Alpha, Beta, and Beyond?

Nouriel Roubini, professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, wrote an article for Project Syndicate, Alpha, Beta, and Beyond:

Even in normal times, individual and institutional investors alike have a hard time figuring out where to invest and in what. Should one invest more in advanced or emerging economies? And which ones? How does one decide when, and in what way, to rebalance one’s portfolio?

Obviously, these choices become harder still in abnormal times, when major global changes occur and central banks follow unconventional policies. But a new, low-cost approach promises to ease the challenge confronting investors in normal and abnormal times alike.

In the asset management industry, there have traditionally been two types of investment strategies: passive and active. The passive approach includes investment in indices that track specific benchmarks, say, the S&P 500 for the United States or an index of advanced economies or emerging-market equities. In effect, one buys the index of the market.

Passivity is a low-cost approach – tracking a benchmark requires no work. But it yields only the sum of the good, the bad, and the ugly, because it cannot tell you whether to buy advanced economies or emerging markets, and which countries within each group will do better. You invest in a basket of all countries or specific regions, and what you get is referred to as “beta” – the average market return.

By contrast, the active approach entrusts investment to a professional portfolio manager. The idea is that a professional manager who chooses assets and markets in which to invest can outperform the average return of buying the whole market. These funds are supposed to get you “alpha”: absolute superior returns, rather than the market “beta.”

The problems with this approach are many. Professionally managed investment funds are expensive, because managers trade a lot and are paid hefty fees. Moreover, most active managers – indeed, 95% of them – underperform their investment benchmarks, and their returns are volatile and risky. Moreover, superior investment managers change over time, so that past performance is no guarantee of future performance. And some of these managers – like hedge funds – are not available to average investors.

As a result, actively managed funds typically do worse than passive funds, with returns after fees even lower and riskier. Indeed, not only are active “alpha” strategies often worse than beta ones; some are actually disguised beta strategies (because they follow market trends) – just with more leverage and thus more risk and volatility.

But a third investment approach, known as “smart” (or “enhanced”) beta, has become more popular recently. Suppose that you could follow quantitative rules that allowed you to weed out the bad apples, say, the countries likely to perform badly and thus have low stock returns over time. If you weed out most of the bad and the ugly, you end up picking more of the good apples – and do better than average.

To keep costs low, smart beta strategies need to be passive. Thus, adherence to specific rules replaces an expensive manager in choosing the good apples and avoiding the bad and ugly ones. For example, my economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results.

Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.

With better returns than passive beta funds at a lower cost than actively managed funds, smart beta vehicles are increasingly available and becoming more popular. (Full disclosure: my firm, together with a large global financial institution, is launching a series of tradable equity indices for stock markets of advanced economies and emerging markets, using a smart beta approach).

Given that this strategy can be applied to stocks, bonds, currencies, and many other asset classes, smart beta could be the future of asset management. Whether one is investing in normal or abnormal times, applying a scientific, low-cost approach to get a basket with a higher-than-average share of good apples does seem like a sensible approach.

Smart beta has been the buzzword among institutional investors for a few years now. In March 2012, I wrote a comment on investors chasing smart beta, plugging my friend Nicolas Papageorgiou who is a professor of finance at HEC at the University of Montreal.

Nicolas has since departed from Brockhouse Cooper (now Pavilion) to work with HR Strategies managing money for large institutions and helping them implement a smart beta approach to increase their risk-adjusted returns. He's sharp as hell and knows what he's talking about when it comes to the pros and cons of "smart beta" (contact him here or here if you want non sell-side advice on smart beta).

With the introduction of a series of tradable equity indices for stock markets of advanced economies and emerging markets using a smart beta approach, people like Nicolas will now be able to compete more effectively by gauging their risk-adjusted performance relative to these tradable 'smart beta' equity indices.

What do I think of smart beta? It simply makes sense on one level but I caution my institutional readers to remain highly skeptical and understand the macro environment since the 2008 crisis and why these smart beta strategies have become so popular.

Importantly, massive quantitative easing from central banks after the financial crisis has led to rising equity indices around the world, hammering the bulk of active long-only and long/short managers. Smart beta, which basically adds some quantitative rules (like simple moving average crossovers or complicated stochastic pricing algorithms) to select country or sector ETFs, has also done well in this environment.

Ultimately, smart beta is about making smart tactical calls. For example, in my own personal account, I made a decision back in December 2013 to get out of Canadian stocks and head into U.S. technology (QQQ) and biotech (IBB or XBI) shares. My conviction on global deflation, which remains a central theme governing my investments, led me to making that call, which was smart from a currency/ country/ sector point of view.

But as I shared with you in my recent comment on an ominous sign from commodities, I've had my share of bad calls too, some of which have whacked me hard:

You might be tempted to catch this falling knife (XME) but before you do, let me share a personal trading story. The week before Patriot Coal first declared bankruptcy, wiping out shareholders, I was trading it wrongly thinking they won't file Chapter 11 and making huge gains (+50% in one week). Then one day, BOOM!, they filed for bankruptcy and I scrambled to sell that big position for pennies.

If I remember correctly, that happened in the summer of 2013, right after I recommended a lump of coal for Christmas back in December 2012. That was a painful and costly mistake, one that taught me to be careful trading countertrend rallies in weak sectors and that just because a stock has suffered a huge decline and looks oversold, it can always go lower and even head to zero!

Now, admittedly, trading ETFs is safer than trading individual stocks but when all the components are dropping like a hot knife through butter, be very careful, there could be more damage ahead and the sector can stay out of favor for a lot longer than anyone expects. There are plenty of other coal stocks that got slaughtered this year (or filed for bankruptcy).

There is nothing like trading and losing your own money to teach you painful lessons on making money in markets. I'm also lucky to have friends like Fred Lecoq who trades his own money and taught me valuable lessons in understanding weekly indicators and why sectors and stocks can remain out of favor for a lot longer than you think.

And as I stated in my last comment on red light for hedge funds, even the best hedge fund gurus have suffered huge losses in their careers. That goes for everyone including George Soros, Ray Dalio, David Einhorn, Steve Cohen, and Ken Griffin who is now hailed as the new hedge fund king (see below).

Interestingly, Griffin's Citadel almost got obliterated back in 2008. He (and many other hedge funds) literally had to close the gates of hedge hell to stem the wave of redemptions back then. In October 2008, I wrote a comment on whether manic depressive markets will grind higher where I recommended investing with Citadel after it suffered huge losses:

I wouldn't bet against Ken Griffin and I am confident he will reemerge from this brutal hedge fund shakeout a stronger and better money manager. I can't say the same thing about 95% of the hedge funds out there, but he is one manager who understands what true alpha is and he knows how to capture it.

I thought most investors redeeming from Citadel back then didn't have a clue of why the fund suffered such huge losses and why it was going to come back strong. (The Wall Street Journal just published an article on how Citadel has left the 2008 tumble far behind).

That comment prompted this email response response from Griffin back in October 2008 (click on image):

That was my only interaction with Ken Griffin, and just to be clear, he has never contributed a dime to my blog and neither has Ray Dalio or any other hedge fund "guru." Don't blame them, for the most part, I think they're a bunch of over-hyped, over-glorified and overpaid asset gatherers collecting huge fees for delivering alpha but also for sitting on billions where they capture that all-important management fee no matter how they perform.

Anyways, back to the topic at hand, alpha, beta and beyond. Things move so fast in these Risk On/ Risk Off markets that it's virtually impossible to beat the algos and their high-frequency trading platforms. This is one reason Citadel and a few other elite hedge funds are up big in these markets when most hedge funds are struggling to survive.

But I don't buy the story that "algos are taking over finance" arbitraging away all alpha. In fact, I agree with professor Robert Shiller who recently wrote an insightful comment on The Mirage of the Financial Singularity:

In their new book The Incredible Shrinking Alpha, Larry E. Swedroe and Andrew L. Berkin describe an investment environment populated by increasingly sophisticated analysts who rely on big data, powerful computers, and scholarly research. With all this competition, “the hurdles to achieving alpha [returns above a risk-adjusted benchmark – and thus a measure of success in picking individual investments] are getting higher and higher.”

That conclusion raises a key question: Will alpha eventually go to zero for every imaginable investment strategy? More fundamentally, is the day approaching when, thanks to so many smart people and smarter computers, financial markets really do become perfect, and we can just sit back, relax, and assume that all assets are priced correctly?

This imagined state of affairs might be called the financial singularity, analogous to the hypothetical future technological singularity, when computers replace human intelligence. The financial singularity implies that all investment decisions would be better left to a computer program, because the experts with their algorithms have figured out what drives market outcomes and reduced it to a seamless system.

Many believe that we are almost there. Even legendary investors like Warren Buffett, it is argued, are not really outperforming the market. In a recent paper, “Buffett’s Alpha,” Andrea Frazzini and David Kabiller of AQR Capital Management and Lasse Pedersen of Copenhagen Business School, conclude that Buffett is not generating significantly positive alpha if one takes account of certain lesser-known risk factors that have weighed heavily in his portfolio. The implication is that Buffet’s genius could be replicated by a computer program that incorporates these factors.

If that were true, investors would abandon, en masse, their efforts to ferret out mispricing in the market, because there wouldn’t be any. Market participants would rationally assume that every stock price is the true expected present value of future cash flows, with the appropriate rate of discount, and that those cash flows reflect fundamentals that everyone understands the same way. Investors’ decisions would diverge only because of differences in their personal situation. For example, an automotive engineer might not buy automotive stocks – and might even short them – as a way to hedge the risk to his or her own particular type of human capital. Indeed, according to a computer crunching big data, this would be an optimal decision.

There is a long-recognized problem with such perfect markets: No one would want to expend any effort to figure out what oscillations in prices mean for the future. Thirty-five years ago, in their classic paper, “On the Impossibility of Informationally Efficient Markets,” Sanford Grossman and Joseph Stiglitz presented this problem as a paradox: Perfectly efficient markets require the effort of smart money to make them so; but if markets were perfect, smart money would give up trying.

The Grossman-Stiglitz conundrum seems less compelling in the financial singularity if we can imagine that computers direct all the investment decisions. Although alpha may be vanishingly small, it still represents enough profit to keep the computers running.

But the real problem with this vision of financial singularity is not the Grossman-Stiglitz conundrum; it is that real-world markets are nowhere close to it. Computer enthusiasts are excited by things like the blockchain used by Bitcoin (covered on an education website called Singularity University, in a section dramatically titled Exponential Finance). But the futurists’ financial world bears no resemblance to today’s financial world. After all, the financial singularity implies that all prices would be based on such things as optimally projected future corporate profits and the correlation of profits with expected technological innovations and long-term demographic changes. But the smart money hardly ever talks in such ethereal terms.

In this context, it is difficult not to think of China’s recent stock-market plunge. News accounts depict hordes of emotional people trading on hunch and superstition. That looks a lot more like reality than all the talk of impending financial singularity.

Markets seem to be driven by stories, as I emphasize in my book Irrational Exuberance. There are stories of great new eras and of looming depressions. There are fundamental stories about technology and declining resources. And there are stories about politics and bizarre conspiracies.

No one knows if these stories are true, but they take on a life of their own. Sometimes they go viral. When one has a heart-to-heart talk with many seemingly rational people, they turn out to have crazy theories. These people influence markets, because all other investors must reckon with them; and their craziness is not going away anytime soon.

Maybe Buffett’s past investing style can be captured in a trading algorithm today. But that does not necessarily detract from his genius. Indeed, the true source of his success may consist in his understanding of when to abandon one method and devise another.

The idea of financial singularity may seem inspiring; but it is no less illusory than the rational Utopia that inspired generations of central planners. Human judgment, good and bad, will drive investment decisions and financial-market outcomes for the rest of our lives and beyond.

In other words, you can have the best algorithms in the world running 24/7 in all markets but if you ignore animal spirits and the madness of crowds on the upside and downside, you'll be making big mistakes and potentially suffer catastrophic losses.

I still maintain that now more than ever, if you get your macro calls right, you can navigate through these markets and even make decent returns. It's getting much tougher because extreme volatility can rip you apart but if you get the big picture right, you can come out of this relatively unscathed.

My big calls center around global deflation but I realize that markets don't go up and down in a straight line and that there are always countertrend moves going on in weak sectors as sentiment tends to overshoot on the downside.

As I've recently discussed, we could be on the verge of a snap-back rally in commodity and energy shares but I remain very skeptical and cautious, preferring to steer clear of these sectors:

[...] go back to carefully read my comments on Bridgewater turning bearish on China and a tale of two markets. We could be setting up for some nice countertrend rallies in Chinese (FXI), emerging markets (EEM), energy (XLE), commodities (GSG), metals and mining (XME), and gold (GLD) shares in the next few months.

How is this possible? First, if markets deteriorate further, the Fed won't hike rates this year. Second, real rates in emerging markets remain too high relative to real rates in the developed world, so expect more central bank easing in emerging markets in the near future. Third, the reflationistas may be temporarily right,  global growth will likely come in stronger than anticipated in the next few quarters, which will help boost energy and commodity shares.

But make no mistake, my long-term forecast of global deflation remains intact which is why even though I might be tempted to trade countertrend rallies in energy and commodities, I keep steering clear of these sectors in favor of tech (QQQ) and biotech (IBB and XBI).

It's important to keep in mind however that central banks have been pumping incredible liquidity in these markets over the last couple of years and that even though the China bubble is imploding, there is enough stimulus to propel risk assets much higher and to even boost energy and commodity shares from these depressed levels (I call this the last dead cat bounce before alpha pops and the tidal wave of deflation swamps global markets).

Below, a long and rare conversation with the new hedge fund king Ken Griffin (May, 2015). No doubt about it, Griffin is one of the best and sharpest hedge fund managers in the world. At 46, Griffin is already on top of the rich hedge fund world and is now setting his sights on an IPO, a goal which has thus far eluded him. But take the silly title of "hedge fund king" with a shaker of salt as I've seen so many hedge fund titans rise and fall over the years, including Ken Griffin (but still have to hand it to him as he bounced back strongly after the crisis).

Also, investment guru Mark Mobius has dismissed claims that an oversupply of crude is behind oil's selloff, and believes the end of the broader commodities rout is in sight. He might be right in the near term; longer term, global deflation will continue to ravage commodity and energy shares.

Lastly, Bill Fleckenstein, Fleckenstein Capital President, discusses his short ideas and explains why he says the market and the Fed are "trapped." After a long hiatus, Fleckenstein is getting ready to launch his new short fund, which may be a sign that the worst is yet to come (or a great contrarian indicator!).

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