(This is a lightly edited version of a letter originally distributed in March 2011. Remarkably few of the facts or conclusions have changed since that time. Perhaps the biggest question mark surrounds commodities and their pricing.)
With the occasional fit and start and the occasional geographic exception, global equity markets continue to roar ahead. This seems to reflect a combination of strong short-term earnings and a true desire of investors to believe companies overall are well positioned to capitalize going forward. Does this reflect reality? Obviously, no one has a definitive answer, but it is hard to provide the world a clean financial bill of health. We have discussed many of the issues before, but it is probably worth stating a few unsolved problems around the world:
- Very high levels of government debt and associated deficits in the U.S. and many European countries – without an apparent willpower to combat them in a meaningful way. This raises fears of rising interest rates, sovereign defaults and/or crowding out of private sector investment.
- A financial system that is still dependent on artificially low interest rates to remain viable. Exposure to less than stellar credits puts many institutions at risk and it is very uncertain as to whether proposed regulatory reforms for banks, insurance companies and pension funds will improve the system or make it more tenuous.
- Increasingly volatile and expensive commodities could certainly dampen growth, particularly in rapidly expanding, net commodity-importing economies such as China and India.
- Wage pressures are increasing, not only in developing countries, but also potentially in the U.S. and other developed markets, as the concessions gained during the crisis are being fought by labor in the light of improved corporate profitability.
- The deteriorating demographic profile of developed nations is not being accompanied by sufficiently aggressive policies of delayed retirement or healthcare cost confinement to obviate increasing government spending. This is likely to lead to higher overall levels of taxation and thereby lower disposable income.
- A torrid advance in share prices among the most ‘vulnerable’ growth companies has the word ‘bubble’ being whispered; at the very least the risk/reward profile for investment in many companies has shifted materially for the worse.
- The sprint for yield has turned a creditor recovery into a potential fixed income bubble.
- Extraordinary changes in computer and communications technology perfect markets, improve communications and dramatically lower information costs. At the same time these are destroying long-standing franchises, can decimate profit margins of established intermediaries and completely up-end existing businesses based on information e.g. newspapers, telephone directories and broadcasting. The derisory valuations of many corporate icons associated with computer hardware stem from these apprehensions about the accelerated pace of competitive technologies.
- State direction and intervention in markets unprecedented since the Second World War, in which the boundary lines between private business activities and state policy can be difficult to discern, especially in energy and commodities.
It is remarkable that a mere three years after generalized problems in financial markets which gave rise to both widespread calls for root and branch reform of the financial system, and renewed criticism of financial markets per se, that these markets have recovered to the point where localized booms are common and risk tolerance has revived. Retreating from the brink and seeing a general corporate belt-tightening has created legitimate levels of optimism. Many portfolios have seen their equity component increase through appreciation, likewise higher risk parts of their fixed income allocations, yet the ‘beta’ focus remains surprisingly robust. Whereas the movement in the institutional world over the past decade has been towards carefully evaluating risk-adjusted returns, we perceive a notable shift towards simple returns. There seems to be a desire/need to fully cover the holes created during the crisis and a willingness to believe in the ability to shift allocation in time to avoid any severe market downturns. Obviously, some will be able to achieve this, but by definition the amount of ‘beta-alpha’ (the value added by anticipating market turns) is limited and in market downturns, most investors lose.
In an environment over the past year and a half, where correlations among securities and sectors has been particularly high (less so recently) and where volatility has also been high, the appeal of allocations to pure ‘beta-neutrality’ has waned, as a result of relatively less impressive returns. There has undoubtedly been interest in alternative ways of generating returns, but most of the underlying fundamentals have been based on being long the beta of specific sectors, rather than looking for differences between winners and losers in each of those sectors.
What is alpha, who wants it and why?
There has been an evolving interest over the past two decades in all forms of alternatives, initially by high net worth individuals and more recently by global institutions. Not surprisingly, there has been an increasing amount of information available, of serious study and due diligence and of thinking about new ways to create and balance overall financial portfolios. Although the general level of understanding has certainly increased, there remain significant lacunae and large areas of definitional inconsistency and confusion. First, there is a general conflation of the terms ‘alternative investments,’ ‘absolute return’ and ‘alpha generators.’ This arises from the fact these are simply different from the traditional asset classes of bonds, stock and cash that have often represented the totality of a portfolio and still today generally represent the vast majority and have not, to date, enjoyed the same level of attention and study.
From our ongoing interaction with a broad range of investors, we perceive the rise in interest (since the turn of the millennium) in non-traditional investments to result largely from an understanding that increasing correlation among and within asset classes leads to higher systemic risk within portfolios. Most institutions and many individuals, therefore, have sought higher levels of diversification. The biggest problem, however, is that over the short-term, diversified strategies can appear correlated and correlated strategies can appear diversified. By definition, alpha requires judgments that run contrary to the mainstream. To the extent sentiment is unified (whether correct or not), the possibility for mean reversion decreases. For most strategies, alpha manifests itself over a longer time period; as such, measurement criteria need to differ from those for traditional investments. And, unfortunately, since ‘alternatives’ are not a true unified asset class, the metrics vary from strategy to strategy.
Real Estate. Although both institutional and high net worth investors have had exposure to real estate for a long time, it is still often considered an alternative investment. Given the general illiquidity of the area, it does not correlate directly with other asset classes, yet it is dependent on many of the same underlying fundamentals (e.g. a healthy economy, low interest rates, positive investor sentiment, etc.) and, therefore, has more underlying beta than often attributed to it. Furthermore, from a portfolio tracking perspective, it also benefits from very infrequent marking to market which, by definition, leads to a lower level of correlation with more liquid strategies.
Thumbnail: Underlying beta, less liquid, lower correlation.
Private Equity. The original concept behind leveraged buyouts was to acquire companies with steady cash flows, where leverage could easily be added and then rapidly paid down through the disposition of undervalued assets on the balance sheet. As time has evolved, the area has largely become a combination of leverage, financial engineering and attempts at turnarounds. Given the large exposure to the equity of private companies, the de facto beta is high, largely enhanced by the considerable leverage applied. However, as the companies are most frequently private, marking to market is infrequent, resulting -as in real estate – in a lower ‘marked’ level of correlation than other more liquid strategies. This does not signify value can’t be added from a return enhancement perspective, merely much less than commonly believed as a diversifier.
Thumbnail: Leverage beta, alpha through financial engineering and corporate restructuring.
Venture Capital. The ultimate beta plus alpha play. As early-stage companies are not public, their marks are uncorrelated to their sectors or the market in aggregate. Yet, most frequently their success is dependent on the same factors as their competitors in the public
markets. From time to time there is a ‘breakout’ company that defies or redefines categorization, but this is not the majority of VC investments.
Thumbnail: Illiquid beta, alpha through careful pre-selection of potentially differentiated sectors/companies.
Infrastructure. This, by definition, is a long-term play and often genuinely has lower correlation to equity markets. However, the success of projects still often relates to levels of interest rates and the strength of the underlying economies in which they reside. Furthermore, competition among strong, large competitors often limits the upside potential. These investments are often much better diversifiers than return enhancers, but the liquidity/return tradeoff needs to be carefully evaluated as, in many cases, does the potential sovereign risk.
Thumbnail: Alpha from differentiated cash flow streams dependent on significant illiquidity.
Hedge Funds are not a homogeneous category. As such, in order to evaluate them properly, we have broken them down into some of their most frequently defined components.
Long/short equity: Given the fact this area represents approximately 30% of hedge fund assets and 46% of actual hedge funds, it is by definition not a homogeneous sector. Managers in this area can have widely disparate gross and net exposures, ranging from massively long to very short. They can also be sector or geographic specialists or true generalists. There is no single measurement characteristic. This leads to a particularly high need to understand differences and set appropriate measurement criteria. For example, which is a better track record, one with a ten-year 10% net return or one with a 15% net return? Who knows? The answer depends on the volatility associated with it. If the 10% return came with a volatility of 3% and the 15% with 50% volatility, an investor could have taken the first result, applied judicious leverage and come up with a better risk-adjusted return. If the markets were up 12% a year and the 15% return was on average 150% net long, while the 10% was net neutral, an investor could have leveraged the index (without fees) for a portion of the investment and invested in the neutral fund for the rest to achieve a better risk-adjusted return. The key in long/short equity analysis is to define a differentiated and sustainable research or trading edge – sufficient to justify the very high frictional costs (i.e. fees and expenses). These are not easy to find over the long-term. Over short periods it is less difficult to find outliers, particularly those dependent on beta. However, those managers with skill and conviction are more likely to shine over longer time frames. Furthermore, very few managers are able to generate sustainable out-performance through market timing, a.k.a. tactical allocation!
Thumbnail: All over the map. Distinct alpha generating possibilities, but often a significant amount of explicit or implicit beta. Beware of paying alpha fees for beta.
– Relative Value: This primarily entails a largely quantitative search for and analysis of securities in the same or similar sectors, with the goal of going long those that are statistically undervalued and short those that are overvalued. Depending on the closeness of the alignment, managers use varying degrees of leverage, sometimes exceeding 3 or more times! Although these can demonstrate very attractive, steady returns and alpha, given their short-term neutrality, the tail risks, depending on the levels of leverage can be extremely high, particularly during periods of unexpected and/or extreme illiquidity. Over the longer-run, this strategy often looks like selling naked options – a beautifully steady positive return stream followed by a significant loss, resulting in unattractive longer-term returns, particularly relative to the fees charged.
Thumbnail: An alpha strategy that can suffer losses during periods of negative beta, when there is systemic illiquidity and leverage becomes dangerous.
– Event: Once again, this is a very broad-ranging strategy. Originally dominated by risk-arbitrage, this has now broadened out to reflect a much more diversified range of corporate events and quasi-events. It combines a fundamental analysis of companies that can hopefully be alpha-generating in and of itself and a probabilistic framework that assesses the upside and downside of specific events, allowing managers to take long and short positions, thereby limiting market exposure and creating alpha. In actuality, practitioners vary from completely long to virtually market neutral. The sector benefits from the level of corporate actions that stem from volatility, interest rates, high priced scrip (shares), etc.
Thumbnail: Potentially highly alpha-generative, but often a high component of beta. Often long fallow periods, requiring active rebalancing unless run as part of a more diversified multi-strategy fund.
– Distress: This entails the investment in the securities of companies going through periods of difficulty, either prior to, during or post the filing of bankruptcy proceedings. It requires an ability to analyze the entire balance sheet of a company, understand the market environment for its sector, a full analysis of the legal ramifications of different actions (and the concomitant probabilistic outcome analysis), an understanding of the strengths – real and perceived – of holders of various classes of securities and a capital base that matches the duration of the securities in which the fund invests. This is often largely a net-long strategy, but the beta will vary considerably depending on the class of security invested in. Bank debt with short-term maturities can have virtually no beta, whereas junior subordinated debt in pre-petition companies can have betas of 2 or 3, as can post-bankruptcy equities. Liquidity is often evanescent and patience is required. It is also a highly cyclical field – opportunities exist most when default rates are higher and debt is hard/expensive to issue. There can be very long periods when the returns to this area can be dull and disappointing, and losses can be very high in the event of a large shift from optimism to pessimism.
Thumbnail: Often strong alpha potential, although a distinct beta component. Need a willingness to accept illiquidity. Often high differentiation among market participants.
– Global Macro: By definition a very broad category, almost un-definable and frequently unpredictable. A manager can be diversified or focused, levered or unlevered, directional or not (either way); the general unifying definition is more top-down than bottom-up. This is the ultimate game of combining conviction with timing. Most fail; those who succeed can do so in a spectacular way. This is generally used as a diversifying strategy, which it often is. Unfortunately, the downfall of many macro traders is being down as much or more as beta managers during market meltdowns or periods of illiquidity that they didn’t anticipate.
Thumbnail: A potential diversifier with strong alpha, but not necessarily a hedging strategy. Can have enormous beta at times, but not predictable. Enormous long-term differentiation among participants.
– Short-term Trading: This can be both purely statistical, purely qualitative or a combination of both. A true believer in efficient markets would dismiss the alpha generating capability of this area. However, markets often don’t adjust as quickly as they theoretically should and there are practitioners who can profit from this. The returns are often very uncorrelated and the area has had a more constrained downside than the other strategies outlined here. The upside, however, is also constrained and any analysis needs to carefully factor in the high frictional costs required to generate often modest absolute long-term returns.
Thumbnail: Potentially alpha generative, with limited downside, but with relatively constrained absolute returns relative to fees and expenses.
– MBS: Historically a very large area of issuance, much more reduced since the sub-prime debacle. The securities are in and of themselves highly complicated and the strategies of trading around them equally so. The pure relative value plays, included in the category above as well, have often generated steady returns for a period but have then been subject to severe damage in many periods of illiquidity or unexpected shifts in the shape of the Treasury curve. We don’t anticipate this to change. For more tactical investors, because of the complexity and mistrust, there can be periods of interesting risk-adjusted opportunities. Not an area for those not willing to drill down deeply and fully understand the risks.
Thumbnail: Very uncorrelated, with distinct alpha generating potential, but a high level of complexity and many other forms of risk.
– CTAs: The trading of hard and soft commodities and financial instruments can provide highly differentiated returns. Depending on the leverage and directionality, the risks can be extremely high. Often viewed as a good hedge for the rest of the portfolio, this can be true. However, as most CTAs depend on trend following, a rapid shift in a trend, contemporaneously with a shift in the markets can result in CTAs being down as much or more as their supposedly more directional counterparts.
Thumbnail: Potentially a diversifier and alpha generator. Uncertain levels of beta. Risks depending on leverage and ability to shift out of trends at the right time.
What are investors looking for?
Returns! Obviously, investors are always looking for returns. Their equity and fixed income allocations are what they are. They have portfolio guidelines they need to meet and allocate accordingly. These are mainly beta-driven, with a desire in many cases for alpha around the margin. Although the events of 2008 and their impact on alternatives put most strategies and managers in the penalty box, the concern about the bounce-back, over-valuation, risk of rising interest rates has brought many PMs back to considering various options within alternatives. However, experiences of the past have an impact on current investment patterns. In some instances this is very productive – i.e. taking more time to understand an underlying strategy, questioning process, structure, fees, governance, etc. In others, it surfaces contradictions – i.e. as a result of bad experiences with redemptions, seeking greater liquidity in strategies that can’t fundamentally support it. Ironically, it has also shortened the measurement time–frame for many managers. Strategies that previously were measured on a rolling three-year basis are perhaps now measured on a rolling one-year basis. This sets an expectation of behavior pattern for managers and allocators – you will be measured in a certain way, therefore it behooves you to try to maximize returns over that time period (with the unstated and perhaps unintended ellipsis of “whether or not that fits your strategy and/or style”). There is a huge current premium on ‘beta alpha,’ the ability to time allocations in and out of strategies. In the old days that was called market timing – tried by many, successfully implemented by few. The same is true today. Looking back three years from now there will be a group of winners and a much larger group of losers.
Speaking two years on, my guess of a three-year time window has understated the willingness of governments to maintain an easy money posture. My conclusion is no different, merely pushed out by some period.
