Attempts to treat alpha as a commodity that can be explained using traditional economic principles have always been met with a healthy dose of skepticism. If alpha is indeed a “free lunch”, then putting a price on it would be like auctioning off a dollar bill. You’d end up paying just under a dollar for it. Assuming the transaction had no ancillary benefits to you, you’d probably stop the bidding there. But alpha opportunities are essentially limitless, so investors would pour money into these free lunches until the market inefficiencies exploited by them closed up – driving the supply of alpha down to zero.
Besides, how could you possibly capture the aggregate demand and supply for alpha across the entire investment management industry, let alone across the total universe of investors? Clearly, traditional economic orthodoxy requires some tweaking to explain the demand and supply of alpha.
These are some of the fundamental questions tackled in an article by Harry Markowitz, Robert Snigaroff and David Wroblewski (the latter two of Denali Advisors and the former of your Finance 101 textbook). Rather than trying to examine the global supply and demand for alpha, they focus instead on the ability of a single manager to deliver alpha (based on a given fund size) and on investors’ interest in allocating their capital to these funds (based on the manager’s alpha).
They model a manager’s ability to generate alpha based on various factors including fund size, number of holdings, historical performance and others, but settle on a “lean” model than keeps the most salient factors and drops several with “little statistical or economic significance.” The result is a supply curve based largely on the AUM of US institutional equity funds tracked by eVestment Alliance (i.e. not just hedge funds).
Unlike many products, however, the supply curve for alpha is downward sloping. Usually, if you produced more products, you’d have to use more expensive production processes. You’d have to restart that aging extra factory, plant wheat on marginal land or extract oil from more expensive shale. But it turns out that an increase in a fund’s AUM actually decreases the alpha (as a percent of AUM) delivered by the manager.
Markowitz, Snigaroff and Wroblewski also create a “lean” model to summarize investor demand for alpha (measured as asset inflows/outflows). This model is very similar to the supply model but also includes alpha as a factor. The less alpha a fund delivers, the more negative the inflows (or the larger the outflows as the case may be).
Sample data points based on these supply and demand models is presented in Table 4 of the article and reproduced below in chart form (note: the authors make a few other heroic assumptions to help us get our heads around the idea):
The authors find that alpha is highest among smaller funds (note that we’re not talking about hedge funds here but all institutional investment mandates):
“[T]he ability to supply alpha declines with increasing AUM, as anticipated, but alpha is positive for sufficiently small AUM (not certain a priori) and it crosses from positive to negative at product AUM equal to $300 million, a relatively low size for an institutional product.”
But how could nearly all institutional funds be losing money every year? The trio points out that fund outflows of one or two percent can easily be overcome by producing returns of that amount. They note that an $8 billion fund can “hold its own” if it could just produce a return of 8% p.a. to backfill as investors run for the exits.
A plain vanilla supply and demand model where alpha is a product produced by a manager and purchased by an investor apparently remains elusive. But this variant of the traditional model, using alpha as a proxy for price, is food for thought. In conventional demand and supply diagrams, the intersection of the two curves suggests a simple and elegant price/quantity equilibrium. Unfortunately, the intersection of the alpha supply and demand curves seems to suggest no such equilibrium.
Final thought: One idea might be to treat negative alpha as a “cost” to receive some kind of undefined value from investing with a manager (hope, career progression, meeting board expectation, etc.). Thus, smaller funds, actually “pay the investor” while larger funds require to pay for the privilege of investing (akin to a bank account – sometimes you get paid interest, but these days you have to pay additional user fees). This would result in an upward sloping supply curve. As assets grow, the price demanded by suppliers rises…