By: Alpha Male

October’s edition of Bloomberg Markets Magazine included an article about peak oil theory that reminded me of the current debate in hedge fund circles about the modest returns of late.

Hedge fund naysayers have had a field day over the past year or two deriding hedge funds for not producing alpha (only exotic beta) or worse yet, for producing alpha that is destined to shrink and eventually disappear.  Duke professor David Hsieh’s recent comments regarding the finite amount of market inefficiencies available to be exploited by hedge funds ($30b/yr. or 3% in a $1 trillion industry) have helped fuel the debate.

True or not, many commentators blame anemic hedge fund performance on the crowding of trades around the same arbitrage opportunities.  While this may be true in some strategies such as merger arbitrage, the jury remains out on whether hedge funds have become victims of their own growth.

But is alpha finite like oil?  And if it is, did we just live through a golden age of hedge fund alpha generation - never to be repeated?  Have we passed the point of Peak Alpha?

The Definition of Alpha

“Beta return is available to anyone by right….Alpha is earned by taking it from someone else, literally! It is an anonymous contest. This is the only way you can get a winner and a loser because no one would do it willingly.”

Tris Lett of Integra Capital, a Canadian Portable Alpha leader

To explore this question, let’s step back and review the definition of alpha.  Alpha has no physical properties.  Alpha is not the same as market inefficiency.  Alpha describes the behavior of returns.  So it represents the effect of market inefficiencies - not the inefficiencies them selves.  Alpha is like the wobble of a distant star due to the effect of an orbiting planet.  We can’t see the planet, but we see its effect on the star and we conclude that a planet must exist.  Likewise, inexplicable and consistent out performance is the effect of a market inefficiency.  In most cases, we have no idea exactly what that inefficiency is, but we know it must exist because it is the only logical explanation to persistent, risk-adjusted out performance.

The market inefficiency leading to the alpha might be informational in nature.  An individual manager or group of managers may have succeeded in tilting the playing field in their direction.  To paraphrase The Right Honourable William Sharpe, for every dollar they make on this playing field, someone else must lose a dollar so that net aggregate alpha is zero across the universe of investors.

But what if we are only looking at a sub-set of players on this playing field (say, hedge fund managers)?  Then it would be possible for net aggregate alpha (in this group) to be positive.  And as long as market inefficiencies existed in the entire global capital market, it could be possible for one group to profit from the losses of the rest.  To accomplish this, the rest of the market must remain oblivious to their exploitation by the alpha-generators in order for the alpha-generators to, well, generate alpha.

But over time, they would undoubtedly smarten-up and stop the exploitation - making the playing field level once again.

This gradual process of smartening up is analogous to the extraction of oil.  So when we say alpha may be finite, we really mean that market inefficiencies may be finite.  And when we talk about alpha “running out”, we are essentially saying that production exceeds discovery - that alpha reserves are falling.  This, of course, is a key plank in both the Peak Oil and Peak Alpha platforms.

The Era of “Easy Alpha”

This is really the central question.  Can we find market inefficiencies at a rate that exceeds the rate in which these inefficiencies are exploited?

US oil production peaked in 1970 at 11.3 million barrels a day.  As the Bloomberg article points out, output has fallen 39% to 6.8 million barrels a day since then.

US large cap alpha may have also peaked.  Today, there is a general consensus that, due to its liquidity and informational efficiency, the US large cap market is one of the most difficult in the world in which to generate alpha.  The era of easy oil is long gone in the continental United States.  Likewise, the era of easy alpha has also been relegated to the history books.

New Production Comes On Line

By the 1970’s, America’s oil future lay overseas in yet undiscovered deposits from Nigeria to Venezuela.  The oil was plentiful since no one had ever exploited these deposits before, and it was technologically easy to extract.

Similarly, as US equity markets became more efficient, investors began look to the less efficient markets overseas for new sources of alpha (i.e. undiscovered inefficiencies).  These inefficiencies hadn’t yet been arbitraged out since no one had operated in these markets before.  There were a lot of inefficiencies and they were relatively easy to exploit.

This is why one of the most popular portable alpha strategies being employed today involves shorting an EAFE index against an EAFE manager to isolate their alpha, then synthetically creating a long position in the (more acceptable to pension plans) S&P500.  Why?  Because research shows EAFE alpha is easier to find than S&P500 alpha.

Deposits become depleted, but the search goes on

Long before US oil production peaked in the 1970’s, the oil industry in America’s first energy heartland, Pennsylvania, had come and gone.  As the Bloomberg article points out, some people in the late 19th century were predicting the country would soon run out of oil.  But so much crude was subsequently discovered in Texas that the Texas Railroad Commission had to cut production support prices (OPEC’s Cartel 101″ case study?).

A few years ago, many people heralded the coming demise of convertible arbitrage hedge fund strategies.  They argued that the method of valuing the embedded options in converts was becoming ubiquitous and that the “free-lunch” was coming to an end.  I remember managers throwing in the towel on convert arb saying that any high school kid can price these things now.

Notwithstanding the fact that convert arb seems to be on the comeback trail, this prophecy may have been true.  But even if it was, can we really conclude that the world is running out of alpha?  Convertible arbitrage may simply be the Pennsylvania of the hedge fund industry.

So why have several hedge fund sub-strategies posted modest returns recently?

The price of oil responds to a plethora of factors.  But rarely, if ever, can the blame for short term price movements be pinned on the state of world reserves.  Likewise, market inefficiencies are discovered and exploited at varying rates.  So to blame low short term hedge fund returns on the end of alpha is premature.

As Manouchehr Takin, senior petroleum analyst at the Centre for Global Energy Studies said to Bloomberg Markets, If oil was still $20, no one would be talking about peak oil.

Similarly, if recent hedge fund returns weren’t in the single digits, no one would be talking about peak alpha.

“Enough Alpha to Last 100 Years”

Bloomberg points out that in the 1980’s, many OPEC members began systematically overstating their reserves in response to production quotas that were tied to proven reserves.  Many peak oil theorists say this overstatement has carried through to today.

Some would also argue that hedge fund companies have overstated their alpha reserves - in this case, to sell their funds to investors.  Are there actually as many market inefficiencies as they say?  And even if there are, do these companies have the technology to economically exploit these inefficiencies to create alpha?  Did we actually pass the point of peak alpha years ago - while no one was watching?

It’s interesting to note that today both OPEC members and hedge fund managers stand accused of lacking transparency.

Synthetic Oil, Synthetic Hedge Funds

Many scientists say that we have used only 25% of the world’s oil.  While the cheap oil many be gone, there will always be new sources to extract at gradually increasing costs.  For example, Canada’s oil sands represent the world’s second largest proven reserve of oil.  Then problem is, it’s mixed in with sand and dirt in the form of bitumen.  Separating the oil from the sand is no small feat.  It’s expensive and costly.  But if the world oil price is high enough (around $30/bbl.) then it makes sense.  Once in a usable form, it can then be transported to markets as a complement to supplies of conventional oil.

Likewise, there is alpha mixed with the beta in all actively managed mutual funds and active institutional mandates.  It just needs to be separated from the beta to be more useable.  Financial technologies such as swaps, futures, ETFs, CFDs, and options are the “alpha refineries” that can accomplish this.  Once in a useable form, the alpha can be ported to other portfolios.  This requires new technologies and, like processing oil sands, is also expensive.  But the result is alpha all the same and it can complement supplies of conventional alpha (hedge funds).

“Beta is cheap!” they say. “Why buy it mixed in with (valuable) alpha in the form of an active long-only fund?  Why not buy it on its own for just a few basis points?”

Embedded beta is the “sand” of most mutual funds: cheap & plentiful, but frustratingly mixed in with the good stuff.

Hubbert’s (Alpha-) Peak?

In 1956, geologist M. King Hubbert made the Malthusian conclusion that world oil production would peak by the 1970’s (see his original paper).  The “Hubbert Curve” came to represent the normal distribution of oil production over time.

Peak alpha theorists essentially suggest there may be a form of Hubbert Curve at work in the hedge fund industry.  It’s impossible to say for sure whether this is true.  But my colleagues and I believe the situation is far more complex than the Neo-Hubbertite naysayers suggest.

Then again, maybe we’re on drugs.  If so, tell us.  Click register at the right and chime in.  (Especially you lurkers - you know who you are).

- Alpha Male