Alpha: looking in wrong place?
Institutional investors coping with a low-return environment have recently been pouring unprecedented amounts of capital into hedge funds. The stated motives for doing so vary, but are all rooted in the search for higher expected returns. Some point to the track records of hedge funds during the recent bear market and conclude that they provide a good hedge against equity market downturns. More subtly, some argue that an increased allocation to investments with an absolute return objective will increase the risk-adjusted return of a mixed asset class portfolio. Finally, some suggest that we need a postmodern portfolio theory that more explicitly separates sources of alpha and beta in order to achieve higher expected returns efficiently, and that one of the principal sources of alpha available is hedge funds.
However, separate research from Ibbotson Associates and Dr Burton Malkiel published recently suggests that the amount of alpha in hedge funds is a lot less than one would expect from looking at the widely marketed indexes of hedge fund performance. Backfill and survivor bias may lead to an overstatement of returns in these indexes by about 50%. They appear to be good indexes of the successful hedge funds rather than the available opportunity set. In addition, Malkiel’s research reveals the critical point that there is little or no persistency of returns; managers who are above median in one period are just as likely to be below median in the next.
This should not be surprising. Most hedge funds are invested in highly liquid markets that should be reasonably efficient. Using more complex strategies than the ‘simple’ long-only approaches of traditional managers does not change the character of the markets in which they invest. Arbitrage and other investment anomalies in such markets rarely persist for long after discovery. Liquidity of markets is not an indicator of the availability of an information advantage to investors.
The reverse is more likely to be true. It is in illiquid markets that we should expect to find greater information advantages and persistency of returns. This is in fact the case. The best managers in private market assets, such as private equity and real estate, are considerably more likely to continue to be the best managers in subsequent periods than are the best managers in any public market asset classes.
Admittedly, private market assets are not a universal panacea for the plan sponsor looking for new sources of return. They are labour-intensive, specialised activities that have become capacity-constrained by the weight of money looking to invest in them. The top private equity managers are increasingly selective about who they will allow into their funds. All of the major open-end commingled core real estate funds in the US market have queues of investors waiting to get into them.
However, private market vehicles have something going for them that hedge funds do not. They offer the opportunity for beta returns, not just alpha. The capital asset pricing model allows an investor in private markets to expect a premium for accepting illiquidity over a market cycle. For example, private equity should earn a premium return over public equity investing because it finances corporations that are financially riskier than public companies. To the extent it does not, capital will flow until the asset class is repriced and the relative expected returns are restored. This is what beta is, the return available for investing in an asset class with an expected return.
Hedge funds are nothing of the kind. As one knowing gibe has it, hedge funds are the only fee schedule ever confused with an asset class. There is no expected return for the hedge fund industry as a whole that is assured by the underlying arbitrage that the capital asset pricing model normally provides to asset classes over the long term. Their investment strategies are too diverse for that to be the case.
Active management in liquid asset classes makes available alpha as well as beta, for those who are able to discern which managers have an information advantage. A hedge fund, in contrast, is an opportunity only to those with the skill to perceive in advance which managers will add alpha, as there is no beta to fall back on if one guesses wrong about the skill of the manager. Most investors in traditional long-only strategies would be happy to see that they had added a hundred basis points of alpha by good manager selection; one hundred basis points from a hedge fund would leave an investor behind on fees.
However, the liquidity of the markets in which hedge funds invest has given them the ability to accommodate all who seek new sources of return to cope with the currently low expectations for traditional asset classes. And there is no doubt that some hedge funds, those built around a sustainable information advantage of some kind, will do well. But for the industry as a whole, the hedge fund experience is a bad case of déjà vu. As with the real estate industry in the late 1980s, and the venture capital sector in the late 1990s, there is simply too much money coming in.
In each case, capital piled into an asset class that was not scalable. For venture capital and real estate, the problem was that their markets were too easily overwhelmed by the amount of money seeking a home. That may yet turn out to be the case for the hedge fund industry, if its weak returns over the last two years relative to equity markets prove to be the beginning of a period of underperformance brought on by too much money chasing too few opportunities.
But the hedge fund case is also likely to be different, because its attraction has been the implicit premise that there is a lot of alpha available among hedge fund managers. Sometimes explicitly but usually more subtly, enthusiasts argue that the unique combination of talent and incentives that hedge funds offer is what is needed to consistently make money off the liquid markets that they share with traditional ‘long-only’ managers. Yet most phone calls to recruit analysts to the hedge fund industry are not about unique investment ideas, but rather about the larger amounts of money available for working at a firm with a different fee structure. This may be good or bad for the individual analyst so tempted, but it cannot be reassuring to potential investors.
Like the search for love, the search for returns can lead to a lot of disappointments. Alpha is the latest infatuation, and hedge funds are its hottest incarnation. The interest is intense, but in the long run it is likely that institutional portfolios will stay wedded to exposure to asset classes with expected returns to achieve most of their returns.
The search for alpha is more likely to be rewarded in illiquid asset classes where information advantages that give rise to it are more frequent and more persistent, but that will not prevent those who feel that they can pick managers from also looking for it in the liquid asset classes. Whether they will be more successful in hedge funds or traditional ‘long-only’ managers, only the market will decide.
Bernard Winograd is CEO and president at Pramerica Investment Management.
Pramerica Investment Management is the asset management unit of Prudential Financial, Inc in the US. Pramerica is a tradename used in Europe and select countries outside of the US by Prudential Financial, which is not affiliated with Prudential plc of the UK