If the nutritional content of conference snacks says anything about the physical and mental demands of the event, then this one is going to be the Kailua-Kona Iron Man Triathlon. Instead of serving only glorified Twinkies and hotel coffee, organizers here plied us full of Power Bars and tasty little treats called “Balanced Gold high protein bars.”
Sessions began today at 7:30am and by the 10:00am coffee break, the audience had heard from no less than 3 panels and 2 individual speakers. And this is the first of three full days of lectures and panels by academics and other freakishly intelligent practitioners.
The “Factor” Factor
If there is a theme emerging already, it’s “alternative beta”. Investors seem to be questioning whether they are paying for alpha and receiving some kind of beta while for their part, managers seem to be wondering if alpha is becoming harder to produce in the first place.
This fundamental question weaved its way in and out of different sessions taking on various forms. For example, panelists in a session on strategic asset allocation debated which was more important when they allocated capital: “the strategy” or “the manager”.
An ensuing debate about whether hedge funds qualified as a true “asset class” pitted those who said that hedge funds were just an equity strategy against those who argued that the fundamental factors driving hedge funds returns qualified them as a distinct asset class.
One panelist, the manager of a large pension fund, believed the best hedge fund investors tended have an “asset allocation mentality”, not a “trading mentality”. Translation: as in the traditional investment world, sector (or strategy) allocation is more important than security (or manager) selection. And in the hedge fund world, allocating to a particular strategy is tantamount to simply allocating to alternative beta(s).
Another manager of a large pension plan referred to how their fund tended to track “common influences” (a.k.a. common factors or alternative betas) and said that they mitigated those factors using a derivatives overlay.
The Alpha Meal Plan: Eat everyone else’s lunch
With Haskel’s warnings to re-focus on “true alpha” still echoing in the halls, participants turned their attention to whether alpha was being “squeezed out” of markets under our noses. One of the members of this panel argued that he felt alpha was indeed being squeezed out – at least superficially. He said that alpha may appear to be shrinking since returns that used to be qualified as alpha are now simply being re-categorized as alternative beta.
And Stephen Harper of Strathmore Capital (not the Canadian Prime Minister) probably summed up best what “true alpha” was all about. Said Harper:
“We ask ourselves what it is that compels someone to sit down in the cafeteria day after day and allow the guy beside him to eat his lunch? We want to understand what motivates them to do that.”
The topic of alpha as a “zero-sum-game” also made its perennial appearance at this event. The “zero-sum” argument is commonly leveled against hedge funds (although strangely, not against traditional long-only funds). But as panelists essentially pointed out, who cares? …as long as you’re on the winning side.
Conversely, an academic might say that the losers care – and that they would eventually disappear either because they throw in the towel or run out of money (or as Stephen Harper would likely say, they have their entire meal-card used up). Thus, the lower strata of winners would become the new losers and the cycle would repeat. If this cycle holds, then the question is: would some managers always remain at the top while the pool of losers continually replenishes itself?
Markowitz and Jagger: Both still doing what they love after all these years
In a finance world with a lot of rock stars. But one name – Harry Markowitz – tends to rise above them all. He’s the Mick Jagger of finance – not just because he was one of the original inventors of a new way of doing things, but because he’s still at it today – as energetic and enthusiastic as ever.
Markowitz addressed the audience after lunch via satellite from a studio in sunny Southern California (everyone down there has their own TV studio, right?). His presentation was titled “Portfolio theory, hedge funds, Adam Smith and the financial wisdom of rabbits.”
My kids want to get a rabbit. So I was particularly interested to hear that it may be able to impart some financial wisdom upon me. Perhaps that “Flemish Giant” they’re looking at could do a regular column here at AllAboutAlpha.com…
Alas, Markowitz was only referring to old fashioned natural diversity and selection, not trained rabbit-bloggers. And before rabbits, he points to simple germs as organisms that have also practiced diversification with great success. He used this metaphor to tie together a wide-ranging presentation on the history of mean-variance optimization.
During the Q&A, I asked Markowitz about 130/30. In particular, I asked him about the role of mean-variance optimization in determining if 130/30 was more efficient than a combination of a market neutral portfolio and a separate beta overlay.
Markowitz referred to a paper he wrote a couple of years ago with none other than Jacobs & Levy. In it, the trio introduced the concept of “trimability”. Trimability, said Markowitz was the key to being able to create more efficient portfolios using an integrated 130/30 structure instead of the bifurcated structure above.
Markowitz’s wit and wry sense of humour was not lost in the satellite transmission. After refuting common misconceptions about what he has allegedly said in the past, Markowitz responded:
“I didn’t say that! People quote my books. But I can tell by my revenue, not everyone is reading my books!”
And with tongue firmly planted in cheek, Markowitz expressed frustration that others had tinkered with the original version of the efficient frontier:
“I (originally) had the chart the other way around. But some wise guy turned the axes around and now I have to talk about it this way.”
“Engineered” Hedge Funds
Graham Thouret of Diversified Global Asset Management (DGAM) says that every hedge fund strategy has a “half-life” – a “decay”. The trick to creating a fund of funds is to separate the “non-traditional” strategies (read: returns from the alpha end of the spectrum) from the “traditional” hedge fund strategies (read: returns from the alternative beta end of the spectrum) and to manage the two classes in a different way. The result is what Thouret called an “engineered hedge fund”.
Of course, you always need to replenish the “non-traditional” strategies as they continue to migrate toward the “traditional”, more highly commoditized end of the spectrum.
How? In two ways, said Thouret. One: through “origination” – helping managers devise new strategies, and two: through, “activism” – helping managers focus on what they do best.
An “Orthogonal” Kind of Guy
In the prelude to his book “The (Mis)behavior of Markets”, Benoit Mandelbrot’s co-author describes him as “orthogonal”. This is an appropriate description of a man renowned for both his innovation and his command of geometry. Mandelbrot is the inventor of “fractal geometry”, essentially the study of recurring patterns and the “roughness” of lines such as ocean coastlines, the edge of a leaf or the choppiness of a price line on a financial chart.
A contemporary of Markowitz, Mandelbrot actually worked with him at IBM back in the 1950s. Since then, he has been a professor at several universities in Europe and the United States. But in case you think he’s no longer an active participant in today’s financial dialogue, note that he was the co-author of this article in Fortune magazine with “Fooled by Randomness” author Nassim Taleb (see related posting, “Definitely not a normal guy“).
Like Taleb, Mandelbrot questions whether the world is “normal”. That is, he wonders if things like stock prices can really be described using a normal distribution. His conclusion: no. He essentially argues that variability is itself variable. He says that variability has different “states” (ranging from “mild” to “wild”) and that his fractal models do a better job of emulating market behavior than does the ubiquitous normal distribution.
When asked by an audience member if there was perhaps a “quick fix” to the normal distribution that could suffice while practitioners tried to learn the complexities of fractal geometry, Mandelbrot replied that there was not.
So it appears we may all soon wish we didn’t skip Grade 8 geometry…
Carbo-Loading for Day Two
After 10.5 hours of thinking and with lactic acid building up in participants, it seems certain that we’ll be carbo-loading tonight and downing raw eggs, wheat germ, alfalfa sprouts and energy supplements tomorrow.
And by Friday, we’ll be into the Red Bull.