Alpha, My Local Seven-Eleven & Octane

CAPM / Alpha Theory 23 Aug 2006

By: Alpha Male

Like many suburban North Americans, I am blessed with a local 7-Eleven.  Mine even has a gas-bar.  Last week while filing my car, I was reminded of a common fallacy about hedge funds.

As with most gas stations, I am provided a choice of octane rating in my gasoline.  The good folks at Seven-Eleven suggest that a higher octane rating will make my car go faster.  After all, higher octane-rated gasoline is commonly known as “premium” gas.  Now, I’m no chemical engineer, but octane sounds kind of dangerous to me.  And I’m not the only one – The Merriam Webster Dictionary defines “high octane” as, “very powerful, strong, or effective”.

“So without any octane, my car probably won’t go”, I thought to myself as the pump started to fill my car.  If this gasoline contained only the “other” components of gas, it wouldn’t work in a car’s engine.  I guess my car could role down a hill in neutral, but it wouldn’t drive on its own.  Maybe I could hook up a sail and ride a tail-wind to work.  (But how would I get home?)  Obviously, if my car didn’t drive on its own, it would be useless to me.  After all, I could buy a bicycle for a lot less if I just wanted to ride down hills.

My car is valuable to me because of octane.  Then again, my car is a lot more dangerous because of octane.  Without octane, my car would sit idley in my driveway and not cause problems for anyone.  I might occasionally push it up the small hill at the end of my street and ride it back to my driveway for kicks.  But one thing would be for sure: no one would get hurt.

With a carefully calibrated proportion of octane, my car works just right.  It idles well and it can pass a tractor-trailer in a hurry if needed.  Of course, I could get in a car crash.  I might run over a squirrel.  I might even park in a loading zone and get towed… But that’s the risk you take in order to use a machine that drives – under its own power – to where ever I want to go on God’s green Earth.

If my car ran on 100% octane, it would be quick indeed!  There is a reason aviation fuel has the highest octane rating.  Aviation fuel would be inadvisable in my puny Volvo to say the least.

“So Octane is a blessing and a curse”, I thought to myself as the gas pump reached half-way.  And that’s when I realized that octane was to gasoline as alpha was to mutual funds. And gasoline was to my car as mutual funds were to my portfolio.  Without octane (/alpha) gasoline (/a mutual fund) is useless.  You could always rely on other natural (/market) forces like gravity or wind (/betas) to make your car move forward (/generate returns).  But your car could never move under its own power on flat surfaces (/generate returns in flat markets).  With no octane in your gas, you might as well buy a bicycle (/ETF).  It’s a lot cheaper and will work just as well as your useless car (/mutual fund).

But Too much octane (/alpha) could be dangerous.  Sure, you might generate great speeds (/returns), but you probably don’t know enough about driving (/hedge fund investing) to do this safely and you are more likely to get into a serious accident (/”blow-up”).

Strangely, few car accidents have been blamed on the octane in gasoline even though octane has been the one common element at every car accident in recorded history(!).  You see, Alpha, like octane, is neither inherently good nor inherently bad.  It is a necessary requirement of all actively managed funds.  It is inadvisable to fill your whole portfolio with pure alpha strategies (i.e. hedge funds) and it is inadvisable to fill your whole tank with pure octane.

Gasoline contains octane whether you like it or not and mutual funds contain “embedded hedge funds” (a.k.a. alpha) whether you like it or not.  Hedge funds and octane are most valuable when they are mixed at just the right proportion.  Nothing can guarantee you reach your destination safely or on-time.  Other factors might conspire against you (the weather, traffic etc.).  But just the right amount of octane (/alpha) is a necessity and will at least give you a fair chance of getting from here (/today) to there (/retirement) faster than just rolling your car down a hill.

The gas pump at 7-Eleven stopped with a thud and snapped me out of my benzene-fume-induced daydream.  As I headed into the store to pay, I realized that when people say “I don’t want any hedge funds in my portfolio – look what happened to Long Term Capital Management!” it’s like they are saying “I don’t want any octane in my car – look what happened on the freeway last week!”.

The bottom line is that if the 7-Eleven gas bar is really in the octane business (which it is), then mutual fund companies are really in the hedge fund business.

Now if only mutual fund companies also sold those Danishes with the sugary icing…

– Alpha Male

Footnote: the auto enthusiasts and gas station attendents among you will note the other interesting similarity between “octane rating” for gasoline and “embedded hedge fund content”.  Octane rating does not refer literally to the amount of octane in gasoline.  It actually refers to the behavior of the gasoline and compares it to the behavior of a hypothetical mixture of octane and heptane (a hydrocarbon with some opposing properties to octane).  In other words, the octane rating is the proportion of octane in the octane/heptane combination whose characteristics exactly match that of the gasoline.  This means that your gasoline does not literally contain 87% octane – it just behaves as if it did.  It behaves this way because each of its several dozen actual hydrocarbons in the gasoline shares some common characteristics with octane and some with heptane.  The aggregate effect of the “octane-like” qualities and “heptane-like” qualities is described as if it were actually real octane and heptane.

Similarly, a mutual fund does not literally contain a hedge fund and a passive market beta (e.g. an ETF).  Of couse not.  A mutual fund might contain several dozen stocks – each with characteristics of the market (beta) and an embedded hedge fund (alpha).  Like the octane rating, we can also describe a mutual fund as if it were literally a combination of an ETF and hedge fund.

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