June 2008

ALPHA SOURCES: Healthy Returns

Alpha investing is meant to set the pulse racing and investors are always seeking new sources, such as healthcare and alternative energy. But they need to beware of beta masquerading as alpha. By Matthew Craig
Anyone in the investment world who thinks that alpha is a kind of Italian sports car must have been asleep since 2001. Investment alpha comes with promises of high performance, but that is the only resemblance.

Asset managers would typically describe alpha as the excess return produced by manager skill, while  beta is the return from general market movements. In the past, investors were prepared to take plenty of beta, but this has changed. A combination of market downturns and extreme volatility, funding pressures at insurers and pension funds and the growth of hedge funds has made alpha generation more important for the investment industry.

But use of the term ‘alpha’ has been abused, some think. Insight Investments co-head of the multi-asset group, Patrick Armstrong, comments: “There is a lot of beta masquerading as alpha in our view,” while Investec Asset Management head of investment strategy, Philip Saunders, calls alpha one of the most mis-used terms in finance and comments: “Essentially, fees for alpha are a lot higher than fees for beta, so people tend to be fairly loose with their definition of alpha and beta by default.”

With ‘2 and 20’ fees (2% annual and 20% performance fees) charged by hedge funds for alpha, as opposed to around 50-75 basis points or less for market beta from a passively managed institutional fund or exchange-traded fund (ETF), the incentive for misrepresentation is clear. “A lot of what is called alpha is in fact beta. It might be exotic beta, but it is beta, nonetheless,” Saunders says.

Beta dressed as alpha
This is one concern in talking about new sources of alpha. For example, both hedge funds and traditional fund managers are offering investment approaches that aim to meet investor demand for consistently positive returns. They may be marketed as hedge funds, diversified multi-asset funds or absolute return funds, but the aim is to produce good returns regardless of market conditions. In some cases, this type of approach may rely on beta more than the managers wish to let on.

As an example of beta dressed as alpha, Saunders mentions clean energy, as a subsector within the equity market. “Someone came up with it as an investment theme. That’s fine, but the question is, are they adding value through it, or are you getting a discrete and focused form of beta?” In his view, the beta element needs to be defined precisely, so any sustainable skill involved can be identified.

As an example, he cites the performance of active managers after the turn of the century. Saunders says: “Active managers and alpha made a comeback, but a lot of that was due to a small and mid cap bias, which is actually a beta effect. If managers tilt their portfolios away from part of the market, is that manager skill or a structural bias?”

Another issue is the use of exotic beta. Exotic beta could be described as a kind of fool’s gold for the hunter of alpha. Saunders describes exotic beta as systematic returns that are difficult to access. He adds: “You need skill be able to access this beta. It may be that you need a high degree of proficiency in the use of derivatives.”

Exotic beta also tends to become commoditised over time, becoming ordinary beta. For example, equities or private equity from certain African countries may be illiquid and unavailable via an ETF, so only a few fund managers offer these assets. Over time, this will change though and the exotic beta frontier will retreat as market access becomes more commoditised.

For investment purposes, alpha and beta can be separated or combined. However, alpha is difficult to find consistently and expensive to obtain. So for many investors, using market beta is both inevitable and cost-effective and the flipside to the current obsession with alpha is that a period of strong market returns could make absolute return funds, offering pure alpha, look a poor purchase. Nevertheless, the ingenuity of the fund management industry is seeking out new sources of excess return, many of which are being called alpha, but some of which are clearly beta.

Insight’s Armstrong says: “We think we can get cash plus 3% return over the cycle with pure beta, with government bond-like volatility.” This is by investing in a wide range of assets, including commodities. For the latter, Armstrong says some return is from commodity index rises, but there is also an alpha play from shorting the GSCI commodity index.

Another investment opportunity Armstrong identifies is the purchase of financial subordinated debt: “Bonds from financial institutions are giving a 4% premium on cash but at much lower risk than equities, because the central banks always bail out these financial institutions.”

Fund innovation
Man Investments is a hedge fund group that prides itself on offering investors innovative approaches. Its new Man Vision fund aims to produce an annualised return of 12.5% with annualised volatility of 12.5% by investing in strategies such as Asia and emerging markets, commodities, environmental and energy markets, event-driven and healthcare.

As an example of even more way-out strategies, Man Investments head of communications David Gleeson mentioned fine art, movies and freight derivatives as areas that hedge funds are moving into. He added that Man looks to back new managers early: “Hedge funds tend to produce their best returns in the early years and we are keen to get in early with the best and most promising managers.” To this end, it runs a programme called Global Emerging Managers, which will back managers with up to $50m in seed capital.

Volatility is another investment opportunity and Crédit Agricole Asset Management co-head of volatility, arbitrage and convertible bonds, Gilbert Keskin, said it is an asset class and an area where skilled managers can produce alpha. “We have two ways to invest in volatility; a directional way or using a long-short approach,” Keskin comments.

The directional approach aims to benefit from the tendency of volatility to revert to a mean, while the long-short approach aims to arbitrate volatility discrepancies between different indices or single stocks. In both cases derivatives are used to isolate the volatility element of an option representing an underlying asset.

Keskin adds: “Volatility works very well in time of crisis and the alpha generation process is decorrelated from other processes – that is the main reason investors should consider it as an asset class now.”

Routes to returns
Other fund managers have different takes on the ways to find returns on current markets. Henderson Global Investors uses four different investment engines for producing alpha, three of which are quite different to traditional asset management, according to Alistair Sayer, the investment director for the multi-strategy equity team.

Fundamental stock-picking is a more familiar investment technique used. The other areas include: liquidity (“We will use our capital to provide liquidity for the market at a price”), market-neutral strategies and event-driven strategies.

Sayer comments: “Using these four strategies across three regions gives twelve ways to produce alpha for a global portfolio.” Henderson Global Investors offers long-only funds, enhanced index funds, 130/30 or equitised long-short funds and market-neutral hedge funds and the alpha sources can be adapted to each investment type. “A lot of managers and clients are frustrated with poor performance in traditional asset management and don’t want to go passive, so they are attracted to these strategies,” Sayer adds.

Threadneedle Investments hedge fund specialist Mark Pierce comments: “Managers are increasingly looking for alpha, not in new assets, but with new ways of accessing assets.” As an example, Pearce gave the structured credit market, where managers are getting more tailored exposure to particular risks in their portfolio.

“This is important for two reasons. Firstly, old school assets can be accessed in a new school manner. Secondly, it enables managers to tailor risk. How managers access assets is becoming more important than the asset alone,” Pearce says.

This theme was reinforced by Mercer’s global head of manager research, Andy Barber: “A wider range of managers are looking for non-traditional sources of alpha. Managers who were traditionally in the long-only space are moving into the hedge fund space.” Partly this is due to higher fees, but there is also a desire to retain skilled managers who might otherwise leave.

For investors, questions to ponder include how much of hedge fund returns are actually due to markets and not manager skill, the ability to short in managers from a long-only background and the question of survivor bias in hedge funds unveiled to the public.

Compared to assessing the quality of an Italian sports car, determining the quality of alpha on offer from an investment manager could be much more demanding for investors.

© 2008 funds europe

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