This is the third and final posting on Alexander Ineichen’s new book Asymmetric Returns.  In it, Ineichen argues that alpha is the result, not of security-selection per se, but of downside risk mitigation.  He rounds out the 300-page book with a discussion of the implications for asset managers and the future of alpha.

A License to Print Money

What is the best business model ever?  Alexander Ineichen knows – and it’s not a hedge fund manager (at least, not exactly).  Answer: a lottery.  He calls a lottery “the best business model – ever.”  In fact, Ineichen says that their extreme profitability is the main reason governments haven’t been able to keep their hands off them.

But why?  Explains Ineichen:

“…cash flows are stable (since) the sample of fools buying lottery tickets is fairly stable…they already (presumably) know that their purchase is uneconomical from a probability-weighted expected return point of view.”

Ineichen goes on to explain that the “fools” to which he refers are really just players behaving uneconomically.   Calling casinos the “second best business model ever”, he raises a point that is central to the argument that alpha actually exists.  He says casino gambling losers aren’t really “losers” after all since they benefit from a “form of entertainment and sensation”. Regular readers will recognize this as being similar to the arguments put forth by Max Darnell and others to explain why alpha might be somewhat immortal.

Alpha and “Subjective Economics”

Later on in the book, Ineichen also turns his micro-economic observations into a macro-economic argument for the inexhaustibility of alpha:

“Market inefficiencies exist because some market participants do something that is uneconomic.  That does not mean uneconomic market participants are irrational.  They market participants might be incentivized to do what they do.  This means their “economics” is different…”

But what exactly do these market participants do that is so “uneconomic”?  Students of commodities will surely point to the textbook example of non-economic players hedging business exposures in the futures market.  But Ineichen points to a more obvious form of non-economic decision making right under our noses:

“(Benchmarking) might be might supply yet another massive and long-lasting market imbalance…The reason is that benchmarking…means that the actions of the benchmarker (or his agent) are determined or at least heavily influenced by subjective economic criteria (the economics of the principle and the agent).”

“Benchmarking means that the action of one player becomes predictable to the other competitors; that is, the benchmarked investor is essentially showing his hand to the other players.”

We interpret this notion in two ways:

As William Sharpe points out in his new book Investors and Markets, all investor utility curves are unique since investors differ along three dimensions: “position” (extra-portfolio risk exposures), “preferences” (risk tolerance, savings propensity etc.), and “predictions”.  Sharpe argues that market equilibrium will eventually be reached even though investors are quite different.

So when one market participant decides, for example, that her preference is for zero risk and dumps all her equities, other market participants will be there to pick up those equities in short-order at (marginally) reduced prices.  And if thousands of, say, pension funds perpetually bid-up large cap stocks because that’s the only asset class they’re allowed to own, then market participants (e.g. hedge funds) might find value in, say, small cap names.

Another way to look at Ineichen’s “subjective economics” is from the perspective of the Fundamental Law of Active Management.  This axiom (with its extension to include portfolio constraints) basically states that a manager’s success is contingent on his skill, the number of investment opportunities in his universe and the proportion of those opportunities he is able to bake into his portfolio.  Being constrained to hugging a benchmark reduces a manager’s latitude and therefore his chances of success.  Meanwhile, another manager facing no such constraints (a hedge fund manager) is able to capitalize where the constrained manager couldn’t.

But even if you think Ineichen is wrong and that all economics is “objective”, markets are perfectly efficient, and all players are rational economic beings, he argues the hunt for alpha would continue:

“All investors know the hunt for alpha is a zero-sum or negative-sum game after fees.  In addition, many investors doubt the sustainability of pure alpha.  So why do they play the game?…Many investors are probably overconfident with respect to…picking alpha-generating managers.”

“Hedge Fund Beta”

Acknowledging the recent hullabaloo about “alternative beta”, Ineichen essentially argues that a continuum exists between pure alpha and pure beta.  “Alternative beta” essentially describes everything on that continuum.  We submit that near one end would be a skill-based strategy that can be codified to a small extent (e.g. a proprietary stock screening technique used by a value manager).  Near the other end would be an exotic ETF (that is mostly passive, but requires some skill to assemble).

In Ineichen’s words:

“True alpha…is a source of return that is entirely explained by the managers’ investment skill and is not compensation for any systematic risk.  Hedge fund beta is something between the two extremes.  Hedge fund betas are systematic risk premiums that require a slightly more sophisticated strategy than a long-only strategy.”

“The proverbial dart throwing chimpanzee cannot do it.  There is no passive alternative, that is, a pure non-adaptive way to capture the premium.”

“If it requires skill to unlock the value of “hedge fund beta” than calling it “beta” might not be appropriate.  Your author’s mother-in-law would not be able to identify “beta”, find an optimal entry point, manage risk over the duration of the trade, find an optimal exit, and, at the same time, keep transaction costs low.”

We are particularly sympathetic to Ineichen’s last point (above).  After all, why don’t we call it “Alternative Alpha“?

In the concluding pages of Asymmetric Returns Alexander Ineichen returns to his central thesis – that the future is all about risk management, not returns management:

“The asset management industry is at a crossroad.  In our view, the belief that returns are manageable must be relaxed.  Risk is manageable, but not returns.”

- Alpha Male