Seeking Alpha

There are two broad investing approaches: investing in an index or trying to beat that index. The first approach is called "beta" investing and the second is called "alpha" investing. It is also obvious that the beta investing approach does not require much skill on part of the investment manager, and an investor should therefore seek to minimize the fees he pays to access beta returns.

The second approach, alpha investing, does require considerable skill on part of the investment manager, and therefore those alpha strategies come with moderate to high fees, depending upon the skills and track record of the investment manager.

The challenge for the investor lies in differentiating between a true alpha strategy and one that is simply beta in disguise. True alpha-generating managers are few and far between, and even they do not produce alpha on a consistent basis. In the paragraphs below I will highlight some of the ways I create efficient portfolios for my clients when assessing and differentiating between alpha and beta strategies.

First, let us look at some math to calculate the alpha of a strategy. Here is a practical approach to calculating a strategy's alpha:

Alpha = Ra - [Rf + Beta(Rm - Rf)] - Fees

Ra is the asset's return
Rf, is the risk free rate, usually taken as the 1 Year US treasury bill rate.
Rm, is the return of the underlying index that the asset is trying to beat.
Beta is a measure of the sensitivity of the asset's returns to the market returns, also called a measure of the systematic risk. So if the market volatility was 10% and the asset's volatility was 20%, then the asset's beta would be 2.
Fees are all the fees charged for accessing that strategy

Example 1: (True Alpha)

Let us assume that we are trying to calculate the alpha of an asset for the past year.

Rf = 1%
Rm = 10%
Beta = 1.5
Ra = 20%
Fees = 3.00%

Therefore, asset's
Alpha = 20% - [1% + 1.5(10% - 1%)] - 3.00% = 2.50%

In this case, the investor would have benefitted from investing in the asset despite the high fees, as they would have derived pure alpha, or excess returns over the index of 2.50%.

Example 2: (Beta disguised as Alpha)

Now let us take an example of an asset that is no more than beta disguised as alpha.

Rf = 1%
Rm = 10%
Beta = 2.0
Ra = 20%
Fees = 3.00%

Therefore, asset's
Alpha = 20% - [1% + 2.0(10% - 1%)] - 3.00% = -2.00%

In this case, the investor would not have benefited from investing in the asset and would have been better off just buying the underlying index and leveraging themselves by a factor of 2, most likely through a leveraged ETF or by buying on margin.

The above example is a classic case of how some investment managers disguise beta as alpha and sell it for high fees. The beta of 2.0 above shows that the asset has twice the volatility of the underlying index. This means that when the underlying index rises by 10%, the asset would rise by 20% and when the index falls by 10%, the asset would fall by 20% as well. This would happen regardless of any management from the investment manager, so why should an investor pay the high fees of alpha for what is truly a leveraged index investment.

Example 3: (2008 Financial Crisis)

Another example of investor duping became apparent after the 2008 financial crisis. In a presentation to the Business Roundtable at The University of Chicago in 2010, I showed the following example of how investors would have been better off investing in an index rather than investing in macro hedge funds. This was true for US equity hedge funds, commodity funds as well as hedge funds focused on Asia.

The study below compared the returns and beta of the sectors against the underlying index. For the hedge fund indices, I used HFR indices ("Hedge Fund Research Inc."), a major hedge fund database company.

 2008 2008 Beta 2009 2009 Alpha S&P500 -38.00% 24.00% HFRX Global Hedge Fund Index -23.00% 60.53% 13.40% -1.13% 2008 2008 Beta 2009 2009 Alpha CRB (Continuous Comm. Index) -26.00% 37.30% HFRX Commodity: Energy Index -13.36% 51.38% 2.15% -17.02% HFRX Energy/Basic Materials Index -29.42% 113.15% 25.35% -16.86% 2008 2008 Beta 2009 2009 Alpha MSCI Emerging Market Index -54.00% 74.40% HFRX Total Emerging Market Index -25.00% 46.30% 23.87% -10.57% HFRX Asia Composite Hedge Fund Index -18.49% 73.96% 16.81% -38.22%

In the above table, I calculated the beta based on the returns of 2008, the year of the financial crisis, and in my opinion the best time period to test the true composition of a portfolio. Taking that measure of beta, I calculated the alpha produced by the strategies in the subsequent year. The result shows a massively negative alpha for most of the strategies and this does not even include the illiquidity risk. Post the 2008 financial crisis, a lot of hedge funds had suspended liquidity and locked up their client's capital. In the above case investors would have been much better off investing in the underlying index rather than in hedge funds that failed to deliver any alpha and also suspended redemptions.

Generally, an investor makes money in 3 types of strategies:

1.Mean Reversion Strategies: After a period of volatility that can be caused by a number of factors ranging from massive institutional money flows, market news to position liquidations, prices of securities might deviate from their true intrinsic value. Mean reversion refers to the movement of the security price back to that intrinsic value.

2. Momentum Based Strategies: The second way an investor makes money in a market is by following a trend. These trends can be short lived with durations of a few weeks or very long lasting like the Internet boom or the Asian equity market boom.

3. Carry Trade Strategies: As the name suggests, carry trade strategies involve selling option premium or buying high yielding assets and financing them with short term cheap borrowings. Carry trade strategies thrive in a market with cheap credit and low volatility.

Each of the above mentioned strategies has a time and place based on the economic cycle. Some of these strategies can be executed on a long only basis, especially the long duration momentum based strategies, by buying ETFs, while some require the expertise of a hedge fund manager's proprietary trading methodology.

The world of investing has changed quite dramatically over the past few years. As trends have disappeared, buy and hold mutual fund type strategies have not worked in over 10 years. Making predictions about a coming year based on the best macro-economic analysis also does not work on a consistent basis, which is why the traditional hedge funds have suffered of late. The investing world is becoming very fast paced and technical.

Some of the true and consistent sources of alpha I have found are in pure trading strategies that are driven by systematic algorithms, rather than human emotions. I like to study some of the latest advances in the field of statistical modeling that have taken place over the past decade, which have given rise to a new generation of systematic trading strategies. For the next few years, investors would be best advised to seek out investment managers that understand and can create a portfolio of such systematic strategies to generate alpha for their investors.