Seeking Absolute Alpha Because Beta Might Not Be There

by: Veryan Allen

Warren Buffett, the world's richest person, seems to prefer security selection to asset allocation. He searches for alpha because he doesn't expect beta to deliver enough. Ye olde split of simple 60/40 stock and bond beta driven asset allocation is just not going to cut it and is needlessly risky anyway. Fortunately for investors there is a solution - adding to the portfolio the absolute returns generated from the security selection, risk management and market timing abilities of the world's best and most "expensive" fund managers. Diversify away that systemic risk and stagflation damage with new investment strategies.

With the separation of alpha and beta there is less attention to the fact that beta itself splits into PRICE beta and DIVIDEND beta. And alpha comes from the RELATIVE alpha of good traditional funds and the much more valuable ABSOLUTE alpha produced by quality hedge funds. As Warren points out, both betas are unlikely to provide the performance of the past. Hopefully beta might contribute one day but in the meantime investors need a triple portion of absolute alpha in their portfolios:

Alpha 1: buying securities that will go up and knowing when to book those gains
Alpha 2: shorting securities that will go down and knowing when to book those gains
Alpha 3: figuring out which managers can do 1. and 2. consistently

Berkshire Hathaway's (NYSE:BRK.A) annual letter to shareholders, which is written by Warren Buffett (pdf file), was as insightful as ever. Apart from "The party is over", the most salient quote was, "You can occasionally find markets that are ridiculously inefficient or at least you can find them anywhere except the finance departments of some leading business schools." There are even people with tenure at prestigious universities who think Warren's returns are from luck or simply the "reward" for taking higher risk. Actually he took less risk than "the market" and his investment skill is the reason for all the alpha he has generated over the years.

Warren says to avoid the 2 and 20 crowd. He's right. It is the 2 and 20 alpha stars AHEAD of the crowd we need. Adding alpha from security, strategy and manager selection is essential. He has been adapting to the changing opportunities in the markets for several decades. The oracle of Omaha goes long the Brazilian Real, various commodities, trades Chinese oil stocks and short sells options. Warren Buffett, the derivatives trader - "derivative contracts that I manage" - and pioneer of the alpha-seeking multistrategy hedge fund. "Beware the glib helper who fills your head with fantasies while he fills his pockets with fees." Absolutely correct. Only pay fees for alpha since beta exposure is effectively free. Fees for luck, not skill, are unacceptably high.

In aggregate, the entire group of active managers will underperform their benchmarks. "Hedge funds" consisting of the entire set of products that say they are hedge funds won't, on average, be any good. I can't think of any reason why an investor would want to invest in a hedge fund index of "all" hedge funds any more than an "all" stock index. But just like Benjamin Graham and several Nebraskan doctors spotted Warren's talents BEFORE he went on to great things, it is possible to identify other good managers with the skills to perform over the long term, even if their strategy itself is short term. Fees are irrelevant if the AFTER fee performance meets targets. Those 1950s Nebraskans had no complaints about Warren keeping 25% of "their" profits because he worked hard for them.

Stock market past performance, in aggregate, provides little indication of future performance. 8.2 years into the century and a negative TOTAL return from most developed market betas! How long should we wait and how poor must investors become before the "equity markets go up over time" mantra materializes? No one I know is prepared to wait around to find out if stocks will go up over time. Be inpatient for absolute returns from any fund manager. Despite his buy and hold persona, Warren expects his holdings to perform in a reasonable time frame or he dumps them and rightly so. Many investors can't afford to tie up capital in steeply declining asset classes and why should they endure such high volatility in the first place?

From 1900-1949, the Dow rose from 66 to 200 for a 2.25% annual return from price appreciation. Dividends added a lot in those days. From 1950-1999 the rise from 200-11,497 equated to 8.45% annually. Index appreciation over even very long periods is not stable and very temporally dependent. This century the Dow has "grown" a little from 11,497 but dividends are much lower nowadays. If there were some inherent "expected" price appreciation in stock markets, should not the two 50 year periods' price appreciation be more similar? Shouldn't we have already seen more sustained appreciation this century by now? With such long term variability and derisory dividends, beta does not look good going forward. In sum, seek absolute alpha because beta might not be there for us. Performance is what you keep, not what you make and then give back.

Absolute returns are more useful to investors than relative returns. That's returns after inflation. Inflation varies also but inevitably takes its toll so most portfolios cannot afford a big drawdown from an extended bear market. The PPI and CPI, now known as the Preposterous Price Index and the Completely Preposterous Index, are underestimating real inflation: The inflation you and I see at the supermarket and gas station. Even TIPS won't help as much as hoped since they track what authorities say "core" inflation is, not what it actually is. In the real world, food and energy do impact purchasing power so there may be significant basis risk with TIPS. Most investors can't ride out a long bear market while inflation erodes their purchasing power and why should they?

The Economist magazine recently ran an advertorial for "passive" funds, emphasizing the "high" fees of "active" management. Beating the market is indeed very difficult, requires hard work and expensive expertise. But why try to beat the market when the market is going down? Investors would be better off with reliable absolute returns that far outpace inflation each and every year. There are always cheaper "products" in any space but that does not cause higher end players to lower fees. No proper hedge fund manager worries about cheaper funds. I'll happily pay 2 and 20 for consistent performance from a blend of skilled investment strategies than endure potentially decades of opportunity cost, wasting time in "bargain" beta. Did Lamborghini or Maserati panic about their pricing structure because Tata Motors just launched a $2,500 car? Of course not. Performance comes at a price.

History is a great persuader but terrible predictor. The 20th century was ultimately the "triumph of the optimists" aided and abetted by the bubble of the 1980s/90s. But those returns do not guarantee that the 21st century won't be the "revenge of the pessimists". There is scant evidence that "buy and hold the equity benchmark" will work. Mostly just historical data erroneously extrapolated into the future. It is fascinating observing those who "know" everything will turn out just fine decades from now and say we can ignore the path along the way. Optimism is fine but overoptimism is dangerous, just as we are seeing right now in real estate, credit and stock markets.

Predictably, the Economist cites the John Bogle quote that the S&P 500 returned 12.3% annually from 1980-2005 but has no mention of the 70% loss after inflation that investors "received" from 1965-1980. It also writes of a hedge fund that dares to charge 5% fees and 44% of profits but curiously omits the 38% a year since 1990 after fees that fund generated. Such data snooping is typical of the long only beta brigade. I have looked at the full data set and the inescapable fact is that it is security and strategy selection not asset allocation that will drive portfolio performance. Skilled alpha seekers do have losing periods, even Warren, but when alpha returns drop below high water marks, they are much shallower and shorter than the deep extended drawdowns of beta. Of course proper manager due diligence, portfolio construction and diversification are essential in identifying that skill.

Warren points out in his letter that the Dow only grew 5.3% per year in price appreciation last century. We have been treading water since, so I updated Warren's numbers to include the "growth" this century. The Dow closed at 65.73 on 29 Dec 1899 and 12,266.39 on 29 Feb 2008 so we are down to a miserable 4.95% annually over the last 1298 months. But let's look closer at this alleged "expected return" from "stocks".

The Dow does not include dividends, which is misleading considering dividends were such an important contributor to the total return. If 2% dividends had been paid since 1900, the Dow really closed at about 100,000 on 29 Feb 2008. Average dividends over the 108 1/6 year period were as high as 5%, which gets us to a 10% total return, which equates to the Dow now being around 2,000,000 if it included dividends. So for those shocked by 100-200 point intraday swings, the total return Dow is actually experiencing 25,000 to 50,000 daily fluctuations. Just type 65.73*1.10^108.2 into Google to see what 65.73 invested at 10% compounds to. But that provides no information on what $65.73 today will be in 108 years from now if you put in stock market index beta. We don't know that result.

Historical performance was indeed quite good assuming someone survived the non-growth from 1900-1932, 1929-1954, 1965-1982 and 2000-...? Of course that is restricting analysis to stock markets that did survive the entire period. Just like many individual equities go to zero, several large countries' stock and bond markets went to what was effectively zero last century. I am not being apocalyptic, just reiterating that risk management, diversification and hedging for any scenario are necessary. Let's hope world wars and depressions are gone forever. A year ago inflation and real estate crashes seemed like they were gone "forever".

If you had invested in 1900, then 33 years later you would still have been waiting for that equity risk premium to kick in. High dividends and the post war baby-boomer bull market meant that by the mid-60s it seemed like "stocks" had an inherent upward drift especially if you only use data starting from 1926, which led to the financial "models" of the late 60s and early 70s. Forget about alpha because the market is efficient and random so beta will arbitrage away any new information! Later the very anomalous 80s/90s mega bull market "confirmed" the over 10% a year from beta hypothesis just in time for the current bear market that began in 2000. Few real scientists would have fallen for such a spurious conclusion or make such a non-predictive data mining error but many orthodox economists continue to believe it. The "expected" return from stocks in their entirety is considerably lower.

Did anyone actually put $65.73 into the Dow on the last trading day of 1899 and now has $2 million? Of course not. It is too long term to be useful information. Most investors need real returns quicker than beta can be assumed to deliver. 39,510 days ago there were no academics ranting on about "expected returns from risky asset classes" - a classic case of outcome bias. Those who claim "stocks" rise over time only "know" that because they are looking at the result. No one in 1900 recommended buying the DJIA because they had no idea it would go on to perform so well. Knowing the past doesn't mean you know the future.

Warren points out that index growth will not be like the previous "wonderful" century, that beta and income are not going to be sufficient to meet assumed target returns. Despite the 10% returns at 20% volatility, a 90% implosion and several 50% drawdowns, we are still urged by the random walkers to risk our hard earned cash on equity beta! Even with the "performance" of the past, what kind of return on risk is that? Alpha seekers would be laughed out of the room with such risk-adjusted returns but not the beta bandits.

Recently some have started pushing "commodities" or "currencies" as supposedly having an expected return! Commodities have been in a bull market so the long term return now does indeed look good, but there is no "expected return" from commodities any more than stocks. Trading oil, gold or wheat is an alpha decision that requires high skill and domain expertise. "Currencies" are not an asset class and their performance is relative to where you are. For Japanese and US investors, "foreign exchange" has been a great "investment", but for Brazilians, Australians and most Europeans, investing in other currencies has been a loser. Risky asset classes like equities, credit, commodities and currencies are security selection instruments, with the need to choose managers who can figure out what and when to buy and short sell within each asset class.

Risks and liabilities change, so return sources and portfolio construction must also change. Why are investors urged to keep to a static asset class split when markets and economies fluctuate so widely? Don't the opportunities and risks change? Warren is right that 8% probably can't be achieved with traditional beta, but is possible with a properly constructed dynamic portfolio that changes as conditions require. Derivatives are indeed weapons of financial destruction in the wrong hands, but there are many risk reduction benefits from the competent use of derivatives. Hedging and diversification with strategies is the safer route and more certain to the target return.

Worrying for shareholders in Berkshire Hathaway is the short sales of credit default options and long dated puts on various stock market indices. Warren is hoping that investing the premiums will exceed any liabilities at expiration. He says Dexter shoes was a bad trade but the option trades are potentially much worse. Surely Warren is aware that 33 years into the last century, on 29 Dec. 1932, the Dow closed at 59.12. No gain in the bellwether index for the first third of last century. Could you wait till after 2032 for beta to start working its "magic"? BRKA might end up owing plenty of cash to those who purchased the options.

High downside but limited upside doesn't look like a typical Warren trade. Has he stress tested or Monte Carlo simulated for the S&P 500 being below 500 on expiry date? AIG (NYSE:AIG) also short sold credit default options on securities that someone thinks deserved to be "rated" AAA and had to mark to what there currently is of a market. Japanese insurance companies short sold similar instruments in the 90s and also thought they could reinvest the premium and wouldn't have to pay out. They were wrong. There is much to learn from the Japan experience. It was driven by an internecine network of credit crossholdings backed by wrongly priced real estate "collateral". Mark to market is a cruel but necessary discipline.

Buy foreign equities? Since history is claimed to be useful, let's not forget what happened to investors in China, Russia, Germany and Japan in the first half of last century. Those markets suffered a 100% drawdown while the USA only had 90%, but even the USA had to shut down for a while in 1914. Parts of the credit markets are effectively closed right now. Perhaps things are different(!) but a simple ukase to "buy foreign" is wrong. It is always time to buy good foreign securities and short sell bad foreign securities. Bottom up stock picking may be a fine strategy but geopolitics and macro economics can never be ignored. Every component in the Dow is now an enormous global company, so is likely to be as good a proxy for world growth as any other. The MSCI "World" includes just 23 countries, by the way.

The performance of all alpha seekers will sum to zero as fees and execution costs undermine the journeyman's attempt at something that is so difficult. An index of "all" hedge funds is like an index of "all" stocks; why invest when they are certain to include many underperformers? Some securities are good but others are bad. Some fund managers are good but investment talent is rare. Equity indices are unhedged, have no skill, lose money too often for long periods with unacceptable volatility. Reinvestment of the relatively high dividends paid in earlier decades was a key contributor to long term compounded returns. Prior to 1982, dividends were the largest component of the total return in many stock markets.

Invest in the leaders not the followers. Pick the good funds or hire someone with the experience, analytical resources and domain expertise to pick alpha generators whose future risk adjusted returns will make management and incentive fees trivial. I too wish it were still possible to achieve 8% per annum with a simple portfolio of "stocks" and "bonds", but unfortunately it won't be. "Equities" and "real estate" might indeed go up over time but I just don't want to take the chance they don't. Every investor needs to be activist with their own portfolio. Security triage is essential. The only things investment grade are those where the returns are higher than the risks.

It is not so much the unknown unknowns that worry me as much as the known "knowns" that are wrong. We don't need two quarters of negative "growth" to know we have entered a recession. Real estate and credit prices are stronger indicators of economic strength and consumer sentiment than stock markets. Ben Bernanke is right - there is no danger of 1970's stagflation. Instead we have 2000's style stagflation and the remedy won't be easy to find. Banks continue to report VaR as if such numbers were indicative of the risks and exposures they have. You can have low Var but enormous risk and vice versa.

There will always be hedge funds that lose money and a few that implode. Some stocks go bankrupt, so avoid all stocks? A house once burnt down somewhere so never buy real estate? Cuba and North Korea defaulted on their government debt so don't buy treasuries and JGBs? Sounds silly but that is what we hear whenever a hedge fund goes under. Everyone accepts that specific securities blowing up does not mean avoid all the opportunities available in the asset class. But skepticism of any investment strategy other than long only still reigns. In any era there are always opportunities for alpha even when beta disappoints.

An investment strategy should be robust to structural changes in the market and financial regime shifts. I am tired of fundamental stock pickers who claim reg FD made things more difficult. Or quant types who complain about decimalization or trading algorithm copycats. Good investors make do with what current conditions are and innovate their strategies. Market evolution is certain so an investment process must be fortified and robust. There will be many more changes in the future. The markets are providing an ideal environment to show who has skill and who has previously been lucky.

Hedge fund blow ups and large losses from speculators marketing themselves as "hedge funds" are portrayed as negatives, when in fact shaking out the weak strengthens the industry and the case for investing in the good funds. Lots of poor quality hedge funds shut down in the first oil crisis of the mid 70s but the good ones thrived. Plenty of funds closed or imploded in 1994 and 1998. It just emphasizes that skill is rare while thorough due diligence and manager diversification is essential.

The hedge fund bubble is bursting? No. January was bad but February was good on "average". Trouble in a few specific areas of hedge fund land? Sure. That is why manager and strategy diversification is so important. Overdue volatility and a bear market was bound to catch out some weaker players. Carlyle Capital craters, DB Zwirn shuts down, Sailfish implodes, Richmond Capital loses 50% and AQR suffers from the same model development DNA as Goldman Sachs' Global Alpha. Losses and meltdowns for some poor funds just transports alpha to the good funds.

Invest in the breakaway leadership group, not the the peloton. The Peloton hedge fund founders couldn't keep an eye on their own millions in a simple bank account so they could never have been expected to be able to manage client billions. The trouble with a cycling peloton is that if the riders at the front of the pack trip up they also disrupt the followers. Never invest in a fund that has just won an award and never give money to anyone who is so haphazard with their own cash. It's the yellow jersey winners and kings of the mountains to look for.

It is curious how when "hedge funds" have a generally rough month, some say redeem and the "bubble" is over, but when long only funds lose a few trillion those same experts urge investors to stay in for the long haul. Some even have the effrontery to say don't pay attention to market declines! Just ride out that volatility and make it back in the dim and distant future. Even if you hate hedge funds, I don't think anyone could say they haven't changed the markets and consequently the assumptions that underlie so many market postulates.

There are many dilettantes in investing and as in any industry, hedge funds obey the 80/20 rule. At least 8,000 of the products that say they are "hedge funds" are no good. Finance isn't rocket science; it is much more complicated than that. Too many employ hubristic heuristics to make their models solvable, equations that allegedly fully describe all market phenomena. The silly simplifications are what cause the problems in the first place. It is complexity that solves them. The trouble with most investment "advice" to individual investors is that it is too simple to work.

The assumption that stock markets can be relied on to go up over time is a classic Type 1 statistical error. A false positive backed up by confirmation bias. Stocks generally went up therefore they will? Investors need time in the market since "no one" can time the market! A rare few can and those fund managers can often be identified in advance. Claiming the market can't be consistently timed is like saying no one can consistently run the hundred in under ten seconds, can't consistently hit basketball three pointers or shoot under par on the golf course. Warren has been successfully seeking alpha for a long time and 1000-2000 bona fide hedge funds will also be delivering for their clients.

Economists set great store in the anatocism of the past. Compounded interest that were not known in advance. Practitioners like Warren Buffett are pragmatists and adapt to current conditions as they see fit. I realize many investors still believe they will eventually be compensated for the risk of equities. I hope they are right but I can't afford to trust so I need to verify as well. I have verified that investment skill exists and persists into the future beyond any statistical and practical doubt. I have not been able to verify the same for beta. Stock market price appreciation and dividends are just too unstable so we need alpha as well, just in case.

Asset allocation is unlikely to be the main driver of performance over time. The primary factor will be security, strategy and manager selection: Fund managers that work hard to find securities that will go up and those that will go down and managing risk in case they are wrong. The variability of portfolio performance is dominated by hedging, risk management and the appropriate use of derivatives. The path does matter for the long term achievement of investment objectives at the lowest volatility. As Benjamin Graham wrote many years ago "The essence of investment management is the management of risks".

Diversification with many securities is not hedging. You can own 10,000 stocks and bonds and not be properly diversified. Alpha sources need to be front and center in every portfolio. I don't know whether the Dow will be at 24 million or back down to 65.73 in 2099 but I can tell you for certain that a lot of alpha will have been created along the way. Alpha returns are complementary to beta returns. I would rather chase skill than chase performance because skill is persistent.

Although I have been pessimistic about the markets for the past year or so, I am an optimist at least with respect to the ongoing existence of some humans with the talent to trade successfully no matter how far the stock market drops. And they can impose whatever fees they want as long as they perform to demanding requirements. Produce 8% of absolute alpha above real inflation with careful control of risk satisfies a lot of investor requirements.

There is $64 trillion in money management and just $2 trillion in "hedge funds". The proportion is going to be a lot higher and yes there is always going to be a bottom decile of "hedge funds" that get themselves into trouble. That does not change the optimistic outlook for the hedge fund industry. A proper hedge fund should relish an equity or credit bear market. Even if you don't like shorting, it also creates opportunities to buy value cheaper as Warren Buffett has done many times in his search for alpha for his shareholders. It is a market of stocks, not a stock market. Some go up, some go down. Why invest in them all?