Alpha-Centric Investing: A 'Seismic Shift'

We have always argued that actively-managed mutual funds are essentially a marketing package for two fundamentally different formations: a large deposit of beta and a vein of pure alpha. Unable to travel either the peaks and valleys of beta or the undulating topography of pure alpha, mutual fund companies long ago found a neutral territory that seems to have satisfied investors worldwide for over 50 years.

Now the landscape is changing. Or perhaps more accurately, investors are now expressing a desire to try their hand at portfolio construction using basic ingredients such as cash, beta, and alpha.

This FT article (”Equity fund outflows bring need to adapt“) is a must read for anyone who thinks we’re nuts. The newspaper describes the changes facing the asset management industry as nothing less than a “seismic shift”. Kevin Parker, the head of Deutsche Bank’s $800 billion money management business tells the FT:

On one side, you have exchange-traded funds and, on the other, you have [private equity firm] Blackstone and the hedge funds. It leaves firms like ours, traditional long-only buy-side firms, needing to make some very tough decisions.

The FT also cites Jim McCaughan, CEO of Principal Financial Group as an advocate of alpha-centric thinking:

Jim McCaughan, the chief executive of Principal Financial Group, believes the asset management industry has, in the past two to three years, undergone its biggest change since the 1960s…

Like Mr Parker and others, he sees the change as being investors’ shift to either “beta” in the form of indexed money or “alpha” in the form of absolute returns. A recent study by McKinsey estimated that corporate pension plans would, in the next five years, invest at least half the total of the $2,300bn they now have in equities into different strategies.

Continues the FT:

Most analysts estimate mutual fund growth will be only about 2 per cent in coming years, meaning that fund firms must find new sources of revenue. Many are developing new and more lucrative high-margin products such as 130/30 funds – a modified long/short fund…

On its surface, the growth of 130/30 strategies seems to run counter to this trend. After all, the whole purpose of this strategy is to combine more alpha with beta - not to separate alpha from beta. But we suggest that the mere recognition of an alpha component and a beta component (often generalized as the “beta one” characteristic of these funds) makes 130/30 a step forward and worthy of the alpha-centric moniker.

According to the FT, the seismic shift may change the landscape forever. Just in case you read the STA report released last week (see posting) and believed that hedge funds are the only asset class with the capacity to shake the entire financial system, note that this article ominously concludes:

The big outflows from managed equity funds could also have an impact on the stock market as more funds sell to meet redemptions.

The possibility that Q1 was only a tremor will surely keep Parker, McCaughan and other asset management CEOs up at night - and ready to stand in a secure doorway or take refuge in a bath tube when the “Big One” hits.

Comments

[Richard Shaw]

"The big outflows from managed equity funds could also have an impact on the stock market as more funds sell to meet redemptions."

Chris,

Interesting article.

That quote from FT seems to imply that the money would come out of managed equity funds and not be reinvested in the stock market or some other vehicle. Is is not equally likely, or even more likely, that the bulk of those redemptions would be simply moving assets from one form of vehicle or management approach to another within the stock market? If that were the cash the net money flows to the stock market and the price impact would be flat.

I agree with the argument that traditional mutual funds are under great challenge, but I don't think that means equity investing overall is losing assets, unless the implication is that a larger portion of assets will be tied up in derivatives instead of stocks themselves.

Richard Shaw
QVM Group LLC

[whidbey]

This is just the first swallow, but it is the harbinger of the end of fund managements that earned very little for clients (half regularly went below the S&P in performance), yet retained large blocks of capital despite their performance. Investors were apparently indifferent or mislead by thinking Alpha did not apply in fund management. Certainly the funds avoided comparing performance.

At the same time IRAs having corporate sponsorship which favored the high fee mutual funds is also coming to an end. The proposed changes in ERISA will force employers as plan sponsors to manage retirement money at least cost while offering choice to employees, and stop some very shady,if not fraudulent, practices where only the high annual fee funds were offered participants.