BGI: Why Buy Pre-Packaged Alpha & Beta?

Opalesque‘s Matthias Knab reported from Hedge Fund Investments Japan IQ 2007 in Tokyo last week about comments from BGI’s Stan Beckers on alpha/beta bifurcation.  His alpha-centric views echo those of his boss Blake Grossman (see related posting).  Reports Knab:

“At a hedge fund conference in Tokyo this week, Stan Beckers, Managing Director and Head of Alpha Management Group at Barclays Global Investors, said the new 130/30 is a ‘first step leading to a decomposition of the current asset management practices.’  Even today, most alternative products would come as ‘pre-packaged combinations of beta and alpha. Why?’, he asked, should investors continue to purchase these products at inflated prices ‘when you can buy them separately’, he said in a session dedicated to Portable Alpha.”

When asked by Knab about the appropriate fee for true alpha, Becker’s provided a refreshingly frank answer:

“I asked Beckers what kind of fees he sees developing in this new, true alpha-oriented asset management paradigm. Beckers said that in the current environment, the fees are certainly set by the market. Going forward, he thinks a fee or a respective income split of 1/3 to max. 40% of delivered alpha going to the manager and the rest to the investor will be adequate.”

These fees seem astonishingly high as first glance – so high, Beckers calls them an “income split”, not a “fee”.  But Beckers is actually a lot closer to the mark than it may look.  A fund producing 90% beta returns (0% fee) and 10% alpha returns (40% fee) would have an overall fee of 4%.  Making that 40% fee entirely contingent on the alpha returns would tilt the playing field even further in the investor’s direction.

Regular readers might recall this posting from last fall about Merrill Lynch’s fee structure for portable alpha mandates.  At the time, Merrill officials said:

“Typically, MLIM looks to charge somewhere between one-quarter and one-third of the alpha generated, structured as a flat fee, a performance fee or a combination thereof.”

Fees can be thought of as a direct reduction in alpha because they are consistent over time.  Any money saved on fees goes right to the alpha “bottom line”.  So imagine a mutual fund with a 1% management fee that manages to track the S&P 500 almost perfectly.  An investor might be excused for being pleased she kept up with the overall markets, but the reality of this situation is more dire: the manager has effectively charged a fee equivalent to 100% of delivered alpha.

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