By Julie Segal  Institutional investor Sept 18,2013

Intense competition, technological advances and regulatory changes have left [institutional] investors struggling; raising the question “is alpha dead?”

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Alpha continues to shrink and become more rare

 

The margin between the best and the average manager is narrowing, so the results get narrower

…Michael Mauboussin, head of global financial strategies at Credit Suisse in New York, had shown me statistics that he had prepared for a Columbia University class on security analysis that he was teaching, illustrating that the margin of out performance – that is, alpha – of US large-cap mutual funds has been steadily shrinking for 40 years. “The difference between the best and the average manager is narrowing, so the results get narrower,” says Mauboussin.

Trend of US Large-cap fund manager performance and distribution anotated

 

 

 

 

 

 

 

 

 

There’s been a big decline in the % of managers beating their benchmarks

[Suzanne Duncan, the 40-year-old global head of research for State Street Corp’s.Boston – based Center for Applied Research]…cites a joint paper from the Center for Applied Research and the Fletcher school of Law and Diplomacy at Tufts University that found less than 1% of 2,076 US mutual funds tracked between 1976 and 2006 achieved superior returns after costs. She also refers to a working paper from the University of Maryland that reports that before 1990, 14.4% of equity mutual funds delivered alpha, whereas in 2006 only .6% of the managers could say the same thing. The authors define funds that produce alpha as those having stock – picking skills sufficient to provide a surplus beyond recovering trading costs and expenses.

Increasingly, luck may be the factor separating today’s top-performing manager from their equally skilled peers

… [The Paradox of Skill], a concept developed by the late biologist Stephen Jay Gould to explain that in many fields, as people become more skilled, luck ironically becomes more important in determining outcomes. “Absolute skill rises, but relative skill declines, leaving more to luck,” Mauboussin explains.

… In investing the paradox of skill means that many managers are producing similar results. In other words, alpha is going down.

Was alpha more plentiful in the ‘good old days’?

…For [Peter] Lynch [manager of Fidelity Magellan fund] alpha was easier to get in the beginning than at the end. Mauboussin points me to the work of finance professors Jonathan Burke and Richard Green, which shows that between 1977 and 1982, when the market was still below its 1966 high, Lynch produced a mind – boggling two percentage points of gross alpha per month. During his last five years managing Magellan, Lynch delivered 0.2% monthly in gross alpha, as the fund had grown from about $40 million when he started to $10 billion in assets.

Some of the low-hanging fruit has been plucked

…Investors benefited from the profits to be had in whole new categories of investments, such as high – yield bonds and the ability to tap international markets. “Some of the low – hanging fruit has been plucked,” says Robert Hunkeler, who has overseen International Paper Company’s pension fund for more than 16 years. “When I think back to the 80’s and early 90’s, it wasn’t uncommon that a large allocation to international equities would have given you a big leg up over your competition. High – yield bonds were still called junk bonds, and many people didn’t invest in them because of that. Those were what I call cakewalks.”

Fiercer completion makes it harder to produce extraordinary returns

[Mark Lasry , co-founder of New York – based Avenue Capital Group, a $12.3 billion alternative – investment firm that specializes in distressed investing] …makes the point that fiercer competition has made it harder to deliver returns. He says that debt that he buys at 65 or $.70 on the dollar today might have been purchased for 60 or even 50 cents years earlier. “As people understand what we do, sellers hold out for higher prices,” he says…

Harder to detect alpha when market returns are subdued?

…Investing in a low – return environment is extremely difficult. Returns for both stocks and bonds are expected to be in the single digits, at best, for the next several years, if not for the rest of the decade. Even a great alpha generator will deliver less if the pie is smaller.

Is alpha buried under near-zero risk-free rates?

… With the risk – free rate at a record low, it’s more difficult than ever to produce alpha. But it’s a great time to be writing about how difficult it is to find alpha, because investors rarely think about the increased risk that low interest rate’s present, Mark Lasry insists. “It’s just mathematically harder to find alpha because the risk-free rate is now essentially zero,”… Asset managers… measure potential investments against what they could earned by taking no risk, such as sitting on cash. At the start of 2008, the three – month LIBOR rate was 5%. Investors were paid 5% to sit on cash, or Lasry could take two times the risk-free rate to make a 10% return. Now, with three month LIBOR at 25 basis points, he has to take 40 times that risk to earn the same 10% return, which is what investors are demanding today.

Alpha Sightings

Does alpha thrive in niches?

…[ Credit Investor GSO Capital Partners, co-founded by Bennett Goodman has] …shown an uncanny ability to consistently produce alpha by investing in a niche part of the markets – analyzing the credit needs of struggling companies and then devising complex one-off solutions so these companies could survive, for which GSO charged a handsome rate…

The advantage of a long time horizon

… [Ashbel (Ash) Williams Jr., the 58– Year – old CIO of the Florida State Board of Administration points to the SBA’s inherent advantages of] its large size and long – term investment horizon… Williams walks me through an investment from the early 90’s that brings the point home. At the time, many California vineyards succumbed to phylloxera, a fatal disease that gave winemakers only one option: to burn their grapevines, sterilize the soil, replant and wait. Unfortunately, 15 years can pass before grapes are suitable for wine making again. In California the long wait knocked out a lot of interest, allowing the state of Florida to buy at distressed prices some of the US’s best land for grape growing.

Picking up alpha in “capital gaps”

… [Rosalind Hewsenian, CIO of the Lenora M and Harry B Hemsley Charitable Trust,] believes alpha is potentially plentiful when capital is scarce. Despite the intense pressure on alpha, it can still be found in what she calls “capital gaps.” But filling those gaps takes resolve, and the risks are higher than in the past. “It’s a scary thing to do, particularly when most people have spent their careers riding the beta wave,”

Creating alpha through activist investing

…[Christopher Hohn, head of the Children’s Investment Fund Management (UK) says few investors]… want to deal with any company that is facing a corporate governance issue, nor do they want to take on the risks, including the possible public relations gaffes, of activist investing. As an example, he points to TCI’s investment in News Corporation following its phone – hacking scandal in 2011, when most investors were fleeing the media giant.

Smarter

… [Fortress Investment Group principal Michael Novogratz] suggests what institutional investors hate to hear and what many managers I spoke to for this story wouldn’t say on the record: he’s smart.

“It’s hard to teach young traders this,” he says, referring to macro investing. “You’re either good at it or you’re not.” Most asset managers won’t say they’re smart – at least, not in public – because their investors want to hear about a formal investment process that can be taught and repeated. They want alpha to be sustainable.

It’s alpha to you

…[ Clifford Asness, managing principal of Greenwich Connecticut – based AQR capital management] … offers an enhanced version of the strategy Asness pioneered at GSAM, but the firm is transparent with clients about that and charges far less for it than would have been the case 20 years ago. Asness explains that the strategy improves portfolios risk return characteristics, even if it’s not technically alpha in the sense of a secret sauce that no one knows about. “We use the phrase ‘it’s alpha to you,'” he says.