Can you spot a fake?
For several years now, academics and practitioners alike have questioned whether the alpha reported by hedge funds is “real” or whether it’s just alternative or “exotic” beta. Yet it seems the mutual fund industry has been largely immune to such rigorous analysis. Once the influence of the market is removed from a mutual fund’s return stream, it is often assumed that what remains must be alpha. However, this alpha is no more “real” than the alpha produced by a market neutral hedge fund.
Now Investment News reports that one mutual fund company has applied concepts such as “exotic beta” to the mutual fund industry. The result is a sort of packaged portable alpha solution for US retail investors:
“FundQuest plans to launch several mutual funds based on in-house research to create active and passive strategies within a single portfolio â€” a first for the mutual fund industry.”
The idea of pre-packaging alpha and beta in various, flexible combinations is the stock-in-trade of many funds of hedge funds (see related posting). But Investment News may be right that the mutual fund industry has never really embraced portable alpha-like solutions. FundQuest may have institutional investing in its blood, however. It’s owned by BNP Paribas, the mega-manager with deep institutional roots.
Apparently, each of 10 new funds will explicitly and dynamically invest in both active and passive funds. Timothy Clift, FundQuest CIO seems to have taken a page directly from the portable alpha playbook. Continues Investment News:
“‘The ratios between active and passive investments will change over time as markets fluctuate and performance changes,’ Mr. Clift said. ‘We might allocate more to passive if the asset class index is harder to beat.’
“For investments where there is readily available information and insightful research, it is less likely that a portfolio manager would uncover anything that 50 analysts haven’t already discovered.
“In investment areas that are less efficient â€” which relatively few analysts cover â€” there is much more of an opportunity for active management to improve returns, said Mr. Clift. For instance, emerging-markets stocks are inefficient, so they would have a high allocation in the active category, perhaps 90%. ‘These stocks experience much more in spikes and volatility,’ Mr. Clift said.”
FundQuest backs up the idea with a free 20-page white paper (available here with a relatively quick and free registration). The firm studied 16,000 mutual funds over a 15 year period to determine which managers and strategies actually produced “real alpha”. They define real alpha as only one part of “traditional alpha”:
“Real Alpha differs from Alpha (referred to here as Traditional Alpha) in that Traditional Alpha measures each investment’s relative performance compared to the broad market indices…whereas Real Alpha measures each investment’s relative performance compared to its best fit or category benchmark. Traditional Alpha can come from two sources: manager skill (as measured by Real Alpha) and category specific risk premium captured by managers (as measured by Exotic Beta).”
Unfortunately for the mutual fund industry as a whole, active management still seems to be a zero-sum game.
“…the study found no meaningful difference between active and passive investing approaches. This finding supports the hypothesis that markets are generally efficient and that it is difficult for active managers to outperform the markets consistently.”
In fact, FundQuest finds that “real alpha” is actually lower than “traditional alpha”. In fact, it’s negative across all timeframes. It seems that exotic beta may be commonly misinterpreted as real alpha (skill) when it arguably results from a form of asset allocation decision.
The FundQuest white paper goes on to recommend an active vs. passive bias for each of 58 Morningstar fund categories.
Kudos to FundQuest for applying alpha-centric concepts like exotic beta and alpha/beta separation to the mutual fund world. While it may seem like quant-overkill now, this type of analysis will someday become mainstream.