Andrew W. Lo, the Massachusetts Institute of Technology finance professor who serves as chief investment strategist of Boston-based AlphaSimplex Group LLC, has argued that innovation is the only way to ensure money management strategies adapt to a constantly changing financial landscape.
For doubting Thomases, the market implosion of 2008 should have been a wake-up call, he says, adding that investors who are pining for a return to normalcy are likely to be wrong-footed by the market's next evolution. With a global population of 6.5 billion funneling trillions of dollars of savings into every type of financial asset, bouts of portfolio-crushing volatility are likely to become more, rather than less, frequent over the coming decade, Mr. Lo warns.
“When you have large amounts of assets being thrown around, you're going to create instabilities,” he said, adding: “If everybody goes to the left side of the boat one day, and everybody runs to the right side of the boat the next, you're going to see that kind of unusual period of volatility.”
Current positions: Founder and chief investment strategist of AlphaSimplex Group LLC; Harris & Harris Group Professor of Finance at the Massachusetts Institute of Technology's Sloan School of Management
Assets under management: $390 million as of June 30
Benchmarks, respectively: HFRI Hedge fund of funds composite index, HFRI Macro (Total) index. Sources: AlphaSimplex, Morningstar and Bloomberg LP.
AlphaSimplex's latest offerings, tailored to address that expected pickup in volatility, started coming out just as market gyrations were taking a quantum leap. The firm's ASG Global Alternatives hedge fund beta replication fund made its debut on Sept. 30, two weeks after Lehman Brothers Holdings Inc.'s market-crushing collapse. The next strategies ASG is set to launch in coming months will help institutional investors hedge against sudden spikes in volatility.
Sept. 30 couldn't have been a great moment to launch a hedge fund beta replication mutual fund. I actually believe the opposite. For a product whose objective is to provide individual investors with an alternative to the traditional stock and bond, long-only kind of asset classes, (with) active volatility management, it was the best possible time to prove itself. I think the mutual fund actually did pretty well from October through the end of the year — down 3.5% or something, vs. the S&P 500 being down 20-something percent. More important, from an operational perspective, the fund had no issues, glitches, problems whatsoever.
And for institutional investors? We just launched the separate account platform (for hedge fund beta and related volatility-management strategies). I think we have something like $130 million, from a couple of clients, and we're in discussions with four or five others.
Would a continued market rebound deflate interest in the strategy? If we go up by another 40-50-60% over the next few months, perhaps, but I think that's unlikely. We've had a pretty traumatic experience, with investors suffering from a disease they didn't know about — diversification deficit disorder.
How are you marketing it? We're talking directly to pension plan sponsors, insurance companies and foundations, (providing) direct exposure to hedge fund betas, customized to a particular plan's needs. For example, one insurance company already had a lot of equity exposure, so we created a beta replication product, but deleted all of the equity betas. It was a simple thing to do.
Your hedge fund beta prospectus showed equities exposure at less than 4%. It varies over time. (One) aspect of our approach that's somewhat unique is we have a fairly targeted level of volatility, and control that volatility pretty actively. In the past, investors have tried to manage volatility by controlling asset allocation between stocks and bonds. In 2008, volatility wasn't stable for either. What we do, using futures and forward contracts, is to increase or decrease the number of contracts dynamically as the underlying volatility of the stock, bond and other markets shifts. So if stock market volatility spikes, as it did during the fourth quarter of 2008, we'll cut the number of S&P futures contracts dramatically.
So, you're not trying to match some hedge fund index? No. We're focusing on absolute returns. What (investors) are looking for from this product is LIBOR plus 3(%) to 5%, produced in a risk-controlled, transparent and systematic manner, and — more importantly — diversification over their largest investments, which are stocks and bonds. Our active volatility management algorithm is basically like cruise control. When you're going up hill, step on the accelerator; when you're going down hill, step on the brakes. The fourth quarter of 2008 was basically all down hill, so we had the brakes on and, as a result, by the end of the fourth quarter our volatility was around 7.5% to 8%, which is what our target was. The volatility of the S&P 500 was more like 50% to 60%.
LIBOR plus 3% to 5% doesn't quite meet pension funds' 8% bogey. We don't view this as a holy grail. Hedge funds are going to have to play an important role, particularly higher risk hedge funds, but you can't put 20% of your pension fund into hedge funds. The industry can't absorb that. You can put 15% into beta replication and 5% into hedge funds. Ultimately, we think that's probably where institutions are going to (invest their assets).
How crowded is hedge fund beta replication now? There are 10 to 15 institutions that are offering beta replication, and I suspect that number will double or triple this year alone. At some point, it's going to be impossible for a full service financial institution not to be able to offer that to their investors. You've got to keep innovating in order to be able to make a business out of it.
Do you have a “Plan B” and “C” and “D”? We have a few more tricks up our sleeve, to take this approach to the next level. What guides our business development is a new perspective on investing. The old perspective — diversify, long-only format, stocks for the long run, control your risk by your asset mix — isn't wrong, but it's incomplete. It ignores market conditions and realities that have come about because of the extraordinary amount of assets that have entered the industry.
One hundred years ago, we didn't have globalization, the population was less than 1 billion; now it's 6.5 billion. The impact on financial markets is profound. What do current market conditions imply about the equity risk premium? What does the current population of investors imply about the dynamics of financial markets? ... The question investors have to ask is “Do you believe that 2008 is an anomaly?” I would argue that, because of the large influx of assets into investment vehicles of all sorts, we're going to see choppiness continue.
What kind of business opportunities do you foresee? One example is this so-called active volatility management approach — cruise control for portfolios, to produce a relatively consistent level of speed for portfolios. We're launching an active volatility management risk overlay product for a large institutional investor that has a number of affiliated asset management companies that it puts seed money in — they have plenty of beta on their own. They hired us to measure the betas of their managers, then eliminate them, using forward contracts. ...
Most pension funds think in terms of monthly and quarterly. The world has changed. They can't do that anymore. If you thought on a quarterly basis, 2008, fourth quarter, you would have been killed.
Institutional investors have to start thinking on a daily time frame, because of the financial arms race that has been developing over the last several years. Technology now enables you to do these kinds of rebalancings on a much more frequent basis, and if you don't avail yourself of these tools, you're going to be behind.