What Actually is Alpha? Revisited
Our astute readers will remember that we wrote on the subject of alpha a few months ago What Actually is Alpha? But as we wake up to a week of heavy stock, bond, and commodity market losses, we thought it prudent to revisit the subject matter. Particularly, as it is also so opportune to evaluate our managers and their claims to deliver positive returns, e.g. alpha under any market conditions.
So, let’s first of all dispense with the so called “absolute return” strategies that promise positive returns with a combination of (long) stocks and bond positions. How have they done in the last few days and weeks? Turns out not so good, and that is simply because both the stock and bond markets went down. But how can that be, given all the talk of “absolute” returns? And what of the relentless assurances that stocks and bonds behave differently and therefore you will always make money somewhere? Well, the less said the better given this evidence, but clearly this strategy is anything but alpha.
What about any other strategies that only buy things, e.g. value investors, stock pickers, macro geniuses – how did they do when the markets went down? They went down. Alpha? Not so much. But what if the benchmark is down more? Don’t really care. We just want alpha, remember: the stuff that makes money if the market or benchmark is up or down. Right, no alpha here then.
So really, the only way to produce alpha is to also sell (short) something, e.g. to have a market neutral strategy, whereby you speculate on the relative movement of prices and not the market direction. How have these strategies done in the sell off? Well, foremost it would depend of course on if they are truly perfectly hedged or whether they have a net long position, e.g. they buy 100, but only sell 50 against that. Why do that? Because markets tend to go up and they can charge a 2% management fee and 20% performance fee and get a free lunch. How do these strategies do when the markets go down? They go down, shocker.
Moving along, what about all other truly market neutral strategies? Well, this is where these market sell offs help and we encourage everyone to check how their investments have done now. We have had nearly 8 years of market gains, everyone looks like a genius and talks of alpha and adding value are everywhere. Let’s see how the hedging and alpha generation truly works when the chips are down. We already highlighted our favourite excuses we always hear and are likely to hear again: “well no one could have expected this” or “sorry, it was a 23 standard deviation event”. Sure, just give me my money back please, I can buy the market for 0.10%. I will look for alpha where it is actually proven to exist, and so easy to see when the markets go down.