Alpha Today, Gone Tomorrow?

Is alpha going the way of the buggy whip? Short answer: no. It is simply that the alpha generation game has changed, and has certainly become more competitive. Is the ability to extract alpha from conventional sources of information becoming harder? Of course - with more managers staring at the same news and data and more dollars chasing the same trades, what would you expect? And Reg FD in the U.S. hasn’t made getting an edge any easier. But this just means that investors need to cast a wider net, think more broadly and to develop new approaches for making money. This might include:

• Expanding geography



• Incorporating new asset classes



• Moving down the liquidity spectrum



• Considering behavioral finance principles



• Investigating and extracting value from new and different types of data

Needless to say, simply doing these things is not a panacea and may result in value destruction - not value creation - if not done in an intelligent manner. Distraction and lack of focus is the root of most evil. The point is to leverage one’s skill sets and competencies into related areas, where intellectual property that has previously  been focused on what are now over-trafficked areas are deployed against less efficient markets.

The Economist recently ran a piece discussing Lo and Patel’s December 2007 study on 130/30 funds, the punch line of which seems to imply that active managers are simply not generating that much alpha relative to passive strategies.

Fund-management skill is becoming rather like the 19th-century
concept of a “God of the gaps”. Once humans attributed the weather or
earthquakes to divine intervention; then they discovered high-pressure
systems and plate tectonics. The number of events that required a
heavenly explanation (the gaps) grew ever smaller.

Skill, or alpha, is fast becoming a residual: the explanation that
remains when all other factors have been discounted. That is not yet a
crisis for the industry, mainly because it is still so hard for clients
to distinguish skill from luck. But for any thoughtful fund-management
executive, it ought to be a long-term worry.

I guess the operating word here is “thoughtful.” If there are any fund-management executives out there that feel they are doing just fine and that innovation is not necessary, they should probably be shown the door (or suffer massive redemptions). As the provision and dissemination of information gets more uniform, it will require more work to unearth alpha-generating strategies. It could mean more intensive research in new markets and under-covered instruments. It might imply new quantitative approaches leveraging not only new sources of data, but new analytical frameworks to extract signal across these source types. As the world flattens, new markets emerge and previously inefficient markets become more developed, “chasing the news” is simply not going to cut it. But by the same token you can be sure that smart and thoughtful money managers will continue to innovate, and will always find ways to generate true out-performance.

The sentiment of The Economists’ article reminds me of the quote (taken out of context, I believe, but powerful nonetheless) attributed to Charles Duell, the former U.S. Commissioner of Patents in 1899:

“Everything that can be invented has been invented.”

It was a silly statement then and it is a silly statement now. Bright people the world over will always make innovation happen, and there are more and more of them focusing on making money from the markets every day. Alpha generation is a phenomenon that will always be available to the smart, hard-working, creative and deeply talented. And while it may be “harder,” that only really means that it is harder for those who are either unwilling or unable to adapt to a changed environment. Value is value, and the best will always be able to find it.

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COMMENT:

AUTHOR: Yaser Anwar

EMAIL: yaser@yaseranwar.com

URL: http://www.yaseranwar.com

DATE: 01/11/2008 09:45:50 PM

Africa is the place to be currently IMO. They’re scheduled to host the Soccer World Cup in 2010, as such lots of opportunities in Real Estate/Construction, Hospitality, Infrastructure and especially Water.

A certain sell-side firm I was meeting said one of the biggest HFMs (no names due to the confidential nature of the talk) has been looking to start an Africa-only fund in Q1 of 2008.

Similarly, Africa is VERY underdeveloped in terms of technology, probably the most, so there are considerable opportunities for long-term thinkers to create eBays of the world/MercadoLibre if you’re from LATAM et al. 

Yaser

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2 years ago | view comments |  Investing