By: Randy Cohen, Harvard Business School & Kerry Stirton, Stellation Asset Management
Published: August 2006, The NMS Exchange
Alpha Male spent this morning speaking about our favorite topics at the “World Hedge Fund Summit” in Toronto. Other session topics were consistent with similar hedge fund events around the world. But one of my favorite speakers at this particular meeting every year is Randy Cohen of Harvard Business School.
Along with Kerry Stirton of Stellation Asset Management, Randy penned a great piece called “Are Hedge Fund Fees a Bargain? And Other Conundrums of Balancing Active and Passive Management” in the August 2006 edition of The NMS Exchange, an investment management newsletter serving the endowment & foundation community. Their thesis:
“(Pensions) should eliminate commitments to structurally underperforming long-only active managers…Active hedge fund managers who aim their sights directly at alpha generation are a much better deal, as are passive index funds that secure market exposure or beta at a cheap cost.”
Like Ross Miller, Cohen & Stirton argue that the effective fee for active management embedded within an index-hugging long-only mandate is much higher than commonly realized:
“(Long-only) managers often hug their benchmark for safety’s sake. It is common for managers to have 90% of their returns explained by the returns of simple benchmark portfolios like the S&P 500 and the Russell 2000. Investors end up on the receiving end of a product that, for 90% of its substance, is effectively an index fund. They pay about 1% of total invested assets, yet they only receive 10% attempts at alpha and 90% beta in their specific capital market.”
“No wonder (active long-only) managers have so much trouble outperforming passive benchmarksâ€”the fees are so high, for so little active management, that only a genius could overcome them. ALO managers have found a fee structure that makes the 1.5% management fee plus 20% of profits charged by hedge fund managers appear a relative bargain. Not only are hedge fund fees sure to be much lower on average (per dollar of true active management), but the fees are tied to performance in a way that serves to better align incentives and save the pain of paying very high fees for poor performance.”
The authors go on to show that an “ETF+Market Neutral Hedge Fund” strategy also trumps long-only from a risk management perspective. They point out that less efficient markets (such as emerging markets) provide higher alpha potential, but are so small in relation to global equities, that they don’t represent adequate diversification. Conversely, highly efficient markets (e.g. US, Europe, Canada) have less alpha potential, but are more diversified. The conclusion: buy your beta in the US and your alpha in emerging markets. Regular readers will note they are essentially advocating a portable alpha strategy – except the alpha is “ready-to-port” and does not need to be distilled from an emerging markets long-only manager.
Which begs the question: Whither long-only managers? Thankfully Cohen and Stirton see hope:
“A fund manager could potentially offer a very attractive alternative to fill the slot occupied by the passive portfolio…with a product that charges fees only slightly higher than passive (say 20 or 25 bp), offers diversification only slightly less (and volatility only slightly greater) than the index itself and attempts to select a large group of stocks that will outperform by perhaps 50-80 bp. Essentially such a manager is saying, ‘Why not throw out the least attractively priced 200 or so stocks and just buy the rest?'”
“Slightly higher” active management charging “slightly higher” fees with “slightly higher” volatility? Ironically, this sounds just like an ETF and a “slight” amount of a market neutral hedge fund, bringing us back to square one.
I still see the main value of a “bundled” alpha/beta offering (a.k.a. a mutual fund) as being a convenient method of gaining beta exposure along with your alpha. Beyond that, I remain skeptical of any form of forced bundling (at least in theory), no matter how “slight” the bundling might be.
Footnote: Randy Cohen is currently conducting research on the “best ideas” contained within active portfolios. The early results of his research indicate that the largest twenty positions in fund (i.e. the manager’s “highest conviction” positions) produce significantly more alpha than the rest of the fund. If only you could ask for a “best ideas” version of your favorite mutual funds…