Shark Attacks, Fast Food, Bad Drivers and No Place to Hide

12 December 2006

This is the final dispatch from Alpha Male’s road trip to Institutional Investor’s “Alpha Generation Forum” in New York last week.

I’d be the first to admit alpha centric investing (portable alpha, active overlays, 1X0/X0 strategies, hedge funds, ETFs etc.) can be brutally boring sometimes.

But to their credit, the speakers at this event kept us all awake without need for intravenous caffeine drips or too many of those jam-filled conference pastries. I found three of the speakers to be particularly engaging – mainly due to their enthusiasm about what they see as a fundamental shift toward alpha-centric investing: Mark Baumgartner, Executive Director of Morgan Stanley’s portable alpha group, Angelo Calvello, the newly-minted North American EVP at Man Investments, and Laurence Siegel, Research Director for the Investment Division of the Ford Foundation.

Baumgartner: “Beware of Fast Food”

Baumgartner describes himself as Morgan Stanley’s resident “portable alpha evangelist”. Like Alpha Male, Baumgartner was once a management consultant in the emerging technology space and believes there are many parallels between the adoption of portable alpha and the adoption of emerging technologies. In fact, one of Baumgartner’s research reports positions portable alpha in the context of Geoffrey Moore’s famous technology-adoption framework contained in the book “Crossing the Chasm”.

As VC readers will know, Moore’s book is about the difference between the attitudes and buying patterns of “early adopters” and those of the “early majority”. According to Baumgartner, crossing the chasm between these two market segments requires extensive market education. That’s where Baumgartner’s consulting background comes in handy.

To cross the portable alpha chasm, Baumgartner proposed a new “risk regime” to understand the challenges of portable alpha. His framework defines “risk” along two dimensions: perceived and actual.

He slots leverage, derivatives, and downside risk into the high “perceived” risk, low “actual” risk category (likening these risks to a shark attack – dramatic, but highly unlikely).

Conversely, he says that alpha selection is perceived as being low risk, but is actually a process fraught with “actual” risk (similar to eating fast food – seemingly innocuous, but more likely to kill you in the long run than a shark).

High Perceived Risk / Low Actual Risk (“The Shark Attack”)

“Leverage”, “derivatives” and “downside risk” are often considered 4-letters words by investors. The reality, says Baumgartner, is that these issues are not necessarily “high risk”. For example, leverage applied to low-correlated investments is not as bad as leverage applied to high-correlation investments. He goes on to argue that downside risk is usually mitigated, not increased, by the adoption of portable alpha strategies. Again, this is due to low-correlation between alpha sources and beta sources inherent in the strategy.

Low Perceived Risk / High Actual Risk (“Fast Food”)

Actual risk may reside in seemingly benign functions such as the selection of an appropriate alpha source. Picking the wrong alpha sources or not understanding the true volatility of beta sources can be far more dangerous than simply using leverage.  In addition, not recognizing “embedded betas” can add significantly to risk without investors knowing it.

High Perceived Risk / High Actual Risk (“Summiting Everest”)

Baumgartner says portable alpha investors are correct in their assessment of these risks. He puts “managing the system” in this bucket and includes manager selection, due diligence and on-going monitoring. Like climbing Mount Everest, he says these activities are correctly perceived as being risky.

Baumgartner’s ideas are summed up in this article.

Angelo Calvello: “No place to hide”

Calvello, EVP of Man Investments, pulled no punches in his frank and outspoken commentary on the future of alpha-centric investing. With a Ph.D. in European Philosophy, and a firm grasp of self-deprecating humour, Calvello refers to himself as a “Portable Alpha Idiot Savant”.

He believes that the proliferation of passive hedge fund replication strategies will mean “there will be fewer places to hide” in the future for hedge fund managers. This, he argues, will actually cause prices for alpha to rise, not fall, as the supply of true alpha shrinks.

Calvello also believes that the current (alpha-centric) revolution will fundamentally impact many aspects of the asset management industry. Said Calvello:

“This will impact the way we hire people, compliance, operations…even M&A in the asset management industry.”

Laurence Siegel: “30% of drivers MUST be wrong”

Laurence Siegel, Director of Research in the Investment Division of the Ford Foundation was co-author of one of the most popular papers we’ve posted here at AllAboutAlpha.com. As an investor, Siegel is able to offer a somewhat more skeptical view of the hullabaloo surrounding portable alpha.

Taking a page from William Sharpe’s playbook, Siegel discussed the zero-sum nature of alpha. However, he acknowledges the inherent requirement for all investors to believe they can actually produce positive alpha. The trick for the winning investors, he says with tongue in cheek, is to make sure the losing investors don’t realize their lunch is being eaten.

He likens this phenomenon to surveys that show 80% drivers consider their skills “above average”, which of course, is mathematically impossible.

Shark attacks, fast food, bad drivers and no place to hide?  Who ever said investment conferences were a cure for insomnia?  

- Alpha Male

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2 Responses to “Shark Attacks, Fast Food, Bad Drivers and No Place to Hide”

1. All About Alpha » Blog Archives » Donald Putnam: ETFs a “Disruptive Technology” Says:
   December 29th, 2006 at 11:18 pm

   […] When Donald Putnam (co-founder of Putnam Lovell) speaks, people listen.  So when he brands ETFs a “disruptive technology”, you know someone is in for a rough ride.  In this case, it’s mutual funds.  Like Morgan Stanley’s Mark Baumgartner and like us at AllAboutAlpha, Putnam views recent financial trends as fundamental game-changing “technological” innovations. […]

2. allaboutalpha.com: AllAboutAlpha.com Says:
   April 18th, 2008 at 5:48 am

   […] Calvello’s bundled solution essentially addresses a need first identified by Morgan Stanley’s Mark Baumgartner for portable alpha to “cross the chasm”, as they say in Silicon Valley, between the early adopters of a new technology and ”the early majority” (see related posting).  Technology author Geoffrey Moore argues that if products to cross this chasm, they must appeal to an audience that cares little about the technical intricacies and mechanics.  The problem in the tech world is that successful suppliers of the early adopters get too hung up with these features and are then unable to satisfy the needs of the broader marketplace.  If this model holds, then Calvello’s bundling idea may be just the thing for which the average institutional investor is looking.  […]