Illegal Alpha

alpha burglarRight up until last fall, practically every alternative investment conference this side of the date line had at least one panel of experts discussing and debating the elusive search for alpha, and how to capture and augment a traditional or even non-traditional portfolio by finding managers that were truly capable of generating non-beta returns.

And then the black swan-poop hit the fan.

Nowadays talk of alpha generation and alpha-beta separation still permeates, though the search for it – and expectations of finding it – has greatly diminished. It’s more about earning a return – period – than earning a return above and beyond what the rest of the market is looking for.

Along these new lines has emerged a very quiet yet growing subset of individuals who believe that alpha still exists, but that getting it isn’t, dare they say, legal.

From market-timing and late-trading to illiquid valuation techniques and 20:1 levered bets to discrepancies in share pricings between markets and indices to the growing popularity of super low-latency flash trading, these pundits, who wish to remain both nameless and faceless for fear of being drawn and quartered by their bretheren, argue that alpha can’t be obtained legally.

Of course, for every one individual who might dare argue that alpha can’t truly be obtained, there are hundreds who will vehemently argue that it can: that alpha in of itself can be created simply by allocating to a non-traditional portfolio or basket, which in turns makes it a non-beta play.

Dig more deeply, though, and true alpha generation begins to look a little more difficult to come by: now-defunct hedge fund Galleon promised alpha, as did a host of alternatives shops before it, Lancer Group, Beacon Hill and many other notorious shops who claimed by definition to produce alpha through their various methodologies and abilities, most of which weren’t, at the end of the day, on the up and up.

From an academic perspective, the question of whether alpha exists and can be obtained is actually nothing new. Roger Urwin and Gerard Roelofs of Watson Wyatt produced this presentation back in early 2006 that questioned whether pure alpha or even pure beta exists.

And from this report published by Dr. Lars Jaeger, a partner with Swiss-based asset manager Partners Group, alpha, if it can be obtained at all, is steadily diminishing.

HF Alpha - Jaeger - November 2009
Which begs the philosophical question: What exactly is alpha? Is it a tangible and quantifiable concept, a true risk-adjusted measure of the so-called active return on an investment in excess of the compensation for the risk borne? Is it an ideal that many lay claim to but that can’t actually be obtained? Or is it simply the first letter in the Greek alphabet?

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha.

According to Montreal-based Castle Hall Alternatives, which maintains a comprehensive database of frauds, blowups and other hedge fund misnomers, some 300-plus hedge fund frauds and / or implosions have taken place over the past decade or so. While difficult to figure out which of those frauds and blowups claimed to run an “alpha” strategy, complex, illiquid, levered or some combination does permeate as a theme.

So is alpha simply an alternative to beta, in which case by definition anything not part of the mean of generating non-correlated returns? Or is alpha in fact plain-vanilla alternative beta? Or is alpha something that is indeed non-correlated and above and beyond what the rest of us mere mortals can produce, but not in a legal or perhaps ethical fashion?

HF Returns - Jaeger - November 2009
As our name suggests, we believe in the ability to generate alpha, and we believe there are many bright minds and quantifiable alternative strategies that can and so produce it in a perfectly legal and compliant way.

However, there likely does lurk a group of managers and traders who aren’t following the rules when it comes to generating it. From a due diligence perspective, the key is trying to figure out – and stay ahead of – those who might be taking the low road to getting it.

Some food for thought for the US Thanksgiving weekend.

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