You’d be excused for thinking we’re a little obsessed with the Capital Asset Pricing Model.  But Alpha is a concept that can be applied to all sorts of regression situations, from the talent displayed by inner city high school principals in turning out scholarship winners, and in the ability of an NFL coach to exceed pre-season expectations.

Now we have another example of such “non-traditional alpha”.  Hedge funds (technically private equity funds) have been dabbling in film financing for some time (witness Perry Capital, GLG Partners, Dune Capital, ABRY Partners, Stark Investments, Melrose Partners, Credit Suisse and Merrill Lynch).  Tom Cruise recently brought this concept to the mass media after he got himself unceremoniously canned from Paramount and reincarnated United Artists with the apparent help of various hedge funds.

And just last week, Morgan Stanley announced plans to sell a bond backed by one studio’s individual movie projects.  Bloomberg cites a source who says it will ”pay investors a return from box-office receipts, merchandising, pay-TV contracts and other revenue” from films made or distributed by that studio over the next two years.

David Joyce, a media analyst at Miller Tabak in New York tells Bloomberg, “Films generate fairly predictable cash flows over time, for example from DVD sales, pay TV, video-on-demand and broadcast TV distribution.”

How predictable?  For more answers we turned to this rather comprehensive study by Mark Ferrari and Andrew Rudd of California-based Procinea Management, a firm that develops quantitative investment strategies for investing in intellectual property.  The study includes the following chart illustrating the key components of cash flows – both out and in.

If alpha results from market inefficiency, then movie funds have alpha written all over them. As Ferrari and Rudd point out:

“Movie projects are priced in an incomplete and inefficient market where valuation and arbitrage are difficult if not impossible, suggesting an opportunity for active management.”

But they warn of 4 challenges: Few opportunities (approx. 100/year), low transparency, little historical research and basically no liquidity.

Nonetheless, Ferrari & Rudd cite earlier research that shows well-chosen factors have some power in forecasting the success of a movie.  In fact, the authors make the case for movie-alpha using the Fundamental Law of Active Management.

“De Vany (2004) modeled dollar profits on a historical dataset of 2,015 films, concluding, ‘The equation is a very poor fit, with an R-squared value of just 0.118.’ However, in comparison to quantitative equity investing, these models show great explanatory power. An information coefficient IC above 0.2, so high that it ‘usually signals a faulty backtest or imminent investigation for insider dealing’ according to Grinold and Kahn (2000), corresponds to only r-squared =>0.04.

“An investment strategy based on movies would have a breadth equal to the number of independent bets per year, of roughly one hundred. Thus despite the high information coefficient, the information ratio predicted by Grinold’s fundamental law of active management for movie investment would be comparable to that available from quantitative equity strategies.”

What factors?  The authors start with production costs and find a significant positive correlation (thankfully for the studios).

Although big budget movies seem to follow through on their revenue promise, the exact mechanism for this is unclear.  The authors suggest it could be the result of bigger stars, better directors, or simply more marketing.  To get a better idea of the role of a director’s innate ability, the authors develop a new regression variable they call the “Director Hit Ratio”.

They conclude that a bad director can skew the results at the low end of the spectrum - a bad director with a low budget is a likely loser.  In other words, if you don’t have a big budget, you better make sure you have a hot director.

Other factors include the movie’s rating and the season of its release.

The movies’ genre also plays an important role in its eventual revenues.  Which begs the question: Why don’t studios make more movies of a high-revenue genre (perhaps action movies)?  The authors – who, as Californians, are probably also certified movie buffs – suggest that “externalities” such as a studio’s desire to develop relationships with actors and audiences might explain this un-arbitraged anomaly.

Finally, the researchers suggest that movies involving young heroes, female heroes and happy endings produce out-sized revenues.

Movie investments themselves come with both happy endings and sad endings.  Overall, the endings have a so/so average, a terrible median and a positive skew.

…We’re guessing that’s Ishtar on the left and Titanic on the right.