ABI Conference Notebook Day 2: Global Risk Appetite, CSI Hedge Funds

by: Christopher Holt

Christopher Holt reports from the Alternative Beta Conference:

Global Risk Appetite: The mother of all betas?
One rainy day in 1997, Jonathan Wilmot, Chief Global Strategist at Credit Suisse became frustrated with using simple equity risk premiums as a proxy for global risk appetite. He wondered if he could better measure our inherent appetite for risk. Out of this experience was born the Credit Suisse Global Risk Appetite Index.

It turns out that global risk appetite is a pretty good leading indicator of global growth. In addition, Wilmot found that moments of “global euphoria” and “global panic” made intuitive sense (which is apparently more than one can expect from other more traditional proxies of risk aversion). Interestingly, the lowest-ever level of global risk appetite (“panic”) and the second-highest-ever level of global risk appetite (“euphoria”) have both occurred in the past 5 years. In other words, we seem to have all developed a serious bipolar disorder.

Wilmot also observed that panics lasted for shorter periods of time than euphorias and that they tended to be sharper and more extreme. Also, euphorias and panics occur in regular sine waves at a frequency of about 41 months (very similar to the cycle in global industrial production). He presented a chart that shows we are currently at the top of one such wave. And if previous patterns hold, we observe that global risk appetite should be about to fall off a cliff (although Wilmot is very clear that he is not making this prediction).

Yikes. We’re glad conference Co-Chairman David Hsieh started off the day by pointing out the fire exits.

CSI Hedge Funds: Forensic Analysis on Hedge Funds
Michael Markov’s company Markov Processes, develops analytical software that explains what a manager did in the past based only on her historical return stream. His software relies on factor correlations and returns-based style analysis first conceived by William Sharpe in 1992. But to address some of the deficiencies in Sharpe’s original regression-based factor model approach, Markov has devised a “dynamic regression” methodology.

We have a soft spot for regression-based analyses. It’s just unfortunate that Markov used of the term “forensic” to describe his process because it conjures up images of analyzing, say, Amaranth (or some other “dead” hedge fund).

Score: Beta 2 Alpha 2
As I munch on my well-balanced breakfast of standard-issue conference pastry, Christophe Grunig, CIO of Harcourt (a $5 billion fund of funds company) is discussing the beautiful variable, alpha. Grunig lives and breaths hedge fund alpha. But unlike his peers, he separates alpha into two distinct categories: “structural alpha” and “skill alpha”. So for those keeping score, we now have two betas and two alphas: regular “beta”, “alternative beta”, “structural alpha” and “skill alpha”.

Now before you cry foul that structural alpha is an oxymoron (i.e. that anything “structural” must be beta), here’s his example: Harcourt invests in asset-based lending hedge funds that essentially act as banks. But hedge funds have an unfair advantage over real banks. Banking consolidation has vacuumed-up smaller banks and leaving niche markets exposed. And in addition (and perhaps more importantly) hedge funds face less regulatory constraints than real banks (e.g. capital requirements). It all adds up to the fact that hedge funds can act more quickly and discretely than their competitors.

These advantages can’t be purchased in a liquid instrument, but they still don’t require any skill. Thus, they are referred to as “structural alpha”.

This raises an interesting question about what qualifies for each bucket of alpha. For example, is an office location in a foreign country a “structural alpha” for a hedge fund that specializes in that country? What about enhanced information flow from the brokerage community? What about the development and use of proprietary screening software? We suspect that a significant portion of alpha can actually be described as “structural”. But much of it only exists thanks to the “skill” exhibited by the managers in previous periods.

Food for thought…Time for another pastry.

Merrill Lynch’s Hedge Fund Replication to Go Mass Market
Ben Bowler and Steven Umlauf of Merrill Lynch weren’t going to let JPMorgan’s Lakshmi Seshadri steal the show with her hedge fund replication offering yesterday. Umlauf’s Merrill Lynch Factor Index [MLFI] also aims to provide a mechanical replication of hedge fund returns (using a 24 month rolling regression). One intriguing application that Bowler mentioned this morning was a tool to short-out hedge fund beta from a hedge fund manager’s performance in order to create an (alternative-)beta-neutral portfolio.

Steven Umlauf revealed that the MLFI is designed to be straightforward and transparent (and “can be executed on a spreadsheet”) because the firm plans to mass market it. And as a structured product, the mass market will also be able to buy it. So we wonder if this will be the entrée into hedge funds for millions of small investors, regardless of the SEC’s final ruling on eligibility.

Stein: Scads of Beta in FX

John Stein is the Co-CIO of Chicago’s AlphaMetrix.. He operates a manager platform made up of trend-following managers such as FX managers. When he helped launch AlphaMetrix several years ago, he wondered if there was any beta in foreign exchange trading. His conclusion so far has been a resounding “yes”. In fact, he defines no less than four separate FX betas:

Trend beta: e.g. correlation to yesterday’s performance
Value beta: correlation to underlying fundamentals (e.g. the purchasing power parity - PPP)
Carry beta: correlation to interest rates (e.g. prediction that higher rate currencies will out perform lower rate ones)
Option beta: correlation to the demand for FX options (often exploited by FX options traders)


You Say “Tom-aye-tow”, I say “Tom-awe-tow”

The “correct” pronunciation of the word beta has been an ongoing issue throughout this event. As a result, we issue the following public service announcement:

• Americans, when in the UK (or anywhere in Europe for that matter), pronounce beta, “bee-ta” to impress people.
• And Europeans, leave your beeta at customs when you arrive in the US and use “bay-da” instead.

(Thankfully, all attendees at this conference can agree that alpha is alpha – since in the end, it’s All About Alpha.)

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