By: Max Darnell, First Quadrant LP
Published: May 2006, Eurekahedge

“Most readily accept the notion that any alpha captured corresponds to alpha that someone else has lost…Some, on the other hand, take the view that for all practical purposes, it is a zero-sum game, but admit that there is legitimacy, at a conceptual level, in the case that can be made opposing the zero-sum assumption.”

Max Darnell, CIO at First Quadrant makes a number of interesting observations about the nature of alpha.  In particular, he suggests that alpha is only a zero-sum game if investor’s utility curves are assumed to be totally homogenous.  Where investors have different utility curves (i.e. different time horizons, non-economic motivations, different risk aversions etc.), positive net aggregate alpha can be created.  Essentially, he is saying that it all depends on how you define success.

“It is, we believe, the distinct minority who hold as a core belief the notion that alpha does not always sum to zero, that opportunities to create net positive alpha across investors exist, and who actively seek out such alpha. The most conventional sources of alpha do, we believe, tend to sum to zero, so looking for constructive alpha opportunities – those transactions that lead to net positive aggregate alpha – typically means looking for alpha in places other than where most active managers tread.”

“Endowments and corporate defined benefit plans, for example, have materially different investment objectives and different appetites for risk. As a result, what may be a prize to one investor may not be so to another. This allows us to consider the possibility that investors may, in fact, be able to trade with each other with the result that both are better off!”

Darnell argues that small pockets of the market may be able to produce a non-zero aggregate alpha due to non-identical utility curves.  

Investors in these pockets of the market tend to have less “constrained” investment strategies (he calls them “benchmark agnostics”) and therefore their unique utility curves can be fully exploited in market trade-offs that increase utility for both parties.  This is called “Pareto Optimization” is also central to economic theory and, in a way, is responsible for the “non-zero” GDP growth the world has experienced since man discovered fire. 

“Benchmark agnostic investors should derive the most benefit from engaging in constructive trades with those who are highly constrained.”

“In the more “constrained” markets (e.g. large cap US), homogenous utility curves mean that investors are unable to trade-off low-value things to other investors who might value them more.” 

Darnell sites an example of a highly un-constrained pocket of the market – global macro (also one of First Quadrants’ core strategies).  But it’s not a huge leap to count several other “benchmark agnostic” hedge fund strategies among the “un-constrained” .  He says that these markets are actually able to produce non-zero aggregate alpha (what he calls “constructive alpha”). 

“…global macro investors provide the best example of investors who live with very little in the way of investment constraints, and are, therefore, best positioned to develop constructive alpha.”

It all sounds very enticing.  Like the game operator says at the county fair, “Everyone’s a winner!”…But only if you can convince the losers they actually won because they saved the hassle and embarrassment of carrying around that huge stuffed animal.  

In any case, this is a contender for the portable alpha hall of fame due to the author’s lateral thinking on the topic of alpha…

“It’s interesting, isn’t it, that the professional, institutional investing world spent so many years boxing in investment decisions more and more narrowly. For an increasing number of investors, alpha capture was, indeed, becoming zero-sum. Even more interesting is the fact that the constraints are being increasingly loosened today, with fewer and fewer investment constraints being applied, allowing for the potential that investment managers be more creative and more opportunistic in finding ways to generate alpha. Opportunities for constructive alpha transactions are on the rise for an increasing number of investors. So long as these managers continue to believe that alpha capture is zero-sum, however, they will fail to capitalize on these opportunities.”

Read Full Article (Original First Quadrant Version)