Is the World Running Out of 'Cheap Alpha'?

by: Christopher Holt

The search for alpha is much like the search for oil, prompting us to muse a few years ago about whether there was going to be a Hubbert’s Peak in alpha. But regardless of whether the world is running out of “cheap alpha,” the process of refining crude returns into something that can power your portfolio isn’t all that different from the process of refining crude oil to power your car.

When you think about it, portable alpha strategies are conducted with clear objectives in mind, much like the operations of a refinery. Analogously, investors typically want to take 100 dollars of West Texas Intermediate returns, crack it, boil it, and refine it down to pure alpha, then sell off the by-products and reinvest that revenue into even more of the final refined product: pure unleaded gasoline.

The problem with oil, of course, is that some of it exists as light sweet crude and some of it is mixed up with sand and rock like Canada’s oils sands or the bajillion barrels of oil shale apparently buried underneath the US Midwest. The sand and shale takes a lot of refining, but the light sweet crude? Well, it’s already a liquid, and that’s key.

You can refine alpha from long-only active management – the asset management equivalent to oil shale – by shorting the appropriate benchmark. This would be akin to selling off crude by-products. But you can also refine alpha from more alpha-intensive sources like, say, existing hedge fund indices, which contain various betas as well as relatively high alpha content. Hedge fund research pioneers Bill Fung and David Hsieh raised this possibility a decade ago in their seminal paper, “Extracting Portable Alphas From Equity Long-Short Hedge Funds.”

A new white paper from Mellon Capital advocates the same kind of approach, but adds another step to the refining process. Authors Eric Goodbar and Karsten Jeske outline a process where an investor who is exposed to the HFRI would sell down their HFRI position, then use the proceeds to short the S&P 500 and load up on the HFRI Global Macro Systematic Diversified Index (an index they say is the best proxy for the “market timing beta” to which they seek exposure). The table below from their paper outlines the steps and motivation for each:

As Goodbar and Jeske point out, the HFRI Macro Systematic Diversified Index contains both global macro and managed futures funds. Both of these strategies protected capital in 2008’s drawdown and have very low (sometimes even negative) equity correlations. So replacing the equity-beta-heavy HFRI with two quintessentially uncorrelated indices makes a lot of intuitive sense.

The results speak for themselves; had you done this, you’d have ended up enjoying the fruits of the green line on the chart below (blue = HFRI Composite, orange = 60/40 stocks/bonds):

Although the return is lower, the duo points out that “there are meaningful enhancements to the risk and correlation profile.” In fact, the Sharpe ratio arising from this “customized benchmark” is 0.14 higher than of the HFRI itself. Of course, your pre-existing exposure to the HFRI would only be approximate since you can’t buy the HFRI. It would be interesting, though, to see this procedure executed using the investable HFRX too.

Which leads us to the question of the nature of the “Timing Alpha” represented best by the HFRI Macro Systematic Diversified Index. They distinguish between two terms that are often used synonymously: “exotic beta” and “alternative beta.” They define exotic beta as “other risk premiums such as credit and volatility” and alternative beta as “the skill that investment managers have in timing the traditional betas and exposure to other risk premiums.”

They go on to focus on the timing dimension and treat alternative beta as a proxy for this “timing alpha”, which they describe as “liquid,” “cheap,” and “perhaps being more durable” than alpha. This would certainly seem to be the case according to the chart below from the paper:

Yikes. Alpha seems to have run out over the past 7 years – prompting Goodbar and Jeske to ask, “Has the hedge fund industry entered a period where alpha is even more difficult to produce?”

If they’re right and the era of “cheap alpha” is over, then investors need to focus on the next best thing: alternative beta (a.k.a. “timing beta”). While it may not be as light and sweet as cheap alpha, it very well beats digging around in the tar sands of long-only investing.