Alpha Beta Separation: A separation of church and state

Is the quest for alpha a religion?  In some ways, it just might.  This according to The Economist last week.  Says the magazine (sorry, “newspaper”):

“The concept of alpha is a slightly metaphysical one and resembles the “God of the gaps” familiar to Victorians. Traditionally, people were inclined to attribute natural phenomena such as earthquakes and plagues to God; eventually they discovered plate tectonics and bacteria. The role of God was steadily diminished to that which people could not explain by other means.”

Separating the secular (beta) from the spiritual (alpha) has been the mantra not only of liberal democracies, but also of a new breed of investor.  Hedge funds find themselves at the center of this metaphysical revolution, not because they simply aim to make “absolute returns”, but because they (claim to) have taken a vow of beta-celibacy.  Continued The Economist:

“In a way, hedge funds, by virtue of their complex strategies, are one of the main perceived repositories of alpha left in the market (the average traditional fund underperforms the market, after fees).”

In an attempt to repent for their historical portfolio management sins, institutional investors such as pension funds aren’t just looking to hedge funds for short term gratification, but they are looking to them for something deeper – something to balance out the day to day ups and downs of beta.

Unlike many traditional religions, the alpha-centric religion is flourishing in both North America and in Europe.  Citywire, a London-based online publication wrote in August:

“The latest trends in the European investment industry show that the separation of the fund market into an alpha world (active management) and a beta world (index funds and ETFs) is a reality.”

Meanwhile in the US, Wall Street & Technology wrote around the same time that:

“…the separation of alpha and beta is a critical growth driver of the alternative investment industry in general and hedge funds in particular.”

The magazine provided the following chart to illustrate why the preferences and objectives of institutional investors were so critical to the future of the hedge fund industry:

But a higher plane of being may prove somewhat elusive to some members of the monastic order of alpha seekers.  Consultancy Celent observed just last week that:

“Alpha/beta bifurcation and greater levels of competition have made alpha generation an increasingly difficult proposition for hedge funds.”

Hedge funds might seem like a kind of fringe cult to many mainstream traditional investors.  But while their unconventional approaches may sometimes seem unorthodox, their objectives are really no different than those of all other active investments – alpha.

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2 Comments

  1. Walt French
    September 8, 2008 at 1:10 am

    Just a thought here… suppose we were to say (as is true on average) that there IS no such thing as alpha; it’s just happenstance of timing of betas.

    Lots of portfolio managers, for example, believe that they find alpha thru some combo of momentum, low P/Es and low Price/Book. But every one of those is an enduring factor of risk in the market, sometimes with positive returns, sometimes with negative returns.

    We saw that in 07 when MANY so-called “quant” strategies, all following similar strategies to the factors listed above, simultaneously had to crank up the “Dear Client” letters describing how their Alpha strategies turned into negative-four-sigma (extremely unfortunate beta) events.

    With a little bit of timing of these strategies, one might actually generate something that looked like alpha… say, if a manager thought her position was a little crowded and some deleveraging might be kicked off by a competitor with similar positions… and then got back in again after her correct market timing call. (And yes, even fairly simple market timing, if endowed with a fair run of luck, looks JUST like alphas, too. Just that most PM’s, I’ll guess, don’t much engage in it.)

    The above thesis (no claims of proof, just an idea to kick around) would dovetail nicely with the systematic way that modern investment managers and hedgers operate these days. It’s the beta!


  2. Evan Plisner
    January 19, 2009 at 11:21 pm

    Walt-

    Andrew Lo of MIT-Sloan addressed that idea in an article titled “Is Alpha Just Beta Waiting to Be Discovered?”…check it out…very thought provoking.

    EDP


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