The Great Divide

The implications of the evolution of alpha

HARRY LIEM, SENIOR ASSOCIATE, MERCER

“There are about 8,000 planes in the air and 100 good pilots”
– Ray Dalio, Chairman and CIO, Bridgewater, on the current state of the hedge fund industry

We have not seen a shakeout in the hedge fund industry for a while now, and certainly not to the extent of that which occurred during the 1970s recession/stagflation, or the late 1990s Asia crisis. As usual, it is difficult market conditions that tend to separate those with skill from the lucky ones.

This article will describe a number of mega trends affecting the investment management community in the coming decade, seen through the view of a number of leading industry practitioners and academics examining both the long only and the hedge fund world as described in my recent book (Liem, 2007).

Interviewed participants include Dr Stan Beckers, Head of Alpha Management at BGI on alpha-beta paradigm shifts, Ray Dalio, Chairman of Bridgewater on the Post Modern Portfolio Theory, Ben Inker, CIO at GMO on the costs and benefits of traditional and alternative asset classes and Professor Stephen Brown from NYU on risk management and the evidence of book-smart versus street-smart behaviour.

Blaine Tomlinson, CEO at FRM, guided us through the main trends in the hedge fund industry. On the current and very much alive passive hedge fund debate we asked Oliver Schupp, President of Credit Suisse/Tremont Index LLC for his opinion. We also posed the question of the portability of hedge fund skill (through ‘alpha transfer’) to other asset classes to Bruce Dresner and Paul Bonde at BlackRock Alternative Advisors, who discussed the theory and mechanics of the different implementation options.

  • * What defines pure alpha (or skill, rather than luck)?
  • What do you think of the current investment environment? * How do you see the industry evolving?
  • Where do you see opportunities in the years ahead? * Do you consider investing to be an art, a science or a skill?

The interviewees discussed the increased demands on investment managers and how they will differentiate themselves in tomorrow’s environment. Their answers were set against the background of 12 economic ‘mega trends’ we identified, which include changing demographics, increased risk of moral hazard, global economic imbalances and debt bubbles, increased competition, the separation of reward for skill and market exposure, increased interest in alternatives and emerging markets, and growth in socially responsible investing (SRI), just to name a few. In the end, seven common themes emerged from the interviews, providing investors an insight into what they may expect from the industry in the coming decade.

THE SEVEN KEY THEMES

1. Active versus passive, it’s a moving frontier
There can be no doubt that markets are becoming increasingly efficient, and as more and more of what was once deemed ‘insight’ becomes systemised, pure alpha (that part of returns which cannot be explained by market related factors) may indeed become rare. As Beckers notes, “Skill can be thought of as divine inspiration.” And divine inspiration is precisely what is needed, as alpha is a finite commodity, or a zero sum game (see eg. Sharpe, 1991). Therefore, alpha you need to take away from the competition. After fees it’s negative sum. It’s always difficult to disentangle alpha and beta because we have not uncovered all the betas yet, but the current alpha-beta and passive hedge fund replication/indexation debate is a step in the right direction.

Seminal work from for example, Hazanhodzic and Lo (2006) or Fung and Hsieh (2002) extended the original Sharpe (1964) framework into the hedge fund space by adding leverage and shorting. As Beckers correctly points out, “After the APT, we’ve discovered additional factors such as small caps, dividend yield, or value versus growth. As the world evolves, we become more knowledgeable.”

As more and more alpha transforms into beta, some of the interviewees such as Brown conjure up visions of the ultimate fund management firm in the future, where humans and computers are flawlessly integrated and operate side by side, capitalising on each other’s strengths, and eliminating each other’s weaknesses, thereby maximising investment returns. Investment technology is changing with great speed, led by cutting-edge hedge funds. The most successful funds will be those which learn to integrate these machine-based systems with seat-of-the-pants checks and balances thereby effectively introducing common sense into the process.

2. The future of the investment industry will be the dual world

There is a broad consensus among the interviewees that we are indeed increasingly set for the great divide. While some fund management firms are positioning themselves for the coming decade with a firm focus on alpha returns and heavily investing in research and technology, many are starting to fall behind. Dalio comments that “in the coming decade, the investment business will consist of alpha generators and beta replicators (and firms that do both), and the alpha generators will have very smart people who understand financial engineering and are equipped with fabulous information technology. In other words, the quality of play will increase dramatically.”

The increase in derivatives means that what was once considered utopia, ie. alpha and beta exposure at the right price for the right mix is now a reality. The man in the street can now buy into asset classes we didn’t even know existed a couple of years ago. ETFs accelerate the restructuring of the industry into beta and alpha providers. ETFs support a real paradigm shift.

3. Generalist versus specialist – a place for both?

The traditional debate of whether one should invest with one generalist manager or outsource to different specialist managers has now moved into hedge fund space with many investors comparing the merits of the fund of fund versus the multi-strategy approach. One could mount a reasonable case for either the fund of funds or multi-strategy approach to thrive going forward, depending on the marginal cost of acquiring alpha externally or developing it internally. Investors should remember that the multi-strategy universe is very ill-defined, with lots of instruments, risk and return targets.

Despite a number of obvious advantages (such as the netting of fees and increased transparency), capacity is more often a limit than in funds of funds and all operational risk is with a single firm. As Blaine Tomlinson notes: “A fund of funds essentially selects the best of breed managers in each sector, with the philosophy that you want complete flexibility to choose the best managers out of a large universe. The diversity of managers and strategies in large funds of funds far exceeds that of multi-strategy funds.”

4. The current environment- concern and hope

The participants note some worrying features of the investment landscape. As the sub-prime mortgage fallout continues, many interviewees acknowledge that many traditional and alternative assets look somewhat overpriced. Again, this will further act as a catalyst for the great divide, as the superior managers will be increasingly distinguished from the average manager in the difficult environment. As the sub-prime mortgage fallout continues, attitudes to risk are being re-assessed. Inker notes that “the most striking thing about today’s environment is that practically every risky asset looks overpriced.”

On the other hand there is hope that emerging markets will be able to take over as the engine of the world. At a time when economic growth in the US is slowing down, economic leadership may pass back to the East. As Robert Lloyd George, Chairman of Lloyd George Management notes: “the pendulum of history which swung so visibly and decisively towards the West in the past 200 years is now beginning to return at an accelerating pace towards a twenty-first century world dominated by the East, in wealth, population, technology and economic dynamism.”

5. The hedge fund industry – expecting a shakeout

There is real concern among interviewees about the fast growing hedge fund industry. Today there are nearly 10,000 hedge funds, with their numbers growing at the rate of 100 to 150 a month, controlling $US2 trillion, and they remain fairly unregulated. Hedge funds have had an image problem ever since George Soros strode centre stage in the sterling crisis of 1992. Then there was the collapse in 1998 of Long Term Capital management, which for a time threatened to destabilise the global financial system.

Critics of this theory might say that hedge funds remain small in size compared to the capitalisation of global markets and hence, there is nothing to worry about. However, it is worth noting that there have been cases where a single hedge fund has been responsible for 10% of the turnover on the NASDAQ exchange on some days, and in aggregate, hedge funds can account for 40-50% of turnover on the NYSE and LSE. Do we really need 10,000 hedge funds, and are they worth their fees? And do they protect us from severe loss of capital as they promise? For the ‘average’ hedge fund manager, the answer seems to be no, on almost all counts, based on most academic and professional literature, (see Asness 2001). The risk is unlimited. As Brown notes, “the alpha can in fact be leveraged up, so in that sense, there is unlimited alpha. Many hedge funds operate by using leverage and assuming tail risk which is not captured in the traditional risk measures.”

6. Ethical investing- the jury is still out

A common theme is that SRI is going mainstream, and some ethical hedge funds are now being started as well, focusing on sustainable returns. In general, investors over the past decade mainly focused on governance, while the attention given to the environmental and social part has been very scarce until two or three years ago.

For budding ethical hedge fund investors, it is worth noting that evidence of the added value of ethical investing in the long only world has had mixed reviews from the academic world so far. As Bauer notes: “In essence, there are three competing hypotheses. The extra-financial information may be found to be relevant (eco-efficiency and corporate governance matter), irrelevant (have no material impact on performance) or relevant in a negative manner (ie. there may be a risk premium for investing in sin sectors such as defence and tobacco). To make things confusing, you can actually find academic evidence for all three hypotheses.”

7. Investing: art, science or skill?

The age old active-versus-passive debate that all started with Fama’s now (in?)famous article on efficient markets (1970), has transformed itself in the hedge fund industry into the current pure alpha-versus-beta factor debate, as more instruments become available and constraints are released.

However, despite all the emphasis on quantitative techniques, most participants note that at the heart of superior performance still lies human insight. As Jae Park, CIO at Loomis Sayles, notes: “There is a scientific method to it all, but it is the art that makes us humans indispensable, as we need to process information and be one step ahead of our opponents.”

Conclusions

“It is always from a minority acting in ways different from what the majority would prescribe that the majority in the end learns to do better.”
– Friedrich August von Hayek (1899-1992)

So what do these giants of the investment world think is going to happen in the investment industry in the next fifteen years? In short, they foresee a great divide, a two tier world, made up of the so-called alpha fund managers who can still do better than the mob and hence can charge higher fees, and those left behind to offer passive indexing and live with lower fees.

  • Transaction costs will come down as the number of derivative instruments increases.
  • The skill of the average player will increase.
  • Capital markets will become increasingly efficient.
  • We will keep finding new betas that explain what was once presumed to be skill.
  • The constantly changing nature of the demand and supply of alpha will increase the complexity of active management in the markets.

Investment managers will need to adapt and innovate to avoid falling into a two-tier industry of outperforming alpha fund managers and those left behind to passively index at rather low fees. Institutional investment is based on the search for alpha or outperformance, however, active investment managers have long battled against the erosion of alpha as their ideas and processes are taken up by competitors. The best of them are constantly searching for new ideas and new sources of information to maintain their competitive advantage. Only those players able to adapt themselves faster than their competitors will maintain their leading edge. Ultimately, we will keep finding new betas that explain what was once presumed to be skill, hence pure alpha or the “divine inspiration” that we talked about earlier, will become rare indeed.


References

Asness C S, Krail, and JM Liew, (2001) “Do Hedge Funds Hedge?”, Journal of Portfolio Management, vol.28, no.1, 6-19
Fama EF, (1970) “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance, vol.25: 383-417
Hasanhodzic J, and AW Lo, (2006) “Can Hedge-Fund Returns Be Replicated?: The Linear Case”, SSRN Working Paper
Liem H, (2007) “2020 Vision: Investment Wisdom for Tomorrow”, Mercer
Fung W, and DA Hsieh, (2002) “Asset-Based Style Factors for Hedge Funds”, Financial Analysts Journal, September/October, 16-27
Liem H, and D Timotijevic, (2007) “Passive hedge fund investing: the role of replication and indexation as sources of alternative beta”, Mercer
Sharpe WF, (1964) “Capital asset prices: A theory of market equilibrium under conditions of risk”, Journal of Finance, 19 (3), 425-442
Sharpe WF, (1991),”The Arithmetic of Active Management.”, Financial Analysts Journal, Vol.47, No.1 , 7-9


Biology

HARRY LIEM
Harry Liem is a senior consultant with Mercer, a leading global provider of investment consulting services. He specialises in hedge fund and strategic research. He is a regular presenter at conferences and also lectures at the University of Technology, Sydney.