AAA Exclusive: 7 questions for Roger Ibbotson

14 Jul 2009

Today, we bring you the first in a series of exclusive interviews with key players in the world of alpha-centric investing.  Approximately once a month, we’ll pick someone from the pages of or from the alternative investment industry in general and pose 7 topical and straightforward questions.

By Andrew Saunders, CAIA ( Editorial Board)

Roger Ibbotson, Ph.D., is the Chairman and Chief Investment Officer of Zebra Capital, a role he has held since the firm was founded in 2001.  However, many of you will know Roger as the founder and former Chairman of Ibbotson Associates, which he founded in 1977. (He sold his interest in Ibbotson Associates to Morningstar in 2006 and is no longer an executive with the company.)

Roger is also a professor in the Practice of Finance at the Yale School of Management.  His book with Rex A. Sinquefield, Stocks, Bonds, Bills and Inflation serves as the standard reference for information on investment market returns.  He also co-authored two books with Gary Brinson, Global Investing and Investment Markets, and in 2001 completed an investments textbook with Jack Clark Francis, Investments: A Global Approach.  Roger also recently published the Equity Risk Premium with William Goetzmann and Lifetime Financial Advice with Chen, Milevsky, and Zhu.

As regular readers are aware, Ibbotson conducts research on a broad range of financial topics, including investment returns, mutual funds, hedge funds, international markets, portfolio management and valuation. He is a regular contributor and editorial board member to various trade and academic journals and has received several awards, including the Review of Financial Studies Award (Best Paper in 1992) and the Graham and Dodd Scrolls (6 times).   His publications are regularly listed in the Top Ten Social Science Research Network Download lists.

He has also served as a consultant to many companies in the financial and investment industry and has managed bond portfolios, traded equity securities, and managed asset allocation accounts.

Q1: Roger, as we approach the second year anniversary of the great quant meltdown of August 2007, how would you characterize investor familiarity, knowledge of and openness to quant strategies?

During the summer of 2007 the risk (volatility) of hedge funds doubled.  It was also a time when many strategies were highly levered and underperforming.  Since most hedged funds targeted volatility, many had to unlever at the same time. Many of the quant funds had similar holdings, which caused the meltdown as they rushed to the same exits.  During the summer of 2008, something similar happened, but this time the cause was the short selling restrictions that the government implemented in an attempt to prop up the most vulnerable companies.  Once again the quant strategies suffered.

In both cases, the quant funds that were able to stick with their strategies were able to quickly recover.  But those who targeted volatility got whiplashed.  Those who kept their leverage intact did reasonably well.  Unfortunately, many investors lumped quant funds into one big category, and have become wary of the whole group.

Q2: Are there questions that investors should ask about quant strategies but do not?

Investors should focus on the returns of each fund and how they correlate with markets, other hedge funds, and other quant funds.  Those funds with relatively low correlations are in the best shape to survive and thrive in new crisis environments. In general, investors need diversification, and they can accomplish it by being more sensitive to betas and correlations.

Investors often select funds with the highest returns, without tracing where the returns came from.  Most hedge fund returns are actually associated with beta, rather than alpha.  This beta consists of a number of systematic risks such stock market risk, value vs. growth, distressed yield, or even being systematically long convertibles.  Although, all these systematic risks get a risk premium over the long run, they do not really provide alpha and can be replicated for less than typical hedge fund fees.

Q3: What has surprised you most over the last year?

The magnitude of the drop in the market.  The negative 37% stock market total return was the second worse year in U.S. history.  The drop exposed the fact that many hedge funds are really not absolute return vehicles, but actually contain a lot of beta. On the other hand, since most hedge funds contained substantial beta, their aggregate return of around negative 20% did not contain much negative alpha.  Ultimately, my biggest surprise is that the market seems to be unable to separate alpha and beta effects.

Q4: Your “ABCs of Hedge Funds: Alphas, Betas, and Costs” has been a popular research paper on Have you updated it?  Have you changed your views?

Peng Chen, Kevin Zhu, and I are in the midst of updating the results.  The preliminary results show that hedge fund alphas are still positive, although not as high or significant as before.  The results also show that the majority of the returns can be classified as beta, then fees, then net alpha, in that order.  Despite the fact that alpha makes up the minority of the return, it is still noteworthy that the net alphas are positive.  This is in contrast to the mutual fund industry where there is little evidence of aggregate positive alpha, even on a gross level.  On a net level, aggregate mutual fund alpha is usually negative.

Q5: You have researched and spoken about investing in asset liquidity as an investment style.  Can you please explain further and provide examples and evidence from your research?

We know that investors like to avoid risk and remain as liquid as possible.  We also know that those willing to take on risk and give up some liquidity demand extra return.  Most research has been on risk, while liquidity may be just as important, but has largely been overlooked. At Zebra Capital, we have found that if investors are willing to give up on some liquidity but still invest in publicly traded securities, that they can realize substantial excess returns.  It is not a free lunch, but it turns out to be a way to buy securities inexpensively.  We are developing several funds to take advantage of these opportunities for the appropriate investors.

Q6: Do you have a view on the form of future hedge fund regulations?

I do not think hedge funds should be very highly regulated.  They have succeeded in bringing great liquidity to markets and have generally forced security prices to more correctly reflect their true values.  They should never have to be bailed out, since their investors should understand the risks they are facing.

The main type of regulation needed is to protect investors from fraud.  We have to know that investments are really made (and not Ponzi schemes).  This should not be very difficult, but it does require reasonably competent regulators who are free from political pressure.  Secondly, we need to develop limitations on the leverage and risk of any entity that the government might even implicitly insure.  We also need to develop better clearing mechanisms for the various swap and derivative markets.

Q7: Are you conducting research for publication at present?  If so on what topics?

I am currently working on three topics, two of which I have already mentioned.  I plan to submit the updated version of ABCs of hedge funds quite soon.  Zhiwu Chen and I are working on another draft of “Liquidity as an Investment Style”.  Finally, I am working on “The Importance of Asset allocation,” which will demonstrate that about half of relative performance from one fund to another can be explained by differing allocations (not over 90% as has been incorrectly argued), while the other half of differing performance comes from differing timing, security selection and fees.

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  1. Walt French
    July 15, 2009 at 1:01 am

    Interesting and thoughtful comments.

    I would add to his proposed regulation ideas the concept that, since hedge funds in some ways function as banks — taking clients’ liquid, short-term money and investing it into illiquid, long-term assets — there is a concern that investors might collectively pull back on the funds, as they did in 2007, and destabilize the entire financial system.

    The concern for breakdowns in markets and institutions (along with more general anti-fraud protections) was the foundation for 20th century banking regulation. That stabilization regime failed as banks shifted from insured, deposits-based liabilities, and one would presume that analogous regulation will be sought for other banking and banking-like situations.

    For example, a money market fund that sets a $1 NAV is acting VERY MUCH like a bank; witness the single-afternoon, > $1 Trillion run last September as evidence that markets alone are capable of causing utter failure in a rush for the exits. That Dr. Ibbotson recognizes the high costs of failure, but does not justify a reason for inaction, is curious.

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