The search for Alpha starts with Beta. Is that the most ridiculous thing you have read this month? I think so, because even though I wrote it and I’m sure I heard it someplace before, I didn’t know what it meant then and don’t know what it means now. I just wanted to be cute, as I have decided to bring the blog back to the topic of finance and markets. My biting, wit-filled political commentary will take a back seat for the time being.
Over the last few weeks a friend, who is without a doubt a critical thinker and understands economics, economic policy and the Federal Reserve as well as anyone I know, and I have been discussing the search for Alpha. While I would never admit this to him personally, I do believe that he and I agree that finding Alpha is extremely difficult. Alpha, you see is the juice one gets by outperforming the market or benchmark. It is the excess return. It is what hedge funds are supposed to deliver and what hedge fund managers get paid for doing.
I have a problem with this. The problem is that I don’t believe that there are so many people who can find Alpha. It is impossible to think that there are so many smart people managing money who can find opportunities that others miss and exploit these for a profit. Am I wrong? I don’t think so. I don’t think these people are fraudulent in their assertions; I believe that they think they can find Alpha and try very hard to do so. The problem is that numbers don’t lie and seem to prove my point.
As many of you know, I have little if any regard for the hedge fund databases, not because they are bad (this will remain my opinion, by the way, until we have standardized reporting) but because I question the quality of the data. Still, most of the databases and indices that track hedge funds showed them down between 25 and 35 percent last year. This alone, good data or bad, I believe proves my point: Everyone is executing the same trade.
The herd finds an idea, runs with it, the first person out makes all the money and the rest get slaughtered. It seems that many so-called hedge fund managers have started to act like their mutual fund brethren – they are managing for mediocrity. They end up here because they want to attract sticky assets – pension plan and endowment assets. The closer they are to the mean, the more likely they are to get this money. I believe that this is the wrong way to go. I believe it is a mistake and I believe it is trend that needs to be broken.
The only way investors are going to recover from the last two years is to look for managers who don’t operate with the intention of hitting the mean. They need to find managers who take risks (calculated risks, that is) that are going to pay off, not only in the near future but in the distant one as well. Managing for mediocrity is not something worth paying for – stay away from these manages. Trust me, it will be worth it.
THINGS THAT DRIVE ME CRAZY
Nothing to report this week. Stay tuned however, this is not going to last.