By Bob Swarup
Alpha and beta.
Of all the words in the hedge fund lexicon, these must surely be two of the most abused. For many years, marketers, managers and investors have bandied the terms about with careless abandon to trumpet their innate talent and ability to make money in all markets.
Few, however, have considered what the words actually mean and what they imply about the industry. Ask around and the answers usually are that beta is the market and alpha is skill. $1.9 trillion of hedge fund assets is testament to how well that message has worked.
Still, it seems a trifle light for something we have all invested so much effort in promoting as defining characteristics of the hedge fund universe. It also begs some questions: what market and what skills, particularly given the lacklustre performance of the universe as a whole in the last few years. Ask further though and you are likely to get an incredulous glance that someone could possibly ask a question that stupid.
But it is pertinent. Alpha has been in scant supply recently and as the number of hedge funds approaches 10,000, it’s useful to revisit what these emblematic terms might actually mean for the industry.
Let’s go back to basics. Both terms have their origins in the Capital Asset Pricing Model (CAPM), a stalwart of introductory finance courses everywhere. The CAPM model purported to demonstrate that financial markets were efficient and defined beta as the systematic or market risk, which determined the passive return an investor could make by simply being in the market.
As it happens, it was wrong. Though the simple underlying principle that you have to take risk to make return was right, there were also returns that could not be explained by this mechanism alone. These excess returns became alpha and the nascent hedge fund industry in the 1990s came to epitomise this with its focus on uncorrelated absolute returns.
In marketing spiel, beta became the market most investors were exposed to, typically equities by convention, and alpha became the skills hedge fund managers brought to the table to give you superior risk-adjusted returns above and beyond.
That was then. We live in a dynamic world and like sand dunes, our underlying foundations also shift with the changing winds.
A financial market is not a static entity. It is a collective noun for the actions borne of the hope, greed and fear of countless human participants. Though we may prey on each other, we still herd together. These ebb and flow over time, euphemistically creating the booms and busts we term cycles.
That crowd is what we term beta. As more and more people rush to trade some new money-making instrument or strategy, a new financial market and a new beta are created. Equity markets and their beta, for example, did not exist till enough people were sitting around trading publicly listed stocks. Similarly, there is arguably now a currency beta, a commodity beta and so on. The endless procession of replicators and new structured products from investment banks are testament to that.
For the hedge fund industry, it means that beta is an ever-changing game. There is not one beta but many betas, spanning both asset classes and strategies. As more and more funds are set up crowding into the same strategies, they will ipso facto create their own beta. A currency manager may have a low beta to equity markets but a high beta to the carry trade. An emerging markets manager may have a low beta to investment grade corporate bonds but a high beta to a basket of Asian currencies.
In other words, our returns are increasingly driven by currents outside our own skill. For managers, their peers – the herd – are increasingly important. Many managers have learnt painful lessons in crowd psychology over recent years and the impact mass liquidations elsewhere in the market can have on an otherwise fundamentally sound book. As the hedge fund universe expands, it is clear that many strategies now have their own cycles – something investors are slowly waking up to. There are waves of serial correlation that impact multiple strategies all at once, making a mockery of the lack of correlation to the wider markets we all tout as a hallmark of our universe. There may have been skill in identifying the original arbitrage or opportunity set but the skill has now also moved towards knowing when to exit.
That is all beta coming to the fore. Beta is still the market but let’s be clear as to what that means today. It is beta that we trade, it is beta that we inhabit and we all are to some extent beta jockeys now.
Alpha is simple. It is skill but not just the skill in extracting inefficiencies from the markets. It is also the skill that makes you better than your peers and the increasing litany of structured products nipping at your heels. It is the skill in knowing not just when to put on the trade but also when to close it, crystallizing that paper profit into real returns.
And therein lies the conundrum. Everyone cannot be better than the rest. 10,000 hedge funds cannot all produce alpha. Only a few can outperform.
That makes alpha a much smaller universe. Some managers are alpha producers, many are not. It’s like the obscure town that shares its name in New Jersey, whose population of 2,369 at the last census is eerily similar to its population when it first sprung up in government records in 1930 – give or take a handful.
It also explains why alpha seems to be in such scant supply these days. A small pool of talent will always get increasingly diluted in an ever growing ocean of hedge funds.
For managers, standing out from the crowd will continue to get harder. For investors, finding alpha will mirror that and due diligence will become harder too. The how you make your money will not be as important as the why.
Beta is still a market and alpha is still a skill. They just mean something very different today.
The views expressed here belong exclusively to the author alone and not to AllAboutAlpha.com, CAIA, or any of Dr. Swarup’s affiliates.