Where has all the alpha gone?

Where has all the alpha gone (to paraphrase a 60’s protest song)? Roughly, alpha is the ability to consistently outperform a well-defined benchmark. Alpha is notoriously hard to measure as most managers do not have records long enough to establish “consistently.” That matter aside, there are at least three forces compressing our notion of alpha – better benchmarks, better information and better liquidity. The traditional long only investing world has been wrestling with this issue for years, but the notion is now moving to the alternative space.

In the 60’s and 70’s, academic research on mutual fund results indicated that a better benchmark definition (compare a manager to a small cap index if she owns small cap stocks) diminished the perceived value added in fund results. Over the last 20 years or so, there has been an unknown quantity of permutations of alternative beta, hedge fund replication, liquid alts, and other repackaged versions of the same theme – to figure out if there is beta in the macho alpha alternative space.

We’ve had personal experience with this. In 1988, our firm initiated a managed futures program for Eastman Kodak’s pension plan. Once the account was up and running, we came upon a critical problem: there was no appropriate benchmark for managed futures. In order to properly measure our performance, we created a new benchmark from a simple model of what we believed to be the risk transfer process in futures markets, entirely based on market prices.

After a few years of trading and calculation, we arrived at the conclusion that this simple, passive benchmark—even in an alternative asset class—was hard to beat. As beta started to be measured more accurately, the “alpha” we thought we knew suddenly vanished. What we experienced years ago is just beginning to develop in the broader alts space – better benchmarks mean less alpha. We have become certain that when people say “alpha,” they actually mean mis-measured beta. Alpha never died; it just never existed in the quantity that managers want you to believe.

Another factor is information — Information is everywhere and free. The arbitrage of legal information is gone, and along with it the associated alpha. In the past, smart (and resourceful) investors had private sources of intelligence strategically positioned around the country, or the world, with access to select information. This kind of information is now more easily accessible online or through other ubiquitous sources.

The same goes for liquidity. Not too long ago, everything from high-yield bonds to emerging markets stocks were traded by appointment-only. Now you can buy a whole basket of different securities around the globe with the press of a key. Even something small, like moving stock transactions from fractions to decimals, eliminated the edge on a whole range of alpha strategies. As capital continues to flow into the alternative space, and working for hedge funds or private equity shops has replaced consulting firms as the premier job for highly educated wunderkinds, there is no shortage of bright-eyed go-getters running through the financial forest chasing the same limited resource.

This may seem bleak, perhaps even ego-deflating. But believe it or not, there are reliable sources of real alpha out there for both managers and asset allocators. The important thing is to do things that others won’t, to move against the cyclical flows of fashion. Let’s look at an actual example. At the end of 2008, in the death throes of the financial crisis, allocators struggled to find strategies that had performed. They found – managed futures. Managed futures excel in periods of high uncertainty, the defining characteristic of a crisis and 2008 results were no exception. There was a rush to invest. The result was 5 years of flat performance. The thing to buy was mortgages, the pariah of the crisis.

Recent literature in the traditional space, focusing on the concept of active share, reinforces this point. Long only managers that consistently deviate from the benchmark, higher active share, tend to outperform. If you want alpha, move away from the common, the accepted, the obvious. Take advantage of human behavioral bias. Take some risk – you can’t expect a manager to outperform and still look like everyone else.

Update: A version of this post was published recently in P&I.  Click here for P&I article.