The “Resistance”

Hedge funds may have been beaten into submission by the combination of market and regulatory events, but hedge fund strategies live on.  Morningstar’s Ben Alpert recently shone a spotlight on the tenacity of the alternative investment industry by referring to it as the “resistance” (to the traditional investing empire, one assumes).

Wrote Alpert:

“It’s true that the pace of new fund launches in the first quarter of 2009 was roughly half that of the past five years, causing a decline in the number of funds for the first time in memory…But even during the market’s darkest days of late 2008 and early 2009, new hedge funds were opening.  A search of Morningstar’s hedge fund database recently revealed nearly 100 inceptions in the fourth quarter of 2008 and 75.”

He goes on to describe several new mutual funds that use hedge fund strategies. More…

Despite the aversion retail investors have recently had to hedge funds, the hedgification of traditional investments is apparently continuing in some quarters of the money management business.

Back in March, Chip Roame, the founder and CEO of Tiburon Strategic Advisors told the online newsletter Advisor Perspectives that:

“Absolute returns and more broadly non-correlated assets are likely to be a growing part of the investing market. Consumers will seek out advisors and institutions that offer non-correlated assets. These strategies will come back and grow within the 40-Act universe and among traditional hedge fund product structures. Investors have paid such a dear price in the current market, and they want to believe that some smart guy can figure out how to properly diversify and reduce risks.”

One group of possible “smart guys” at UK manager Gartmore has just announced its entry into the retail hedge fund market.  Gartmore’s Phil Wagstaff recently told Reuters that: More…

With many investors now convinced that markets will trade sideways for some time, they say beta returns should be forsaken in favour of alpha-centric returns.  Meanwhile, emboldened by what they see as a fire sale in equities, many other are increasing their equity beta exposure right now.  As a result, the age-old tug-o-war between active and passive management seems to have moved back to the front pages.

S&P released this report earlier in the week that was aimed squarely at those who believe active management embeds some kind of put option that protects it during market downturns.  The report highlights the common assumption that active managers can move to cash in times of distress - that they essentially trim their beta exposure in response to the prevailing winds (an argument often made by hedge funds - the quintessential active managers).

But despite this apparent advantage, S&P found that less than half of active managers outperformed their benchmarks in 2008 - a period when markets fell precipitously.  The report doesn’t mince words: More…

We’ve been waiting for the markets to cool down so we can get back to our primary focus here at AllAboutAlpha.com, the ongoing evolution of the asset management industry.  But with breaking stories overwhelming the new cycle nearly every day now, that time never seems to arrive.  Still, today we take a much needed break from the all-too-familiar apocalypse countdown and examine an intriguing new fund that may be the poster child for what emerges from the impending financial ice age.

Putnam Investments is launching what it calls the “Absolute Return 100, 300, 500, 700 &1000” funds.  While the lower expected volatility of the “100″ and “300″ versions simply invest in sleepier asset classes that have a relatively low equity market correlation (namely fixed income securities), the rest of the funds share a unique attribute: they are constructed out of two distinct portfolios - an “alpha strategy” and a “beta strategy”.

According to the funds’ prospectus:

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One of the questions that is often posed to hedge fund managers revolves around the fair allocation of investment ideas to individual funds. If a manager has several funds with varying hurdle rates, performance fees, and management fees, then the manager may have an incentive to funnel her best trade ideas into the one with the most lucrative compensation framework. Add to this the fact that some of those funds might be under their high water mark and some may be home to a disproportionately large personal investment by the manager and investors can get very nervous. The result is often a requirement for a fixed, written policy on trade allocation between funds.

The same kind of conflicts can also exist when a hedge fund manager also manages a mutual fund. Last week we discussed the accelerating phenomenon of “convergence” between hedge funds and traditional long-only funds. We cited an FT article on the possible conflicts resulting from such a practice:

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Last week we told you about a curious market inefficiency - the fact that Asian-focused hedge funds with local offices performed significantly better than Asian-focused hedge funds with no local offices in the region.  It was curious not necessarily because you’d expect otherwise, but rather because the anomaly seems to be ongoing.  In other words, the invisible hand of the market has not arbitraged it away with its usual gusto.  We drew on Andrew Lo’s Adaptive Markets Hypothesis to account for part of this phenomenon.

Here’s another weird market anomaly that seems to be in no hurry to arbitrage itself out of existence.  Individual investors who invest in mutual funds via financial advisors do markedly worse than those who don’t.  This begs the obvious question “why do mutual fund investors even employ financial advisors?”

Professor John Haslem (see previous postings), the author of an article on this question in the upcoming edition of the Journal of Investing, doesn’t mince words.  In an earlier version of his article he writes:

“The actual returns on mutual funds earned by investors are much lower than the rational behavior paradigm of financial economics would suggest. Certainly this is evidenced in the performance of funds distributed through the advisor channel. From the evidence here and elsewhere, much (if not most) of how and where investors go about investing in funds has behavioral biases as well as other behavioral and knowledge overtones.”

We’re always interested in “behavioral biases” because when you boil it right down, they represent one of the few logical explanations for the continued existence of recurring alpha in hedge funds or traditional active funds. So we posed a few questions to Haslem, who is the author of dozens of other interesting papers on mutual funds and Professor Emeritus at the University of Maryland.  Here are his answers:

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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…

“SMAs grow up and learn to play nicely in the advisory community”
By: Janet Aschkenasy, Wealth Manager Magazine
Published: January 1, 2007

While institutional investors have been busy debating the merits of bifurcating alpha and beta, the wealth management industry has inadvertently stumbled upon an enabling technology that may someday bring alpha-centric investing to the masses.  New information technologies are allowing Separately Managed Accounts (SMAs) to evolve into fully integrated Unified Managed Accounts (UMAs).  In fact, IT consulting firms have suggested this is one of the top IT growth areas for the financial services sector over the next 5 years.

UMAs allow an integrated approach to portfolio construction by streamlining reporting, tax management, and account administration from across several outside asset managers.  In a truly “unified” UMA, managers deliver their models only (they do not technically manage the assets).  Then the advisory firm implements the models and tweaks them where required to meet the specific tax or financial planning requirements of each client.  In doing so, UMAs allow advisors to effectively integrate various alphas and betas (whether they be bundled in long-only accounts or isolated in market neutral hedge funds and ETFs).

According to some, baby boomers desire a more active role in portfolio management.  This creates a fertile ground for a more active approach to “managing managers”:

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By: Jonathan Chevreau, National Post (Canada)
Published: December 20, 2006

Jonathan Chevreau is a highly regarded and well-known business columnist in the Great White North.  In today’s National Post, he picks up on Chet Currier’s musings about the possible “End” of mutual funds.  Although Chevreau is a critic of Canada’s “world-beating” mutual fund fees, he still includes the obligatory question mark in the title of this piece (note that Currier included same).  

Chevreau cites one analyst whose thinking is remarkably closely aligned with ours: 

“Once investors realize mutual funds are essentially “host funds” for an embedded ETF (beta) and an embedded hedge fund (alpha), ‘the pressure on advisors to justify their fees will only increase,’…”

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Kudos to Bloomberg’s Chet Currier for shining the spotlight on alpha-centric investing today (”Does Alpha-Beta Spell “The End” for Mutual Funds?“).  Reports Currier:

“The very model of a mutual fund is indeed outmoded, argues a large and growing group of financial researchers and professional money managers who are busy describing, building and proselytizing for a different way of doing things.” 

The piece goes on to provide a balanced view of this paradigm shift peppered with a dose of skepticism that we believe is healthy when confronting such fundamental change.

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Event: Bringing Academic Insights to Wealth Management and Investment Management

Dates: March 13-14, 2007
Location: Geneva
Organized by: EDHEC Risk and Asset Management Research Centre

For those who don’t believe new asset management techniques such as ALM, portable alpha, and hedge funds have any role in private investors’ portfolios, check out this recently-announced event in Geneva next year.  We agree that these investment concepts are usually greeted with glazed eyes and a sense of skepticism by most private investors.  But mutual funds draw the same response 30 years ago.  And today private investors buy and sell billions of dollars of mutual funds every day.  We believe that every new institutional investing concept eventually makes its way to the private client market in some form.

Below are a few of the topics being covered at the event  As you read this list, bear in mind that this is targeted at a private wealth management audience, not the usual institutional audience:

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When mutual funds can be cloned using a combination of ETFs and hedge funds, it’s no surprise that both sectors seem to be growing in tandem.  

Experts have been trying to reconcile these seemingly contradictory trends.  Are we giving up on active management or embracing it?  Do we want boutique alpha generators or do we want a commoditized solution? 

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