Part 2 – Alpha as Life

Passive Investing – Active Investing – Alpha Returns

Index funds are passive investments; their goal is to deliver a return that matches a benchmark index. The Old Testament of indexing is Burton Malkiel’s classic A Random Walk Down Wall Street, first published in 1973 by W.W. Norton and now in its ninth edition. For typical individual investors, without special access to information, it offers what is likely the best financial advice they will ever get: It is hard to consistently beat the market, especially after fees. A passive strategy will do better in the long run.

Of course, no one thinks of oneself as a typical individual investor. That might be your brother-in-law or the guy across the hall. And index funds are just not as much fun as picking stocks. It’s called passive investing for a reason. Alpha, outperforming a passive benchmark, is the goal of active investing. Even Malkiel has admitted to actively managing some his own money.(*) Recent additions to the Forbes 400 list include more than a few people who seem unusually adept at finding alpha, and keeping a piece of it.

The basic fee structure in the hedge fund world is “2 and 20.” Managers are paid 2 percent of assets and 20 percent of alpha. Similar arrangements are also used for performance paid to institutional managers, blurring the distinction between these types of buy-side firms. To see how this works, consider a $100 million portfolio, benchmarked against Treasury bills. If the manager produced a return equal to the T-bills, the alpha would be zero, and the manager’s fee would be $2 million, all from the asset-based portion. Unless the firm gave really good parties or had a great story, it would probably be replaced, since the client would end up earning the T-bill rate minus 2 percent, or something like a passbook savings account.

With a skilled, lucky, or skilled and lucky manager, the situation could be quite different. If the T-bills returned 3 percent that year and the hedge portfolio returned 28 percent, then the manager’s alpha is 25 percent, $25 million on the original investment. Under the 2-and-20 plan the firm would get to keep 20 percent of that, another $5 million on top of the $2 million in asset-based fees. The client keeps $18 million, substantially more than the meager few percent the client would have gotten in Treasuries.

A $100 million portfolio is small as hedge funds go.

It costs money to do the research or proprietary trading to produce that 25 percent alpha, so by the time all the bills are paid, that $7 million the manager takes is seriously pared down. But when the fund gets larger, the economies of scale kick-in in a major way. Investment strategies don’t scale to the sky, but it is (approximately) true that the cost to run a $1 billion portfolio is not that much more than for $100 million. In that case, the manager on the 2-and-20 plan takes home $70 million with performance as in the example. On $10 billion, the manager takes home $700 million, which begins to look like serious coin—even on the right side of the tracks in Greenwich, Connecticut. Deliver this kind of performance consistently, and you can raise the rates to 4 percent of assets and 40 percent of alpha, which would pay the $10 billion manager $1.4 billion with the same performance scenario.

This is where those billion-dollar paydays for hedge fund managers we read about in Institutional Investor and Parade magazine come from, and why people with what seem like good, solid $5 million annual paychecks at places like Goldman Sachs leave to start their own hedge funds. The whole alpha ecosystem depends on, and is a creature of, technology. Before computers, it was sufficiently tedious to compute the alpha of a portfolio that no one did it.

Comparing one stock to another is easy. Real portfolios are much messier. They have cash flows in from additional investments, and cash flows out from payments or withdrawals. There are dividends paid in from long positions, and dividends paid out from shorts. Stocks split, companies merge, symbols change. International investments’ returns are subject to currency variations to the extent that they are not hedged, and if they are, there are costs associated with those hedge positions.

Bill Fouse, who started the world’s first index fund, tells a story about the early days of performance measurement. In the 1950s and 1960s the reporting from investment managers to clients was almost anecdotal. The manager would invite the clients up to the lavishly decorated dark wood-paneled office and show them a list of stocks in their portfolio, with the prices paid and the recent prices.

Nothing would be said about cash flows, holding periods, or dividends, and nothing about closed positions. It was easy to pretty up the report by cleaning out the losers. Everyone would sit around the conference table to review the list of holdings, and enjoy a fine n-martini lunch.

In 1968 A.G. Becker, a brokerage firm, changed the game by using computers to keep accurate annualized scores for clients’ accounts, and by comparing the results with index benchmarks. This was possible only because the firm had acquired one of the early mainframe computers, a room-filling behemoth like the IBM System 360. The news wasn’t pretty. Any asset managers were much better at telling a good story and coming up with a good lunch than they were at managing assets. As Fouse tells it, managers resisted the idea of quantitative performance measurement.

They sent out the word, “Hire them, and you can’t hire us.” Some of their objections were valid; a simple performance measurement doesn’t consider the risks that a manager is allowed to take. Other measures—like the Sharpe, Jensen, and Treynor ratios(**) — refined the idea, but the alpha industry was born and has been growing ever since.

Finance students and Wall Street sorts around the world yearn for knowledge that will let them find ever more alpha. This raises the simple question of Chapter 4 – Where does alpha come from? That question opens this part of the book. The chapter explains why the search for alpha is more than just a snipe hunt, and why the people who find it may be more than just plain lucky.

Chapter 5 – A Gentle Introduction to Computerized Investing, starts out with a description of indexing, the great granddaddy of all quant equity strategies, and how it is transformed into active quant strategies by adding information beyond knowledge of an index’s constituent stocks.

In the last of this part, Chapter 6 – Stupid Data Miner Tricks, we see how with the right mix of hubris, stupidity, and CPU cycles, it is possible to do some real damage to your financial health. In investing, as in the bomb squad, knowing what not to do is extremely worthwhile.

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* This surprising admission came in a dinner speech at the Investment Management Network “Superbowl of Indexing” Conference (December 1996, Palm Springs, California). No performance figures were disclosed.

** The Sharpe ratio is a measure of management skill that adjusts pure alpha (value added) by the variability of that value added. The others (Jensen & Treynor) are refinements based on characteristics of the portfolio, such as beta. They are less commonly used. Details are here

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by David Leinweber