With the explosion of hunters searching for the same scarce alpha and the proliferation of high-frequency trading, is asset management still all about alpha?  Yes, says Jane Li, CAIA, of  FundQuest, a division of BNP Paribas.  Her research of over 10,000 mutual funds (both alive and dead) collectively managing $4  trillion shows that it depends on which category of fund you’re talking about.

Special to AllAboutAlpha.com by: Jane Li, CFA, CAIA, Manager, Investment Management & Research Team, FundQuest

Many argue that more efficient financial markets permanently reduce the potential for managers to produce bona fide alpha.  For example, the author of “Illegal Alpha,” published on AllAboutAlpha.com in November suggested that

“…nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished.”

I disagree.  In fact, following the significant out-performance of many active managers over their passive peers in 2009, it seems logical that investors will rekindle their passion for searching for alpha.

The most important criterion for choosing between a passive or active product is whether active managers are able to add value by generating real alpha. Real alpha is the additional return truly stemming from the unique ability and skill set of the investment manager.

In early 2009, I authored the FundQuest study, What Now?Active or Passive Management? Examining Real Alpha and Exotic Beta. The study analyzed 30,435 U.S.-domiciled non-index mutual funds in 60 categories representing almost $4 trillion of US and non-US assets as of the end of 2008.  It included all live and obsolete mutual funds in the Morningstar database to minimize survivorship bias. Mutual funds were analyzed for the 15-year period from January 1, 1994 to December 31, 2008. Each fund’s behavior pattern and performance was analyzed for 13 rolling 3-year trailing periods ending December 31, 2008.

The study’s main conclusion was that we should not paint either active or passive investments with a broad stroke, as both types of investments have their strengths and weakness.

Importantly, there is very wide variation in the relative performance of either active or passive management from one style category to another. In some style categories, a high proportion of active managers consistently beat index-based investments while in others, very few active managers justified the additional management expenses.

The study also analyzed mutual fund performance patterns in different market environments. The 15-year period was divided into two groups based on market conditions: the bull markets of 1994-1999 and 2003-2007, and the bear markets of 2000-2002 and 2008. The asset-weighted average exotic beta and real alpha of each category for each market condition was also calculated.

Generally, active managers generated more real alpha in bull markets and lower real alpha in bear markets. In aggregate bull markets, the real alpha generated by the entire universe was 0.44 higher than that in bear markets. Specifically, 38 out of 60 categories generated more real alpha in bull markets, while 24 out of 60 categories held relative strength in bear markets. Many growth categories performed better in bull markets, while some value categories generated more real alpha in bear markets. Details are provided in the following chart. As shown below, eight categories generated positive real alpha (>0.5) in both bull and bear markets.

In all, 19 categories of funds generated positive real alpha in bull markets and 12 categories generated positive real alpha in bear markets.

It appears from these findings that active management (in the form of mutual funds in this study) still produces alpha – particularly in niche strategies that may rely more on exploiting informational inefficiencies.  While the “expectations of finding alpha” may be somewhat “diminished,” the reality appears to be that alpha continues to exist.

We’ll see if this hypothesis holds up.  Our next study will be published in the first half of 2010.

- Jane Li, January 2010

For year, researchers have been telling us that one of the biggest determinants of mutual fund alpha (or lack thereof) is a fund’s expense ratio.  What little raw alpha is generated, the argument goes, is eaten up by management fees.

On the surface, a new study of “the dynamics of average mutual fund alphas” seems to suggest the same thing.  But under the surface, the paper makes an interesting observation about the changing structure of markets themselves. More…

The cast and crew of AllAboutAlpha.com were in Los Angeles this week meeting with some of our favorite alpha centric asset managers and investment management consultants.  One of those companies was quant manager Analytic Investors.  Regular readers will remember the names Roger Clarke, Harindra de Silva, Steven Thorley and Steve Sapra for their work on extending the “law of active management” and penning a seminal work on short extension (a.k.a. 130/30) strategies.

Clarke, de Silva and Thorley were at it again this year with the release of a very interesting “monograph” (translation: “100 page mini-book”) on alpha/beta separation.  This paper is required reading for anyone with an opinion (either positive or negative) on the somewhat controversial strategy.  With so-called “alpha” allocations producing decidedly beta-like returns the past couple of years, many have discounted the value of delineating alpha from beta in the first place.

As the trio writes:

“The separation of alpha and beta sources of return in institutional portfolios has arrived and is having a profound influence on the way investors view risk and return. Some observers believe that the impact of alpha–beta separation will be as transformative as modern portfolio theory was in the 1960s, while others consider it merely a passing fad. As usual, the truth is probably somewhere in the middle, but the need for a better understanding of alpha–beta principles and terminology among investment professionals is clear.”

Clarke, de Silva and Thorley present a methodical and cogent argument for why alpha and beta should be separated in the first place.  Much of the material on this topic is either too high level (marketing bumpf) or too technical (a lesson on how to execute a swap for beta exposure).  This monograph is a “Goldilocks” description of alpha/beta separation in our opinion.  Those of you who read “Portable Alpha: Theory and Practice” edited by PIMCO’s Sabrina Callin (who was also on our itinerary this week in LA), will find this to be a useful complement to that book.

One of the questions posed to proponents of alpha/beta separation is “Why?”  Why would you even want to separate the alpha and beta that is embedded in every active fund or investment mandate?  This monograph answers this question in a concise, yet sufficiently-detailed manner.

The problem with active management, say the trio is that the ratio of active and passive risk arises organically out of the myriad of separate investment decisions made by the manager.  The resulting ratio may not yield the highest possible Sharpe ratio, however.  In other words, it may be sub-optimal.

For example, assume you owned an actively managed fund with a 0.62 Sharpe ratio.  If you decide to allocate, say, 10% (or even 50%) to cash, you’d have a fund with a lower volatility, a lower return and, of course, the same Sharpe ratio.

But that (unlevered) 50% portfolio – like any actively managed portfolio – is made up of active and passive risk.  It’s essentially made up of a market beta portfolio and a “pure alpha” portfolio.  If you create an efficient-frontier-like line tying together all possible combinations of these two separate funds, you can see that the unlevered fund you began with is really just one arbitrary point on this line.

Unfortunately, it’s not necessarily the point with the highest Sharpe ratio.  Recall that our fund has a Sharpe of 0.62.  But by reallocating between the embedded “alpha fund” and the embedded “beta fund”, you can increase the Sharpe ratio to 0.73 (see chart below from the monograph).

So what?  Well, if you wanted to allocate 90% to the active fund, you could have a 0.62 Shape (“90/10 Mix” above) or a 0.73 Sharpe by allocating 90% to active fund and shorting the market.  The table below corresponds to the chart above:

Like the apparent free lunch served up in an article we covered recently by the rocket scientists at First Quadrant (another stop on our tour of LA this week), Clarke, de Silva and Thorley seem to have pulled a rabbit out of a hat here.  But as they point out, this is simply a logical explanation for the “active risk puzzle” identified by Goldman’s Robert Litterman earlier this decade.  The problem is essentially that active/passive combinations found in active mandates (whether they are of the mutual or hedge variety) leave part of lunch sitting on the table.

There’s plenty more in this paper worth highlighting.  We’ll get to some of it in an upcoming post.

We’ve read a lot of reports over the past year about how institutional investors are eschewing equities in favour of fixed income and alternative investments. For example, back in February, Pensions & Investments reported:

“Consultants, managers and pension fund executives agree that European pension funds will settle at a much lower equity allocation — unlike the last time, when allocations recovered to previous levels.

In the long term, the allocation to equity will probably settle around 40% (of the total portfolio) rather than around 60%,” said Paul Price, Dublin-based global head of institutional business at Pioneer Investments, which had $213.7 billion in assets under management globally at year-end 2008.”

At around the same time, consultancy Watson Wyatt confirmed this forecast (see chart below from report available here with free registration): More…

One of the great mysteries in the asset management industry over the past 30 years has been the rapid growth of the mutual fund industry in the face of high fees and underperformance vs. passive benchmarks.  Vanguard founder John Bogle, for example, has been an outspoken critic of active mutual funds for these reasons.  Yet to his disappointment, investors still dump truckloads of money into mutual funds, making them a $10 trillion industry in the US alone.

Studies have shown that, overall, mutual funds don’t recoup their fees in the form of market out performance.  That fact is often held up as proof that active management doesn’t pay.  But is that really true?  As we have complained on this website, many so-called “active” mutual funds aren’t active at all.  They are closet indexers.  So it’s possible that the truly active funds can out perform the index, but that performance is being swamped by the lackluster results of the closets indexers.

This is the question addressed in an August paper by Zheng Sun, Ashley Wang and Lu Zheng of the University of California.

To isolate the performance of truly active funds from closet indexers, the trio divided the universe of mutual funds into 10 deciles based on two different measures that have been discussed here at AllAboutAlpha.com.  Firstly, they used the “Active Share” metric devised by Cremers & Petajisto (see related post).  This measures the aggregate difference between the fund’s stock weightings and the index’s weightings for the same stock.  You might call this a “bottom-up” analysis of activeness. More…

They say blues legend Robert Johnson, considered by many to be the grandfather of rock and roll, sold his soul to the devil to be able to play the guitar.  He is said to have “gone down to the crossroads” and given his guitar to the devil, who promptly tuned it for him and provided him with a mastery that made him the legend he is today.

It’s not clear when, or if, the devil ever returned to collect on his debts.  But regardless, Johnson could be said to have sold an option to the devil.  His success was simply the premium he earned on selling that option.  Throughout his career, he should have kept that in mind.

To a great extent, the success enjoyed by hedge funds comes with similar strings attached.  Investors and prime brokers hold an option to withdrawal their capital (equity and debt).  In exchange, they allocate their capital to the fund, thereby enabling profits for the fund (and by extension, other investors in that fund and, of course, the manager). More…

(By: Michael Newman, CAIA, AllAboutAlpha.com Editorial Board)

How much variety is too much?

Diversification is often the mantra of hedge fund investors.  But a forthcoming academic paper from State University of New York (SUNY) professors Greg Gregoriou and Razvan Pascalau suggests that the optimal number of underlying hedge funds within a fund of hedge fund portfolio may actually be as low as 6-10.  Their study is one of the first to utilize actual data culled from a hedge fund database and move beyond theorizing about a magic number.

While that is only one conclusion to be drawn from their data analysis, the primary thrust of the paper is to demonstrate empirically that the number of “HFs included into a FOF has a negative and significant impact on the volatility of returns while having less of an impact on the actual returns.”

Although their findings regarding the volatility of returns has long been an obvious, intuitive conclusion from the application of Modern Portfolio Theory and general rules of diversification, the academic literature had yet to analyze actual FOF data.  Moreover, their observations regarding the limited impact on performance will provide plenty of fodder for those on both sides of the debate about just how much alpha a FOF manager provides.

Getting the Lay of the Land

The paper is equally important for investors in FOFs seeking to get the lay of the land.  The paper begins with a brief review of the academic literature surrounding FOF diversification, much of which seems to predate the tremendous growth of the FOF industry in recent years.  In fact, the bulk of the studies cited were written prior to 2002.  This should caution us from jumping to too many conclusions and remind us that we are, in a sense, observing a moving target.

Fortunately, the data the authors use for their analysis, from the Barclay hedge fund database, runs through the end of 2008.  It’s especially useful for illuminating the contours of the current FOF marketplace.  As an example, of the over 2000 live FOFs in the Barclay hedge fund database, 70% have 30 underlying managers or less.  Similarly, the paper cites a MARHedge survey that found two-thirds of FOFs have between 9-11 managers. More…

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…