Few will argue with Thomas Schneeweis’ credentials as one of the founding fathers of the hedge fund industry as we know it today. Aside from being the Michael and Cheryl Philipp Professor of Finance at the flagship campus of the University of Massachusetts, he is the founder and director of the Center for International Securities and Derivatives Markets (CISDM) at UMass, the founding editor of the Journal of Alternative Investments and a founding board member of the Chartered Alternative Investment Analyst (CAIA) designation.
AllAboutAlpha’s Alpha Male had a wide-ranging discussion with Schneeweis earlier today. Schneeweis studied history in graduate school before doing a Ph.D. in finance. He became involved with the derivatives industry in the early 1980’s, and has (almost) never looked back. In many ways, his unique career has paralleled the birth of the alternative investment industry itself. But as you will see from his remarks below, his appreciation of history is alive and well.
This interview has been divided into two segments: one to be featured today and one tomorrow. In today’s segment, Schneeweis discusses the recent history of today’s hedge fund industry including the birth of the CISDM, CAIA and the JAI. In tomorrow’s segment he takes on hedge fund replication, the SEC and the future of alpha.
AM: Tom, thanks for taking the time to meet with AllAboutAlpha. Tell me about your background.
First of all, I’m old. I started trading bonds back in the early 1970s and got my Ph.D. at the University of Iowa in 1977. You may recall that we had a little problem with interest rates the early 1970s when Nixon implemented price controls while rates were going up. I figured that running a bond portfolio at that time didn’t make a lot of sense. So I took my winnings and got a Ph.D. instead.
I was lucky enough to graduate at the right time. Futures markets in things like treasury bonds were just starting to take off. I was hired by the Chicago Board to Trade to help with their education on derivatives. The 80s was a great period to be involved with derivatives, but people forget that it wasn’t until 1984 that we had stock index futures.
There was a fundamental change occurring in the investment management industry by the mid 1980s. It was precipitated by the oil crisis in 1974, when many firms ran into problems and the federal government passed ERISA to force pension funds to start setting aside more money. As a result, large pension plans and insurance companies needed to invest large amounts of capital.
Then the Reagan era brought with it large amounts of government debt. This further elevated the importance of risk management. And that led to the growth of interest rate and equity futures by the mid 1980s.
In 1987 we had a little hiccup which eventually contributed to problems in the US banking sector. The first Basel Accord forced banks to increase capital reserves and that caused many banks to rethink what they were doing in the proprietary trading area. As a result, many proprietary trading desks were reduced in size and by the early 1990s we saw what was called the privatization of the trading floor.
With banks reducing their proprietary trading, the 1990s saw the rebirth of managed futures and hedge funds (although most hedge funds at that time were in the global macro and CTA veins). Quite often you get an explosion of new financial products in response to a change in the regulatory environment â€“ like the Basel Accord â€“ or in response to changes in the economic environment as we saw in the 80s.
AM: Notwithstanding these sudden changes, do you believe there is a secular evolution toward more complex financial products?
You know complex is a funny term. Complex to whom? At the very edges of the market, you find relatively unique one-off products that serve the needs of one particular client. In the mainstream, however, financial products have actually remained relatively stable over time. Sure, we have come up with new instruments or ways of handling old risks. But the basic elements remain the same.
AM: But academically speaking, are markets more complete now than in the past as a result of these new instruments?
There are different risks out there in which individual investors would like to engage in or reduce their exposure to (weather, electricity etc.). Those will evolve over time as markets grow, but right now they’re still peripheral. They may get a lot of press, but not a lot of money.
You know, we learn a lot from previous attempts at new products. I believe in an efficient market for ideas. I figure that if I’m thinking about it, there are thousands of other people also thinking about it. The difficult part is putting an idea into practice, setting up the requisite operations and determining if there is enough interest to make it work.
AM: Are you saying that the market for processes is less efficient that the market for ideas?
You can always have a great idea. But that idea may not be economically feasible at a given point in time. The bottom line is that it’s really important for the students I teach to have some historical context of how we got to this point in time.
AM: This brings us to the beginning of the hedge fund industry as we know it today. How did you become involved with AIMA, CAIA, the Journal of Alternative Investments and the CISDM?
As I mentioned, the early 1990s saw a rebirth of hedge funds. As a result of the problems of the 1980s, banks opted to provide services to asset managers instead of managing money in-house. Both the stock and bond markets performed poorly in 1990 and 1991 so people were looking for a place to invest their money. There was also dramatic technological change. Computers allowed people to manage money outside of the construct of a large financial institution. Then in 1992 you had Soros (and the Bank of England), reminding people of the potential gains from investing outside of the traditional corporate structure.
From 1990-1995, I was a consultant with a hedge fund. But by 1995 we learned that we couldn’t manage fund of funds in the same way we had before. We needed to manage them using a whole new level of sophistication. We started CISDM as a response to this general need for greater sophistication. We had the support of UMass alumni Mike Phillip (CSFB) and Anshu Jain (Deutsche Bank), both of whom have been in the industry a long time and had been quite successful.
The CISDM was launched primarily because there was no existing academic or non-profit research center that was dedicated to trading at the time. You had Chicago researching various efficient market hypotheses, Duke on options and Berkley on stocks – but no one concentrated on trading.
Since we studied futures as trading vehicles, we became involved with EMFA (the European Managed Futures Association) â€“ the precursor to the Alternative Investment Management Association (AIMA). We worked with AIMA on some of the early research into the benefits of managed futures and hedge funds (95/96). We also had a relationship with the Managed Funds Association (MFA) here in the US.
But we figured you couldn’t have a research centre without a Journal. So we opened up the Journal of Alternative Investments in 1997. We’re now in our tenth year. The Journal was one of the first forums for people doing research in the broader alternatives industry: hedge funds, real estate, private equity, and commodities. In truth, the existing academic journals of the time weren’t as receptive to publishing research in the alternative investment area.
AM: Why was that?
For a host of reasons. First of all, many reviewers didn’t have a lot of understanding of alternatives. They were more comfortable producing articles in the equities and fixed income areas where people had a broader understanding and there was a bigger market. In addition, most of the alternative investment areas were more closely related to economics than they were to finance. As a result, finance didn’t have a good place to put us.
In the mid 1990s, we didn’t have a good fix on the sources of returns for these alternative strategies. We called them absolute return strategies. They were originally positioned as funds with a low correlation with the stock market and a positive return. So people believed the appropriate benchmark was the risk free rate. We believed that every manager was unique â€“ that there wasn’t a lot of commonality between them since each manager was independently coming up with their own trading ideas.
One of our top priorities during this time was to determine if alternative investments were actually separate asset classes. We concluded that if one defines an asset class as an asset with unique risk and return opportunities that aren’t available in other asset classes, then you can call many of these investments a separate asset class.
AM: Would some strategies be more deserving of being called a separate asset class than others? For example, is real estate more of an asset class than long/short equity?
Well, even in that case, I’d ask if real estate is even a separate asset class. Are the risk and return opportunities easily obtainable through equity and fixed income markets? When you create a product that has a unique structure, can you actually regard that as a separate asset class if it offers properties that can be purchased easily in the form of other vehicles?
One of the earliest examples of the line of argument was research that suggested long/short equity is really almost all equity exposure. Thanks to this research, we now know that you can replicate many active long/short strategies by simply going long a value index and short a growth index.
Since every portfolio in the alternative investment space is really a set of assets and many of those assets are reflective of underlying securities, you might regard alternatives as add-ons, not as unique asset classes. In this sense, alternative investments are a packaging vehicle rather than separate underlying asset classes in their own right.
AM: You’re saying the economic engine is the same in both cases â€“ but the difference lies in how you trade the assets?
Yes – or how you put both together. For example, a convertible bond is a bond, a stock and an option all packaged together. So an investor might prefer it to the cost and information required to pick three separate asset classes.
I would say that for me to trade a vehicle, it has to offer me some unique risk and return opportunities not easily available in other investment classes. Not that you couldn’t replicate it somewhere else, but that it would be difficult, time consuming and costly. In other words, I ask myself if this particular vehicle offers me the most efficient means by which I can capture a particular return opportunity. And that means can shift over time.
Tomorrow: Do you believe world is running out of alpha? What is your take on “hedge fund replication”? Is the SEC on the right track?