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Where has all the alpha gone?

Tim Rudderow
Tim Rudderow is CEO and chief investment officer of Mount Lucas Management Corp., Newtown, Pa.

These days, many investors seem to be paraphrasing a 1960s protest song: Where has all the alpha gone?

That, of course, depends on what you think “alpha” means. The standard definition says alpha is the ability to consistently outperform a well-defined benchmark. It is notoriously hard to measure, in part because most managers do not have track records long enough to meet the “consistently” test.

If we go by this definition, there are three primary forces squeezing alpha out of the alternatives space: better information, better liquidity and better benchmarks. By examining these obstacles, we can draw up a more accurate conception of alpha, as well as solutions for capturing it.

The information age

Information is everywhere and free. The arbitrage of legal information is gone, and along with it the associated alpha.

In the past, smart (and resourceful) investors had private sources of intelligence strategically positioned around the country, or the world, with access to select information. This kind of information is now more easily accessible online or through other ubiquitous sources.

Liquidity

Not too long ago, everything from high-yield bonds to emerging markets stocks was traded by appointment only. Today, you can buy a whole basket of different securities around the globe with the press of a key. Even something small, like moving stock transactions from fractions to decimals, eliminated the edge on a whole range of alpha strategies.

Capital continues to flow into the alternative space, and working for hedge funds or private equity shops has replaced consulting firms as the premier job for highly educated wunderkinds. There is no shortage of bright-eyed go-getters running through the financial forest chasing the same limited resource.

Benchmarks and 'mismeasured beta'

This might be the most problematic force of all, if only because it's the least analyzed.

Let's take a step back. In the '60s and '70s, academic research on mutual fund results indicated a better benchmark definition (i.e. comparing a manager to a small-cap index if she owns small-cap stocks) diminished the perceived value added in fund results. In the past 20 years or so there has been an unknown quantity of permutations of alternative beta, hedge fund replication, liquid alts and other repackaged versions of the same theme, all to figure out if there is beta in the macho alpha alternatives space.

We've had personal experience with this. In 1988, our firm initiated a managed futures program for Eastman Kodak Co.'s pension plan. Once the account was up and running, we came upon a critical problem: There was no appropriate benchmark for managed futures.

In order to properly measure our performance, we created a benchmark from a simple model of what we believed to be the risk transfer process in futures markets, entirely based on market prices. After a few years of trading and calculation, we arrived at the conclusion that this simple, passive benchmark — even in an alternative asset class — was hard to beat. As beta started to be measured more accurately, the “alpha” we thought we knew suddenly vanished.

What we experienced years ago is just beginning to develop in the broader alternatives space: Better benchmarks mean less alpha. In fact, we have become certain that when people say “alpha,” they actually mean mismeasured beta. Alpha never died; it just never existed in the quantity that managers want you to believe.

So, where's the alpha?

This may seem bleak, perhaps even ego-deflating. But believe it or not, there are reliable sources of real alpha out there for both managers and asset allocators. The most important thing is to do what others don't, to move against the cyclical flows of fashion. This may seem like simple advice, but few are actually doing it.

Recent studies, including ”Active Share and Mutual Fund Performance” by Antti Petajisto in 2013, reinforce this point. Mr. Petajisto shows that long-only managers who consistently deviate from the benchmark, meaning those with a higher active share, tend to outperform. In fact, he concludes, “the most active stock pickers have been able to add value for their investors, beating their benchmark indexes by about 1.26% a year after all fees and expenses.”

Let's apply this principle to the alternatives space with a recent example. At the end of 2008, in the death throes of the financial crisis, allocators struggled to find strategies that had outperformed. Many flocked to managed futures, which typically excel in periods of high uncertainty. There was a rush to invest. The result? Five years of flat performance.

What managers should have done instead was bought mortgages, the pariah of the crisis. Baskets of mortgages were priced such that, even with further defaults and limited recovery, investors still got the Treasury yield. This was effectively a free option, which numerous managers passed up.

So, where is the alpha? It's wherever human behavioral bias preys strongest. The lesson here is to take risk — you can't expect a manager to outperform and still look like everyone else.

Tim Rudderow is CEO and chief investment officer of Mount Lucas Management Corp., Newtown, Pa.