Thursday, August 21, 2008

Alpha on the Cheap?

In my last post, I looked at how the hedge fund herd is mostly piling into the same trade: short financials, short U.S. dollar and long energy. While it works, it is fine, but when these trades unravel, markets become very volatile and severe market dislocations can easily degenerate into financial chaos.

But why are so many hedge funds piling into the same trade? If these so-called "alpha experts" are supposed to deliver superior risk-adjusted returns, shouldn't they be diversifying their bets and truly limiting their downside exposure? Moreover, there are now close to $2 trillion in hedge fund assets under management out there (with leverage, it's probably closer to $10 trillion or more), which means institutions are paying a 2% management fee and a 20% performance fee for what is essentially beta bets. That's billions in fees for beta bets that can be easily replicated a lot cheaper internally at a fraction of the cost.

In July 2007, the New Yorker published an article by John Cassidy, Hedge Clipping, which looked into whether or not there is a way to get above average returns on the cheap. Mr. Cassidy interviewed Harry Kat, an economist at the Cass Business School in London and an authority on cloning hedge fund strategies.

I quote the following:

It is well known that risk and return tend to go together. If you go to Atlantic City and bet your life’s savings on a roulette wheel’s coming up black, you have a good chance of earning an instant return of a hundred per cent; you also have a good chance of going broke. Playing roulette is a high-risk, high-return activity. Putting your money in a bank C.D. is a low-risk, low-return activity. Truly outstanding investors, such as Warren Buffett, somehow generate consistently high returns at low risk.

Kat decided to determine whether hedge funds met this standard; only if they did could they genuinely be said to have created alpha. In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

With the help of a graduate student, Helder Palaro, Kat also undertook a larger study, in which he examined more than nineteen hundred funds. The results, which Kat and Palaro posted online as a working paper last year, showed that only eighteen per cent of the funds outperformed their benchmarks, and returns even at the most successful funds tended to decline over time. “Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative,” Kat told me. “They are charging more than they are adding. I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.”

In another Bloomberg article published in 2006, Kat was even more explicit:

Synthetic funds would have outperformed 82 percent of the 2,000 hedge funds and 500 funds of hedge funds studied by Kat, a former head of equity derivatives at Bank of America Corp. Most of the gains generated by hedge funds were eaten up by fees, typically 2 percent of a portfolio and 20 percent of profits, he found after studying 15 years of monthly fund results.

"In most cases, managers aren't good enough to make up for the massive fees that they charge,'' said Kat, a professor of risk management at Cass, part of London's City University, in an interview. "The combination of excessive fees and minimal opportunity in the market makes alternative investments really doubtful in terms of their value for portfolios.''

Kat is not alone in questioning hedge fund returns. Other academics like Andrew Lo have also looked into whether hedge fund returns can be replicated on the cheap.

A full discussion of hedge fund cloning strategies is beyond the scope of this post. All I can tell you is that not all cloning strategies use the same statistical techniques and that some of them are fraught with their own operational and investment issues.

Moreover, these cloning strategies are better used to screen out managers than as a standalone product. The whole point of paying for alpha is that you want to be with the top decile managers whose returns you cannot reproduce. Why replicate median returns? If you can't allocate to top managers, then don't bother allocating to these strategies (the same goes for other alternative investments).

Finally, it isn't just hedge fund returns that can replicated on the cheap. Toro's Running of the Bulls Market Blog posted an excellent entry a couple of days ago on How to Earn 40% Per Year Returns Like a Private Equity Fund.

I quote the post below (try not to laugh out loud):

Are you jealous of Blackstone? Have a hankering to be like KKR?

No problem, dear readers. We at Running of the Bulls are here to enlighten you on how to make 40% a year, just like the private equity funds, without having to pay the extortionary fees just to have the privilege of participating in a pool of capital in which you are not allowed to withdraw any money until your first born is in college.

First, one must understand how a private equity firm generates such magnificent returns.

Its easy! It goes something like this.

  1. Find a publicly traded company that has a ton of cash on its balance sheet, is magnificently free cash flow positive and is being ignored by the stock market.
  2. Offer to buy said company at 30% above the market price. The stock market - which has the attention span of a hummingbird - will be thrilled.
  3. Once you own it, gut the company of all its cash, paying yourself a ridiculously handsome dividend, using gianormous amounts of debt to pay yourself that dividend. You deserve it.
  4. Fire half the employees.
  5. A few years later, when the stock market has finally turned its attention to the industry in which the company you just hallowed out and gutted the balance sheet operates, take the company public at a higher price at which you bought it. Emphasize the efficiency gains and much higher return on equity of the company that you generously imbued your business acumen upon.
  6. Convince Congress that secretaries and hamburger flippers should be taxed at a higher rate than you.

Voila! You're a billionaire!

But since you - the average Joe who didn't go to Harvard and spend the first two years of your post-MBA career photocopying for 120 hours a week deep in the bowels of an investment bank - can't do that, here's a way for you to generate similar returns in a similar manner.

Please send me $249 for a copy of my software which will tell you how you can...

Haha! No, just kidding.

Here's how you do it.

  1. Go open a margin account.
  2. Buy one of these ultra floating ETFs which return two times the market rate, such as the ProShares Ultra S&P 500 fund, ticker SSO. Use maximum leverage.
  3. Sit back, relax and watch the money roll in.

If you are a money manager, stick the money offshore. Hire a New York valuation firm to tell you what your account should be worth. Ignore what is happening in the stock market. Charge your clients high fees.

Satirical commentary aside, much of private equity returns come from increasing the leverage they own. The PE funds have the luxury of not marking their investment to market, thus are not bound by current market valuation as market movements are often considered transitory. They also choose when to sell their company back to the public markets. PE funds are able to exploit this "asset class structure arbitrage" quite profitably.

In our example, if one can stomach the volatility and can put up extra cash for margin calls during downdrafts, over time, one would earn similar returns. The average return of stocks has historically been 10%. Buying a double floater ETF increases the historical return to 20%. Buying the ETF on maximum margin generates average returns of 40% per year. [read more on proshare ETFs here]

Of course, even the casual investor can see the inherent dangers of such a strategy. However, initiating such a position in 1982 and removing it in 1999 would have made one very wealthy.

It goes without saying that it would be enormously stupid to do this now. Bear markets are not a good time to lever up positions in stocks with everything you have.

But you get the idea.

Oh we get the idea alright! A lot of pension funds are blindly throwing billions of dollars into alternative strategies, paying hefty fees to pooled hedge funds, private equity funds, real estate funds, infrastructure funds, commodity funds, etc., in search of alpha which is really nothing more than disguised beta. It kind of gives new meaning to the term 'alpha smoke screen'.

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