and is analogous to admitting that the machine is broken, while trying to coax from it a bit more output.

If consultants are correct in no longer promoting portable alpha at least one of the following assumptions must be true: neither alpha nor absolute returns exist; or the consultants have given up on identifying managers or strategies with a high propensity for absolute returns and protecting capital.

Fortunately, alpha does exist, and fortunately, there are hedge funds that truly deploy hedge fund strategies by virtue of their disciplined approach to allocating capital. The construction of an effective portable alpha mandate should assume an even more regimented approach and filtering process than the one applied in the construction of a typical dedicated hedge fund portfolio because portable alpha mandates usually come in the form of a leveraged overlay to a portfolio. Any leverage exposure infested with beta characteristics is doomed to fail.

Of course, portfolio inclusion leading to an effective portable alpha mandate should rely on the selection of talented hedge fund managers, but the selection of the underlying strategies that precede the manager selection process is even more critical. There are three or four such strategies that at least suggest a successful portable alpha inclusion. And fortunately, for the investor sensitive to liquidity concerns, they lie in the most liquid asset classes and strategy styles. These strategies include: (1) discretionary global macro, (2) short-term biased systematic global macro, (3) trading-oriented and non long-biased equity long short, and (4) volatility arbitrage.

Coincidentally, none of these strategies are typically managed from those managers who migrated from the traditional long-only environment. Of course, there are exceptions, but relatively few. The case for inclusion of the above strategy styles, and the exclusion of others, is beyond the scope of this article, but please get in touch through www.mountjoycapital.com for elaboration on this.

Buy now, you are aware of why the senior managing director of the bank’s proprietary trading desk does not rely on a consultant to hire a proprietary trader. And most importantly, you are well aware of why most portable alpha mandates failed and why they did so for the wrong reasons.

Rene Levesque has over 23 years experience in the financial services industry. He is a former equity derivatives proprietary trader and was most recently a one-person hedge fund research team at a $2 billion plus fund of hedge funds group based in Canada. He has interviewed over 2,700 hedge fund managers covering all styles and geographies.