Canada: “Come for the gold, but stay for the alpha”

11 Oct 2007

Continuing our conference-a-continent tour, we attended the inaugural Canadian edition of the venerable “Hedge Funds World” franchise this week in Toronto.  After creating a “Hedge Funds World” for what seems to be every possible region and city on the planet (New York, London, Dubai, Hong Kong, Singapore, Tokyo, Miami, Cape Town, Zurich, Stockholm, Madrid, Hoboken, Burma, Pyongyang, Falkland Islands, North Pole…okay, not Burma) attendees at this event were pleased to finally join the global party.

Perhaps it’s no coincidence that this year also marks multi-decade highs for two of Canada’s favorite exports: gold and oil.  But Phil Schmitt, Chairman of AIMA Canada told the audience that there were plenty of untapped hedge funds in Canada that do not rely on the ubiquitous “resource beta”.  Essentially Schmitt’s message to international investors is “come for the gold, but stay for the alpha”.  (see related article)

And speaking of alpha.  The good folks at Hedge Funds World dedicated much of the afternoon of day one to “Alpha Beta Portfolio Construction”.  Here are some notes from the floor:

Liquidity Alpha

The financial community spends a lot of time discussing the cost of liquidity (or conversely, the premium achieved by accepting illiquidity).  In fact, it’s a common reason cited for the success of university endowments over the past 15 years (see related posting).  But apparently few people have actually calculated the actual cost of liquidity.

Thankfully Morgan Stanley’s Ranjan Bhaduri is doing the heavy lifting for us all.  Said Bhaduri in a session on beta:

“It’s a sad commentary on my life, but I sometimes spend weekends and late nights researching the cost of liquidity.”

Bhaduri’s obsession could have profound implications on hedge fund replication if the cost of liquidity can ever be measured accurately since the liquidity premium is essentially an “alternative beta”.  With so many hedge funds adding lock-ups or raising “permanent capital”, one would (/should) expect a commensurate incremental return.  This would amount to another chink in the armor of alpha, further whittling away at overall return by defining more and more of it as simple alternative beta, not true alpha.

Hindsight (and US exposure) is 20/20

It is commonly assumed that the “short extension” portion of a 130/30 fund must use the same universe as the core “100” portion.  Otherwise, the fund cannot be optimized en masse.  For example, a core portfolio of US large cap names with a 30/30 overlay that is long real estate and short REITs would look a lot more like a portable alpha strategy than a coherent 130/30 fund.

But Phillip Cotterill of Connor, Clark & Lunn, one of Canada’s largest institutional managers suggests that an overlay needn’t draw on exactly the same universe as the core.  In fact, Cotterill told the audience here in Toronto that his firm manages a 130/30 fund that is 110/10 in Canada and 20/20 in the United States.

We’re not sure if co-panelist Dawn Jia of State Street would agree or not.  In her remarks, she referred to research showing that a 130/30 is more optimal than two separate (e.g. 100 & 30/30) funds.  While Cotterill’s two-asset 130/30 fund may not back-track on itself (be long and short the same names), we wonder if it would Jia’s rule that the two parts be optimized as one.

Kamel on Kat

Consultant and former risk manager Tammer Kamel (see related posting) did a great job of explaining distributional hedge fund replication in layman’s terms.  And this, as he points out, while standing between the audience and a frosty cold one at the end of the day (In Canada, tantamount to standing between a hippopotamus and the water).  If you or your colleagues don’t have Ph.D.’s or options trading backgrounds, we suggest you give Tammer a call into order to quickly get your head around this new form of hedge fund “replication”.

The Church of Alpha

One of the speakers – we can’t quite remember who – compared alpha to a religion.  He argued that both religion and alpha attempt to describe the unknown.  Before Copernicus, he said, the heavens were largely a mystery.  But heliocentric cosmology shattered our long-held beliefs about the sky.  And with the sunrise and sunset now explainable, they lost their religious reverence.  Likewise, alpha that is “explainable” becomes beta (or at least alternative beta) when the secret gets out.

Thankfully, said the speaker, there are always new mysteries (e.g. what is beyond the Sun, what is beyond the planets, and what lies beyond the edge of the galaxy…).  Similarly, he noted, there will always be new alphas for us to explain away into beta.

“Alpha”.  Cool term.  But have little use for it.

Jim McGovern, the pragmatic and straight-shooting founder of AIMA’s Canadian Chapter expressed skepticism over the modern obsession with the Greek letter.  He runs one of Canada’s largest funds of funds and his investors are mainly what he calls the “original” inhabitants of hedgeland – high net worth individual investors.  So he questions many of the analytical techniques used by institutional investors.  Co-panelist Arun Kaul of Hillsdale Investment Management, one of Canada’s largest quants went a step further, saying he tries not to use the term any more – opting instead for the more holistic “value-added”.  While we think McGovern and Kaul may be a little quick to dismiss alpha as a useful measure, their practical perspective does help us keep our head (slightly) out of the clouds.

Hedge Funds World wraps up today (Thursday) with speakers from Paulson & Co., Russell, Harcourt and one of Canada’s hottest small funds of funds Alpha Scout.

See you all at the next edition, Hedge Funds World Uzbekistan.

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