Start your alpha engines, “the race is on”

130/30 23 Mar 2008

In a research report published last month, Merrill Lynch’s European equity research group pronounced that the asset management “race is one” as hedge funds and traditional asset managers compete in a “converged” industry where the lines between long-only, private equity, hedge funds and other alternative asset classes are blurred.

Hedge Funds “outperformed by a very handy margin”

Of course, this convergence presupposes that these alternative asset classes actually represent something of value.  And after racking up volatile results over the past 6 months, hedge funds, for one, are raising some eyebrows.  Still, Merrill argues that recent performance does little to diminish the value of hedge funds:

“We have seen a range of articles spreading doom and gloom about hedge funds in 2008 so far. As is often the case, hedge funds, we are told, have been ‘melting down’, ‘blowing up’ and in general misbehaving. Certainly, nobody would suggest that January ’08 will be remembered as a vintage month for the industry.

“However, taking the HFRX as a decent representation of the industry, you find that the industry has outperformed equities by a very handy margin…

“We continue to believe that those who argue that the industry should be aiming to provide strong positive, absolute returns, without any loss-making months, are barking very loudly up the wrong treeWe reckon that it is months like January which show why people should own hedge funds. If you only look at good months, equities win hands down (if you know how to identify good months in advance, do drop us a line).”

“talk of a ‘bubble’ presupposes excess capital allocation.  Hedge fund performance belies any talk of bubbles, we think, simply because it is, at the macro level, so consistent.”

This last point bears some reinforcement, we believe, because “bubbles” occur when investors bid up prices in a relatively short amount of time.  As this report points out, the percentage of assets managed by hedge funds has grown rather slowly, they continue to represent less than 1.5% of global “mainstream” assets and their net asset values are based on underlying securities, not a subjective premium like, for example, tech stocks (see related posting).

While acknowledging alpha/beta separation as “jargonistic”, the report identifies this as “the unifying theme” in the asset management industry.  Like us, the report suggests that the parallel growth in index investing and hedge funds is not coincidental (see related posting)…

“There is no reason for paying active management fees for index like returns.   Hence, increasingly, active managers have to justify themselves on the basis of non-index positions.”

130/30 “one of the most interesting and topical issues”

The combination – and explicit recognition – of alpha and beta in the form of 1X0/X0 strategies is of particular interest to the researchers…

“We see 130/30 as one of the most interesting and topical issues in asset management at present. These funds are driven by the search for greater alpha; in our view, they represent ‘long only 2.0’, a natural extension of long only investing.”

“130/30 is often called a fad or the like (thought not by us), and nothing in investment is ever all good, we reckon…”

Rather than blindly following the industry excitement over 130/30 strategies, the Merrill team goes on to critically examine the arguments against this “topical” investment strategy.  But according to the authors, none of the criticisms really stick.  Even the argument that 130/30 managers are no smarter than the rest of us is countered with the reality that such skepticism is more appropriately directed at all active management and therefore does not address the merits of short extension strategies per se.

Quants 130/30 managers lower on “fee ladder” than fundamental 130/30 managers

On the raging debate between hedge funds and long-only managers, the report concludes that mainstream (i.e. traditionally active long-only) managers will gain market share:

“Our view is that progressively, active managers will gain market share, not because people give up on quant but because the whole pie will increase.  For an active mainstream manager, the great appeal of 130/30 is that it appears a relatively short step from the mandates they already run, in a way that hedge funds do not.”

“130/30 represents not only a shorter step from active long only than do hedge funds, but its natural audience is one which already trusts the long only community.”

And just in case you think they’re making this up, they remind us of the firm’s survey last fall of US institutional investors – which clearly showed a bias toward long-only managers in the 130/30 sweepstakes (see related posting).

While the report refers specifically to the UK institutional market, the same can be said of the US institutional investment marketplace where long-only managers have so far had considerable success in the burgeoning 130/30 business.

In fact, the report goes as far as to say that “fundamental 130/30” strategies are higher in the “fee ladder” (ie. are able to charge a higher fee) than active long-only strategies while “quantitative 130/30” strategies are destined to charge less than active long-only strategies.  So score another one for the fundamental (“mainstream”) managers.

In the end, the big question posed by the researchers is: “Can alternative managers build distribution quicker than mainstream [managers] can build evidence of investment competence in more advanced styles?”

“Investors looking for alpha, over and above format”

The report concludes that institutional investors are beginning to look beyond the “format” of a fund and are instead focusing on the underlying alpha generating abilities of their manager:

“Anecdotally, one of the ways hedge funds receive long only mandates at present is by being approached by plan sponsors who actually ask them to run funds in the long only style, as a result of their reputations either in the hedge format or in their previous lives. This is a direct sign of investors looking for alpha, over and above format.”

For these investors, suggests the report, it’s not about “hedge” “long-only” or “130/30”.  At the end of the day, it’s all about alpha.

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