One of the great ironies in the hedge fund industry is the propensity for many investors to favor relative returns over absolute returns.  This is particularly true among retail investors who, by and large, would prefer to lose money along with everyone else than to make less than everyone else.  What else could explain the complacency with which investors accept -40% market returns while crying foul at the hedge funds that “under perform” in a bull market.

Research into happiness has dispelled the notion that utility is derived from some absolute level of wealth.  Instead, it appears that utility is relative, not absolute - hence the paradox of the retail investor who is petrified of under performing his neighbours, but sanguine about losing his shirt alongside them.

More than some esoteric argument, the phenomenon of relative wealth may actually account for the overwhelming amount of empirical evidence than seems to refute the hallowed Capital Asset Pricing Model.  In a paper released last month based on his new book “Finding Alpha“, author Erik Falkenstein argues that: More…

In the pantheon of inefficient markets, one might expect commercial real estate to shine above all others.  After all, buying and selling real estate (actual real estate, not REITs), can incur significant transaction costs, the market for real estate is heterogeneous and there is no single real estate marketplace to provide efficient  pricing.

So does it follow that the management of commercial real estate investments offer up some juicy alpha opportunities?  That’s the question posed in a study by Shaun Bond of the University of Cincinnati and real estate consultant Paul Mitchell called “Alpha and Persistence in Real Estate Fund Performance”.

While other research has addresses the performance of real estate-focused mutual funds, this study uses multi-factor analysis to examine the alpha generated by large institutional investors in commercial property in the UK (pensions, insurance companies and the like).  In other words, Bond and Mitchell apply techniques that AllAboutAlpha.com readers will find quite familiar.

Persistence

One of the hallmarks of an alpha producing fund is return persistence - serial positive (or negative) returns that chance alone could not have produced.  A top quartile manager that remains in the top quartile for successive periods is said to be persistent.

But when Bond and Mitchell examine top quartile managers, they find that persistence seems to be dependent on the time frame examined.  For example, top performing managers in 1992 fell back to the mean immediately and by 1993 had rejoined bottom quartile managers. More…

A few days ago, we reflected in the rationality of closed-end hedge fund pricing.  And with markets swooning - then recovering this year, the topic of overall market rationality (or lack thereof) is firmly back on the front pages.   It seems the “wisdom of crowds” is being called into question these days.

The academics who brought us the Efficient Market Hypothesis (EMH) were recently  questioned for the website of one of their clients (Dimensional Fund Advisers).  In response to an op-ed in the Wall Street Journal by alpha-generator extraordinaire George Soros, Eugene Fama and Kenneth French argue that hedge fund managers are unqualified to comment objectively on efficient markets since they represent “a threat to their existence.”

Here’s an excerpt of what Soros had to say:

“Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge.”

But Fama and French don’t buy it.  They argue that markets make “mistakes”, but they still efficient price all available information.  If their March 2009 paper on “luck vs. skill” in mutual fund management is any indication, then they’d probably also argue that Soros’ returns are a statistical aberration that is bound to crop up every now and then by chance.

Meanwhile, author Justin Fox writes a summary of his new book “The Myth of the Rational Market” (Amazon, book review) for Time Magazine this week.  Says Fox: More…

As the hedge fund industry smashed through the one trillion dollar level a few years ago, it became vogue to ponder whether the new assets would dilute existing alpha opportunities.  Was alpha a finite resource that needed to be shared among an ever growing number of industry players?  And if so, was the hedge fund industry destined to become a victim of its own success because managers, like chickens, become less productive as they become too crowded?

Research seemed to indicate that average alpha was indeed on the decline as the industry grew.  But many also argued that the industry was being diluted by “unskilled” new entrants.

But if the new entrants were really “unskilled”, their effect on the returns of the incumbents should be minimal.  If a group of 200 “skilled” managers were joined by 5,000 dart-throwing monkeys, then the original 200 should arguably be able to maintain their aggregate alpha.  The simian stock-picking efforts of the monkeys should cancel themselves out.

So what really is the effect of new entrants on the alpha of the incumbents?  And perhaps more importantly given the recent industry shrinkage, what will be the effects of removing players from the competitive landscape? More…

As we wrote in August, hedge funds seemed to be repositioning themselves for a down market.  According to the Hennessee Group, average net (dollar) exposure had fallen from a high of around 55% in mid 2007 (the market peak) to 35% by mid 2008.  Regardless of whether this means hedge funds can tel the future or not, shifting net exposure like that is obviously a useful skill.  The mere fact that funds kept pushing down their net exposure does suggest some ability to read the tea leaves.

Now a new study seems to add credence to the argument that hedge funds have a statistically significant ability to time markets.    Researchers from Citigroup and Athens University of Economics & Business found that there was a significant correlation between hedge fund market beta and market performance itself.  In other words, hedge funds (specifically, “equity hedge” and “equity market neutral” hedge funds in the HFR database) became slightly more correlated with the market right before the market actually rose.

The authors set out to examine the behavior of three factors on hedge fund returns: value, momentum and “market”.  But the market factor was the only one to show a significant relationship to future hedge fund returns.

As the table below shows, the correlation between the average market beta of hedge funds and the market’s returns is insignificant using the last month’s (”t-1″) market returns, is slightly higher using this month’s market returns and is relatively large (0.17) with next month’s returns.  In other words, equity hedge funds seem to modestly ratchet up their market beta concurrent with rises in the market, but clearly ratchet up their beta in anticipation of a good month to come for the markets.  Equity market neutral funds - although market neutral” also seem able to anticipate coming market “up months” (red circles below).

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Melvyn Teo’s paper on the relative merits of locally-based Asian hedge funds vs.  those with no local presence (see yesterday’s posting) amounts to a significant indictment the Efficient Markets Hypothesis.  After all, why would one group of managers (i.e., those without a local office) be willing to forgo higher returns?  And why wouldn’t investors just stop investing in sub-optimizing, apparently irrational funds?  It’s as if these two groups were totally different species or something.

And indeed, they may be different species - in a sense.  Back in 2004, MIT’s Andrew Lo, the author of a huge library of refreshingly easy-to-read papers and articles, proposed a successor to the EMH that actually defined different groups of investors (pensions, individuals, traders etc.) as different “species” of investors and expanding on the biological analogy.  His resulting Adaptive Markets Hypothesis (AMH) explains the apparent irrationality of markets as a rational reaction to a change in environmental conditions.   His Journal of Portfolio Management paper can be downloaded here (academic version available here).

Drawing from behavioural finance, Lo says that investors make decisions using heuristics drawn from trial and error, not from concrete analytical models.  Drawing a page from Darwin, he says that without adequate trials and errors, there is no adaptation.

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Despite the fact that hedge funds have often been described as being synonymous with alpha, they certainly don’t have a monopoly on it.  Naturally, mutual funds have been in the alpha game since the dawn of the fund management industry.  In many ways, the debate over “luck” and ”skill” in mutual funds mirror the tug-of-war between ”hedge fund beta” and “alpha” in Hedgistan.  And, like some studies of hedge fund alpha, new research suggests that mutual fund “skill” is dwindling.  The following review of a recent academic paper on this topic was written by Bob Huebscher, the founder and editor of Advisor Perspectives, an excellent newsletter dedicated to raising these and other issues in the financial advisor community.

Luck versus Skill in Active Mutual Funds

Guest Contribution By: Robert Huebscher, CEO, Advisor Perspectives

A recurring question in the topic of active versus passive management is the degree to which active mutual fund managers who outperform their benchmark can be considered to have done so through skill versus luck.  An academic study, described in an article by Mark Hulbert in the New York Times several weeks ago, answers this question through a new statistical technique.

The study’s authors are Russ Wermers, a professor of finance at the University of Maryland, Laurent Barras of the Swiss Finance Institute, and Oliver Scaillet of the University of Geneva.  We spoke with Professor Wermers on July 25, 2008.

The False Discovery Rate

If all active fund managers were to choose stocks by throwing darts, inevitably some small percentage would deliver alpha, even over some large period of time.  However, they would do so through random luck.  Fund managers are not dart throwers, yet some percentage of them will nonetheless deliver alpha through luck.  Wermers’ tool, known as the False Discovery Rate (FDR), identifies the size of the group delivering alpha through skill, and well as the size of the group failing to deliver alpha through lack of skill.

The FDR technique begins by segregating fund returns into three groups: negative alpha, zero alpha, and positive alpha.  The zero alpha group consists of those funds that earn returns just sufficient to match their benchmark, net of expenses.  They deliver zero alpha to their investors.  Based on the number of funds that exhibit an alpha close to zero, which are almost all funds without skills, the FDR technique estimates the number of funds without skills that end up with positive (or negative) alphas simply by luck (good of bad). Then, it is simply a matter of subtracting the actual size of the positive alpha group from the expected size (based on luck alone) to determine the size of the group of funds that delivered alpha through skill. A similar procedure is used to determine the size of the group that deliver negative alpha (net of expenses) through lack of skills. More…