This is the second of three postings we plan on Alexander Ineichen’s new book Asymmetric Returns. In it, Ineichen argues that alpha is the result, not of security-selection per se, but of downside risk mitigation. Ineichen argues that we are experiencing a “paradigm shift” or “period of enlightenment” in asset management. So if you like this blog, you’ll love this book.
According to Alexander Ineichen, creating alpha is all about creating option-like (asymmetric) return profiles at lower-than-option prices. To prove his point Ineichen compares several hedge fund strategy indices to hypothetical capital guaranteed structured products that, by design, also have asymmetric return profiles. He then poses the question, “If the asymmetric return profiles advocated in this book can be obtained passively, why pay an active fee?”
Ineichen’s conclusion: “…active risk managers need not worry any time soon” about being replaced by simple structured products. (Professor Harry Kat, who argues that hedge funds can be closely approximated by dynamic (passive) trading strategies, might argue otherwise):
“Structured products offer asymmetric return profiles that suit the loss-aversion properties of investors. However, the cost of these products narrows their return significantly. There is no alpha in those products. They typically lie below the capital market line, not above.”
In case his point is not clear to the reader by the half-way mark in his book, he cuts to the chase in Chapter 5, actually calling it “Alpha is an Option”. This chapter – and its appendix – contain a number of interesting notions of alpha…
The “Alpha Engine” Revisited
It is clear that Ineichen believes markets are not 100% efficient. In fact, he compares the efficiency of financial markets to the efficiency of physical system such as a piston engine:
“Physical systems are often given an efficiency rating based on the relative proportion of energy or fuel converted to useful work. Therefore, a piston engine may be rated at 60 percent efficiency, meaning that on average 60 percent of the energy contained in the engine’s fuel is used to turn the crankshaft, with the remaining 40 percent lost to other forms of work such as heat, light or noise. No one would expect 100 percent efficiency.”
Since markets cannot be 100% efficient, Ineichen says alpha cannot be 100% isolated. Ineichen argues that alpha comes bundled with other risks and that pure alpha is best regarded as a “thought complex, an ideal world to which the real world can be compared.”
Modeling: A Superficial Industry
Still, he acknowledges the financial world’s quest to quantify alpha and separate it from beta and he shares his thoughts on factor modeling:
“The idea of factor modeling is essentially to play around with the data long enough until one finds empirical evidence to prove one’s preconception, that is, curve fitting, then go on and pretend one has found something meaningful such as cause and effect.”
Again, Ineichen uses an example to prove his point. He shows the results of a regression analysis using Fama & French’s three factors (the index, value/growth & market cap). He acknowledges that these three factors explain a significant portion of the volatility of the HFRI Equity Hedge Index between April 1997 and March 2003.
But he goes on to say that this 1997 to 2003 time period can be divided into two “regimes” – a bull and a bear market. So he runs the same regression on each period individually. His results: the correlations to each of the three factors changed dramatically between the two regimes. In other words, equity hedge fund managers adapted to the new regime by jumping to another horse mid-period. Says Ineichen:
“We call successfully adapting to changing market circumstances skill and regard it as of great value to the investor. We think this is part of alpha. The optionality is that the investor has a call-like option exposure to factors. If growth works, the risk to growth is increased. If value works, the risk to value stocks is increased.
investors who are capable of introducing a bias toward the current regime are producing alpha even though factor modeling tells us that, looking back, it was actually beta.
Your Scorching Case of Kurtosis Isn’t Really That Bad
Throughout the book, Ineichen also questions the use of kurtosis as a risk parameter. He argues that standard deviation is far more important than its 4th (moment) cousin by actually analyzing the tails in the distribution of (fat-tailed) hedge funds and (thin-tailed, but higher volatility) market indices. In case after case, he shows that the low standard deviation of most hedge fund indices makes up for the relatively fatter tails of these returns streams.
The more important metrics, from Ineichen’s viewpoint, are the ratio of the size of monthly gains to monthly losses (the ratio of magnitude) and the ratio of the frequency of gains to losses (the ratio of frequency). Thus, he spends considerable time working through each of the primary hedge fund strategies, comparing them to passive strategies geared to match their volatilities. As you might expect, the hedge funds come out on top in nearly all cases.
Alpha and the “Renaissance Man”
Asymmetric Returns is chalked full of colourful analogies (giving Lars Jaeger and others a run for their money). But perhaps the most useful and insightful analogy in the book is one that we have heard applied to other disciplines, but not yet to the hunt for alpha:
For his statue of David in 1501, Michealangelo used a single block of marble. For Michaelangelo, sculpting meant to take away, not to add, since the sculpture already existed inside the block of marble. The stone was just covering a work of art; the sculptor only had to take away the parts in excess. The sculptor’s hand, guided by skill and experienceneeded to free the idea inside from the superfluous matter surrounding it. One could argue the alpha in capital markets is already there. One just needs to hedge (take away) all the various unwanted risks in order to carve it out.
We find Ineichen’s Michaelangelo analogy is more complimentary than Jaegar and Wagner’s garbage bag of a regression analysis, more achievable than their dark matter and less scary-sounding than Mark Finn’s “swarm of bees“,
Ineichen’s book also borrows heavily from philosophers. Case in point:
“The current period in financial history could be viewed as being akin to the period of Enlightenment in Western thought. The period of Enlightenment too was characterized by an abandoning of long-held beliefs and intellectually constraining doctrines….Immanuel Kant’s ‘The Critique of Pure Reason’ was one of the markers signaling this important inflection point.”
While Ineichen says the work of several authors might be the modern equivalent to Kant’s work, there is no question that Asymmetric Returns itself represents a landmark “critique of pure (long-only) reason”.
– Alpha Male