Build-Buy-Lease: Three Approaches to Alpha Generation

CAPM / Alpha Theory 03 Aug 2008

We are pleased to present another commentary from the man who first coined the term “alpha-centric”, Angelo Calvello.  Today, Calvello uses examples such as Man Investments and BGI to argue that there is more than one way for asset managers to become truly alpha-centric.

Special to AllAboutAlpha.com by: Angelo Calvello, Ph.D.

Investors, faced with funding shortfalls and stricter accounting regulations, are demanding innovative ways of achieving absolute returns.  In the process, they are challenging the asset management industry to break down artificial barriers and constraints and consider solutions to problems we did not know existed a year or two ago. 

In many cases, these investors are offering those of us who can provide demonstrable value the opportunity to transform ourselves from vendors into partners who share their vision. The common denominator is the concerted focus on finding and generating alpha. The defining challenge for the asset management industry is to create and adopt business models and mindsets that will allow us to succeed in this new alpha-centric world.

Multiple Sources

Institutional investors are already seeking investment solutions beyond narrow, single-source portable alpha strategies.  They are exploring and implementing multi-alpha solutions that provide exposure to multiple asset classes at the portfolio level.

Because alpha is scarce, transitory and capacity-constrained, these solutions need to be structured flexibly so that alpha sources can be changed as they reach capacity or lose their edge. These solutions must also be structured to provide not just the desired return and volatility targets, but consistent positive returns while avoiding large losses.

We have already seen the effect renewed shareholder and regulatory focus on pension plan liabilities is having on institutional investors. The growing interest in liability-driven investing (LDI) is a direct result of dissatisfaction with current best practices. Institutional investors are increasingly recognizing that their liabilities do not match the asset-class benchmarks in their strategic policy allocation, no matter how those benchmarks might be concatenated. 

Over the next five years in the US, a custom liability benchmark will likely become the minimum risk or risk-neutral position –or in the language of portable alpha, the beta–for many institutional investors, supplanting the asset-class-driven policy benchmark.

Are you ready?

These changes should cause an asset management firm to pause and consider if it has the tools to succeed in this unfolding alpha-centric world (in which success is tied to their ability to consistently and continually create, generate and sell alpha.)

In this unfolding alpha world, alpha will remain scarce, transitory, and capacity-constrained.  To survive, investment managers will have to become alpha hunters, continually searching for alpha.  (Even managers at capacity must act this way because their current alpha source will eventually dissipate and possibly force them out of business).  Asset management firms will have three non-exclusive choices in this search for alpha.  

1. Build

One possibility is to try to build alpha internally.  Asset managers would reward portfolio managers according to their alpha-generating capability.  Vesting the ownership of the alpha sources with the asset management firm gives them control of the process and managers, as well as a full share of all fees. 

However, there are also significant disadvantages. First, given the transitory nature of alpha, the firm is not assured of success.  Second, the firm must have a culture that promotes and rewards generating and selling alpha, and this is not an easy task.

The firm’s ethos must be alpha-centric as well as its organizational and compensation structures.  Not all firms can act in this way, are willing to make the capital commitment or take the business risk required to move to and succeed in an alpha-centric world.  Moreover, it takes considerable time not only to create an alpha-centric organization but to find and generate the alpha, with a long lead time and continued effort to become an alpha-centric organization and to find and generate alpha, with a long lead time before the results can be measured.

Additionally, choosing to build alphas also produces a certain concentration risk—the risk that a single firm can overcome great odds to create and innovate truly diverse sources of alpha.

Because alpha is fundamentally the result of human activity and a manifestation of human skill, it is and will continue to be expensive to attract and retain qualified alpha-generators, on the portfolio management as well as the research and development side.  The recruiting issue cannot be underestimated as more and more firms will be competing for the same talent pool.

On the whole then, building alpha allows for ownership and control but it is uncertain, time-intensive, inflexible, costly, and difficult to implement.

2. Buy

Another option is to buy alpha generators (e.g., individual portfolio managers, teams of investment professionals, existing hedge fund managers). This would allow an asset manager to bring alpha-based products to markets more quickly and to fill in existing gaps in a firm’s product line.  However, this also has drawbacks.

Acquiring any alpha source is difficult, expensive, and suboptimal, given that alpha is scarce, transitory and capacity-constrained.  The obvious risk with buying alpha is, of course, that manager skill, the key intellectual property at stake in an acquisition transaction, is an intellectual resource as fleeting as the alpha it seeks to generate.

Additionally, an asset management firm adopting this approach must have two specific skills. First, it must be able to identify appropriate managers with the skill to ensure a good fit with the acquiring firm.  This is a distinct and value-added skill for which clients pay significant fees to funds of hedge funds.  If an asset manager has this skill, it should set up and manage its own fund of hedge funds.  Second, even if an asset manager can find such talent (either directly or with the help of an intermediary), it must be able to value the alpha and structure a deal to acquire the firm or employees.  This is a specific skill not often found with many asset management firms. 

In a world where competition for highly skilled managers will continue to be high, the firm must be prepared to pay a premium for a transitory and capacity-constrained resource.  (This premium could also include the cost of capital to be allocated to the new firm or employees.)  Moreover, even if a firm can find and acquire good managers at an acceptable price, the acquiring firm will still need the appropriate culture and structure to support the integration and ongoing generation of alpha. 

It must also have a contingency plan to deal with the likelihood of poor performance, alpha erosion, capacity constraints, and manager-related issues.

In sum, buying alpha sources is expensive, difficult to execute well, inflexible, and laden with business risk. It would allow a firm to create or improve its presence in alpha world, but it does not carry any assurance of sustained success. 

3. Lease

Finally, a firm could consider leasing alpha by partnering with external alpha sources.

This has several immediate benefits.  First, it can be done relatively quickly and comes with low start-up costs (when compared with buy or build choices). It also provides the firm with access to a steady supply of renewable alpha sources suited to its needs while avoiding the problems associated with full ownership. (For example, the firm could try before it buys.)  This leasing model is similar to the sub-advisory model used by many firms in the traditional investment management world and what funds of hedge funds do to create their alpha streams.

Of course, there are certain disadvantages to this approach as well.  The asset management firm must still be able to find successful alpha generators and structure an agreement with an appropriate fee-sharing arrangements and capacity commitments in return for distribution concessions.

Perhaps more importantly, the firm must be able to anticipate and forecast new types and source of alpha.  Leasing also requires the corporate humility to acknowledge that the firm cannot provide comprehensive asset management services. 

However, traditional asset management firms with outstanding distribution capabilities might be surprised to find that even outstanding managers currently closed to new investments might be willing to partner for the right kinds of assets.

In sum, leasing is flexible, sustainable, easy to implement, and cheaper than the alternatives.  It removes many of the barriers presented by alpha’s scarce, transitory, and capacity-constrained nature. It does require strategic insights, fee sharing, and the willingness for both parties to admit that the mutual benefit gained outweighs any loss of autonomy. 

The risk with this approach is that the leasee might not be able to continuously find sufficient alpha sources or that clients go directly to the alpha sources. 

Observations

These three options should not be seen as mutually exclusive.  An asset manager could achieve continued success by combining the three approaches. 

Depending on a firm’s business objectives and culture, a firm might start by leasing the required alpha while providing employees with the necessary tools and incentives to create proprietary sources of alpha.  Over time, its direct experience with the leased alpha providers would allow it to determine whether it wants to acquire an ownership stake in these firms.  (This lease-with-the-option-to-buy approach might be more expensive, but it allows the manager to overcome several of the barriers mentioned above: identifying and acquiring successful alpha sources that fit into the culture.)  

Conclusion

The process of deciding whether to build, buy, or lease alpha will shed light on a firm’s strengths and shortcomings. 

Trying to do everything in-house seems a sure recipe for disaster, given the complicated and transitory nature of alpha generation. Instead, those firms that can establish partnerships seem more likely to have success. 

To succeed, firms could consider specifying its alpha needs in terms of amount, stability, beta exposure, correlation, capacity, fees, transparency, reporting, and liquidity, and, perhaps in the short term, contract with a firm that is skilled at identifying and accessing good and available managers.  (If done properly, the use of such a procurement agent would be an interim solution.  In fact, firms should structure the relationship with the agent so to enlist their help in building the internal skills necessary to perform their duties.)

The acquiring firm might then hire an investment bank skilled in such alpha-related deals to help it negotiate a global agreement with these alpha sources to ensure fair pricing.  Partnering could also help a firm augment its capabilities in other areas such as best-of-class risk management, accounting, compliance, or regulatory services.  It also could work for those asset managers seeking to use structured products but lack the necessary skills or balance sheet.  Because asset managers will be pressed to develop all the internal skills to succeed in this space, partnering appears to be the most cost-efficient alternative.  

Several firms have successfully adopted all three options.  Man Investments, for one, is an example of an asset management firm that builds, buys, and leases alpha.  Their leasing operation is manifest in their two large fund of hedge funds group, Glenwood and RMF, as well as in Man Global Strategies.  (I would argue that their management of these leased sources of alpha reflects additional alpha, which in Man’s case was acquired when it purchased Glenwood and RMF but built internally in the case of MGS.)  Man’s recent 50% purchase of the credit multi-strategy hedge fund, Ore Hill, and their 25% purchase of Nephila Capital demonstrates their willingness to buy alpha sources.  The most obvious (and successful) example of Man’s willingness to buy alpha is their early acquisition of AHL, the largest hedge fund in the world.  However, this bought alpha was quickly and successfully transformed into a built alpha as AHL, with Man’s support, built new proprietary alpha sources and techniques for managing capacity. 

Barclays Global Advisors (BGI) also built its business upon proprietarily developed alpha but supplemented it with alpha acquired through strategic hires.  Their recently launched fund of hedge funds business is a pure example of leasing alpha. 

The success of these firms could be attributed as much to their culture as their business models, investment acumen, and management skills.

Whatever combination a firm decides to choose, it is imperative that it recognizes that business as usual is insufficient to compete in this new alpha-centric world. Far-reaching structural and philosophical changes are required by the firm as a whole in order to fully embrace the possibilities presented by this new focus on absolute returns. Anything less will fall short.

Angelo A. Calvello, Ph. D.
Environmental Alpha LLC
acalvello@yahoo.com

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.  

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