The Success of Alpha

CAPM / Alpha Theory 28 Aug 2006

By: Europerformance

This article from the website of Europerformance (a European mutual fund ratings agency) argues

a) that alpha is not the sole domain of hedge fund managers (Alpha Male agrees)

b) that advisors need to adopt alpha as a key measure along with return and volatility (Alpha Male agrees), and,

c) that Sharpe’s style analysis should be used to define a custom benchmark for each manager (Alpha Male thinks this is somewhat (oxy)moronic – see comments below).

Excerpts:

“Alpha continues to give rise to debate in the financial community…The debate is generally monopolised by alternative managers who have made this issue a distinguishing mark of their management…It is nevertheless quite surprising that one associates alternative management with alpha and yet none of the data providers calculates or publishes alphas for alternative management. The delivery of an absolute return in no way guarantees that the management generates alpha.

 

“EuroPerformance has implemented an alpha measurement for long only management with the advice and expertise of EDHEC. This enables the overall yield of a portfolio to be distinguished between the relative contributions from the market to that of the manager. “This new approach to the measurement of performance provides the investor with a more comprehensive analysis of risk and performance.  

“EuroPerformance analyses of European markets have been able to show that alpha is not the sole preserve of alternative management and that traditional managers generate alpha, maybe in similar or even superior proportions to alternative management. It is not the management techniques that produce alpha but their use and there is no reason why these skills are not spread between the two camps!

“The success of alpha is equally convincing in the remarks of Olivier Collin, President of the [French professional body for independent financial advisers].  This is leading investment advisers, and in the future the IFA (Independent financial adviser), to incorporate new sources of information into their work practices. Is alpha now going to follow performance and volatility to become the new absolute in performance measurement?”

While the notion of a custom benchmark seems appealing, it is only helpful if the investor actually seeks such a benchmark.  Firstly, fitting a historical return stream to over a dozen factors is bound to produce a low alpha.  After all, the mathematics of regression are designed to do so.  I have referred to this type of analysis as “gotcha academics” elsewhere on this blog.

Second, knowing a manager’s 12 style-analysis correlation coefficients is only valuable if an advisor or investor is actually seeking these particular exposures.  If the advisor or investor was simply seeking a European mid-cap fund, then knowing a manager’s correlation to mortgage backed securities or the Lehman Agg spreads is not relevent.  One could easily argue that the manager deserves credit for laying on those exposures at the appropriate time (assuming returns were, in fact, positive).

Third, so what if the manager is market timing?  This is still alpha.

Alpha can only be calculated knowing an investors stated mandate for the fund.  The bottom line is that mutual fund analysis runs the real risk of getting ahead of what is useful and needed. 

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