Sometimes it seems as if it would be easier to pin Jello to a wall-or trap a unicorn-than it would be to capture alpha, the return that comes only from an investment manager's Midas touch. It's that extra oomph that can only be identified accurately in hindsight. Even veteran investors and market strategists, including individuals who have spent their professional lives trying to track alpha and isolate it from myriad other sources of investment returns, describe it as "mushy" and "elusive." And yet, in today's volatile and directionless financial markets, more advisors are likely to seek alpha.
With investment strategists and pundits predicting a long period of sluggish returns that may not make it out of the single digits, there is every reason for advisors to intensify their quest. But alpha is both hard to define and harder to find.
WHAT IS IT?
Understanding just what it is that you're chasing helps in any quest, pros agree. Let's start with alpha's poorer cousin, beta. "A practical way of thinking about beta is that it's the kind of return that you can get on demand," says Theodore Enders, portfolio strategist at Goldman Sachs Asset Management (GSAM). For instance, if clients decide they want to capture the beta of the large-cap U.S. value stock universe, they can turn to one of several indexes or opt to invest in a low-cost actively managed fund run by a manager who aims to cherry-pick the best stocks but who sticks to that stock market niche.
Alpha is more complex, Enders says, because it can be identified only with hindsight. Technically speaking, alpha measures performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of an investment or portfolio and compares its risk-adjusted performance with a benchmark index. The excess return relative to the return of the benchmark index is alpha. But investment experts believe that alpha is something much more complex than that.
Alpha comes in three different flavors, Enders says. You can get it through stock-picking, portfolio overweighting and a hybrid approach.
* Picking the right securities. The most common form of alpha involves identifying which stocks, bonds or other securities are poised to outperform. For instance, a large-cap manager who builds up overweight positions in stocks that fare better than their peers or the index can be said to generate alpha. "When you read textbook descriptions of alpha, that is usually the kind of alpha they are referring to," Enders explains.
And there may be opportunities right now for stock-picking, according to Thomas Berner, U.S. economist at UBS Financial Services. Berner has found a big gap between the price/earnings ratios of the most highly-valued stocks within the Russell 3000 index and the cheapest. It may take some time for the undervalued companies to recover. "So it makes sense for investors and their advisors to focus their efforts on finding managers who are great stock-pickers, who have a better chance of capturing that alpha," he says.
There's never a guarantee, of course. "The most that any investment manager can do is tell you, this is the way I do my work," Berner says. "You have to be early; you have to be looking in the right place at the right time."
* Weighting betas. Another type of alpha involves overweighting different kinds of beta exposures across an entire portfolio. In this case, the alpha comes from the manager's skill in deciding which betas will outperform the entire universe of available betas. This is the approach that global macro hedge funds take.
* The hybrid. Last comes what Enders and others at GSAM refer to as "balpha." This comes from long-term allocations to betas that help a portfolio do better," Enders says. "Because you can't deliver it on demand, it's technically not beta, but because the return comes from a beta source, it's not alpha. It's a hybrid."
Indeed, across the board it seems to be getting more difficult, even with ever-greater access to data and analytical tools, to figure out what is alpha and what is beta. "The line is blurring," says Rob Arnott, chairman of Research Affiliates, a Newport Beach, Calif.-based research firm.
"It is a moving target, too, which adds another layer of complexity to the process," he adds. That means advisors need to find ways to test the claims of those who say they have delivered alpha in the past, understand how that alpha was really generated and try to gauge whether the feat is repeatable.
ALPHA TRAPS
Simply beating a benchmark doesn't mean a manager has produced alpha. As Mike Murgio, director of investments for GenSpring Family Offices, which advises wealthy clients at 14 family offices throughout the country, explains, "I've met advisors who have put together a diversified portfolio of different investment strategies and say, because the return is different from that of the equity market, that there is alpha." In fact, "they have added a different kind of return stream into the mix." In other words, one kind of beta, or market, return when added to another source of beta doesn't necessarily add up to alpha.
Berner points out that planners need to be familiar with regression analyses and with data sets in order to understand whether a stock-picker is providing alpha and not just a new kind of market return. "I may be able to add more beta, more kinds of beta, by adding mid-cap stocks or emerging-markets exposure, because by mixing that into the portfolio I increase the odds that I'm going to outperform any given single index," says Todd Millay, founder of Boston-based advisory firm Choate Investment Advisors.
Berner recalls a case where a manager boasted of his ability to generate alpha by re-creating the best-performing market portfolio of the prior week and then letting it run for another week. The manager had the right idea-the momentum trade he put on did generate excess returns-but it was undermined by trading costs.
"After those were factored in, he was back to square one, a normal market return," Berner says. Another trap advisors should avoid is paying alpha-style fees for a manager who is delivering only beta or enhanced beta returns, something that happens too often
Yet another peril is failing to monitor exactly how a manager who has generated alpha in the past did so-and whether the markets in which he or she invests are still illiquid and inefficient enough for even the most skilled and knowledgeable investor to stand a decent chance of capturing alpha. For instance, managers like to shout "alpha!" even when the bulk of their return has come from a single bet on a part of the market that has done well.
Back in the late 1980s, when Harindra de Silva began studying alpha, he realized that the entire performance of a global investment manager often could be explained by a single call: the decision on whether to overweight Japanese stocks. "That's when I began to realize that even if they beat the benchmark, that wasn't the question I should be asking," says the president of Analytic Investors, a Los Angeles-based investment firm. "More important was whether they bought the best stocks, both in Japan and outside Japan."
The question de Silva asks is what produced the returns that the manager claims are alpha returns. "If a manager says he or she has outperformed by four percentage points a year, and I find that the manager has done well picking developed market stocks, has had a reasonable turnover and not a huge market bias, that is probably alpha," he says. "But if I dig deeper and find that it's a 20% exposure to emerging markets-an asset class that has been very rewarding-then I have to wonder. Is it really alpha at all? And even if it is, can the manager repeat that asset class bet and time his or her movements right?"
That just highlights the primary risk of alpha: Even when you realize that you captured it last year, that doesn't mean that you can repeat it for your clients in the next 12 months. A market or a manager that generates alpha one year can fail to do so for years to come, whether it's because the manager lost his or her edge or motivation, or because the market morphed in ways that reduced the opportunities to identify and capture alpha.
"The volatility of a fund's alpha return is not like a Treasury bill return-it varies over time," de Silva points out. Global macro funds, for instance had a great run for a few years until about 2005; in 2007 and 2008, most of them struggled. "These guys didn't just get stupid; the opportunity set that they were presented with was radically different," de Silva explains.
THREE QUESTIONS
Before even attempting to chase alpha, Arnott suggests posing three questions. If advisors can't answer "yes" to all three, there is little point embarking on an alpha quest at all.
The first question is whether the market is inefficient enough to offer a savvy, skilled investment manager the right set of opportunities to earn alpha. "If not, forget it; don't even bother."
The second question is whether the market is inefficient in the right kind of way, meaning that even after fees and other costs there is still enough alpha left to keep clients happy. "Most managers can't do that," Arnott says.
Finally, advisors need to ask themselves whether they have the wisdom and insight to select the right set of managers in advance, before they actually generate alpha. "Most people just assume that past is prologue and that people who have done it before will repeat," Arnott says. "If they were rational, 90% of them would admit they don't have any special skill and decide not to try, but instead 90% of them do exactly the opposite.
HERE AND ABROAD
Emerging markets are a favorite target of alpha-seekers today, both because of the high absolute growth levels they have experienced and because the markets still tend to be relatively inefficient and less liquid than their counterparts in North America and Europe. Doing a lot of fundamental research is likely to pay off, the experts say,
In the U.S. stock market, it's harder to get any kind of informational advantage. That may be one reason the SEC appears to have uncovered a pattern of insider trading in a variety of hedge funds, some pundits say privately. If it's harder to get an information edge and generate alpha, hedge fund managers who base their reputation-and their fee structure-on their ability to generate alpha come under pressure to take a short cut and find the raw material for alpha returns some other way, even if that means risking accusations of insider trading.
Some market inefficiencies will always exist, even in areas like large-cap U.S. stocks that appear to be unlikely sources of alpha, simply because investor behavior can be irrational at times. Take the dot-com bubble; betting against it by investing in value stocks and shorting the dot-coms was a great way of generating alpha, for those managers who identified the trend and had the conviction to stick with it.
That's one reason that hedge funds became the flavor of the month in the wake of that market collapse; amidst the carnage, they demonstrated the ability to outperform in non-performing markets. "Then you had every proprietary trader break away to open his or her own hedge fund, and suddenly there were a lot of closet beta managers making money off the alpha-level fees they were charging," says Cliff Draughn, chief investment officer at Excelsia Investment Advisors in Savannah, Ga. "They weren't really justified because they hadn't proven what they could do."
One of the reasons Draughn stopped trying to identify alpha-generating hedge funds for his clients several years ago is that too often the pursuit of alpha involves too much risk. "The only way to add alpha in an efficient market is to run a concentrated portfolio; or you take risk by being in an inefficient market."
WHY TRY?
While even wary advisors like Millay and Draughn are thoughtful and cautious about how they pursue alpha, they don't disagree that the idea of trying to capture it has merit. Nor does Berner, who believes that go-anywhere investment managers in hot pursuit of alpha will likely emerge as the best performers in this kind of market environment.
Others, however, are more skeptical. Does it matter, they wonder, whether outperformance-on a risk-adjusted basis and after factoring in management fees and trading costs-is derived from alpha or from a complex mix of beta, or market, returns? "A better beta-an extra two percentage points-is just as spendable to a client as two percentage points of alpha would be," Arnott points out. "As long as you're not paying alpha fees on steroids for beta returns, that is."
What crystallizes his concern about the reckless pursuit of alpha at all costs is the fact that ultimately alpha is a zero sum game; for one group of investors to profit, others must lose. That means that alpha can't be a universal solution for a whole class of baby boomers in any market environment. "I almost never hear anyone ask, when they go after alpha, who is losing alpha and why?" Arnott says.
That's an important question, he says, because a manager who is convinced of his or her ability to generate alpha must be convinced that the individual or institution on the other side of the trade is willing to settle for negative alpha. "Is that a naïve granny in sneakers you're dealing with or a sophisticated arbitrage house with all the market knowledge in the world?" Arnott asks. Investors and advisors need to find reasons why some investors are willing to settle for smaller returns than they might otherwise earn, and identify the markets where they are most likely to be found, because that's the only way to be confident that an investment decision will yield a modicum of alpha.
For Draughn, the pursuit of alpha simply highlights a number of common delusions among market participants, from the most naïve investor to the most experienced advisor. "We want the laws of physics to apply to financial markets, and that's why we think there is some formula that will lead us straight to alpha," he says.
It's because investment decisions are influenced by emotional responses as well as algorithms that alpha exists in the first place, but it's also why an advisor who single-mindedly pursues it can fall into so many traps. "We may complicate it, but alpha is about looking for someone doing something different and doing it in a different way," Draughn says. "But it's not systematic. It's always going to be an art and never a science that we can construct a discipline around. Until we can predict the future, promises of alpha will remain illusory."
Suzanne McGee is a New York-based freelance writer and the author of Chasing Goldman Sachs.
