Alternative Investments 2007: The Quest for Alpha
Like a hot knife through butter, or like Moses parting the Red Sea, the asset management industry is being torn asunder. The buy side is being pulled toward two polar opposites. On one end are firms that believe they can beat the market; on the other, firms that want to match the market – provide market returns, typically at the lowest cost. At the same time, the buy side is also coming together. The dividing lines between hedge funds and institutional asset managers, lines that were blurring a year ago, are now like lines in the sand, washed away by tidal waves of change. The strategies that were once solely the province of hedge funds --“alternative” investments—are now mainstream and increasingly demanded only by individuals, but also by institutional investors as well.
The process of obtaining investment returns – be they market returns or market-differentiated returns – is also changing. Firms targeting beta, or market returns, have as their goals the elimination of tracking error and reduction of cost. They’re doing this through better use of modeling tools, increased use of electronic trading and derivative products. There is even greater change underway at the alpha-seeking firms. In search of returns, firms are getting more creative, moving overseas and toward frontier markets, moving up and down the capital structure, moving toward shorter-term event-driven strategies and to longer-term holding strategies that look like private equity-type investments. More profoundly, the use of shorting and leverage, the tools used by the first hedge fund as far back as 1949, are becoming more sophisticated and more mainstream.
This growing acceptance of leverage and shorting is most profoundly seen through the explosion in assets under management in “Enhanced Active”, “Enhanced Long” or “Short Extension” equity strategies. An increasing number of investment mandates have been opened up and now allow for 120/20 and 130/30 type strategies. These structures offer traditional asset managers the flexibility to gain greater returns on both their upside and downside bets, while keeping an overall 100%-long invested position. While invested assets are expected to grow steadily, across the broad mutual fund universe, at more than an 11% compound annual growth rate (CAGR) per year; and assets in hedge funds are set to climb rapidly at nearly 43% CAGR per year; assets invested in enhanced active-equity strategies are set to explode at a rate of more than 141% CAGR.
The growth in hedge fund-type investing, including the use of shorting and leverage, the importance of alternative assets, different asset classes, and the new and varied ways that firms are packaging, pricing, buying and selling risk are changing the strategy of investment management firms. Concern over liquidity – always a primary concern of buy-side traders – is now also a primary concern of portfolio managers as well. Among equity firms, the liquidity issue is most potently felt on the short side of the market; a key consideration when thinking about the impact and the efficacy of short-extension funds.
Fundamentally, these changes in the investment management industry are being driven by the needs of the investors looking for returns – questing for alpha. Long-only, equity-dominated portfolios alone have not, and will not, satisfy the demands of all institutional investors--not at the price that is currently being paid. On the other hand, whether it is through absolute return strategies, portable alpha vehicles, or multi-alpha funds, institutional investors have shown that for the right risk-reward characteristics, they will pay a premium.
The impact of these new products and strategies will affect virtually every aspect of the investment value chain, as managers will be driven to be more global and more opportunistic. As managers expand their search to be more global, they’re also finding they must expand their asset selection strategies and become more nimble about moving in, out and between different risk and capital structures. This impacts how firms are serviced, how they are brokered, how their technology infrastructure is implemented, and even how their operations are structured. All of this is in pursuit of one thing – alpha.
So what does this mean to managers, investors, and brokers? To managers, it means that while there may be temporal market challenges, the world of managing money is changing. It is becoming more global, more complex and more challenging. The sources of alpha or performance that have been successful in the past may not work in today’s more nuanced market. Now, while various companies will continue to under- and over-perform, there will be increasingly new ways of being able to capture yield that were not available to managers, even as recently as a few years ago.
To brokers, this new world means that the broker needs to provide an increasingly complex array of products, services, support, and technologies to the manager to enable their success. It is no longer just a US Equity world. Managers will need access to foreign markets, exposure to new and differentiated products, and complex tools to help examine and trade increasingly arcane and challenging exposures.
To investors, a new oyster is opening. A new way of looking at investments, returns, risk, and exposures is developing. While this will be an interesting time for both professional and individual investors, it will also be challenging, as track records won’t exist, complex investment strategies will challenge even the most experienced investors, and few services have yet materialized to vet these new strategies or ensure their fidelity. While it will be challenging, and many will or should wait on the sidelines until a shakeout occurs, with opportunities come adventures, and as long as the oyster doesn’t close on a finger, the quest to find the pearl will be both fascinating and exhilarating.
For those who can accomplish that daunting task, the rewards will be enormous. We are only in the beginning of this major shift. We’ve taken only a spoonful of the alpha-beta soup, and the meal is at least seven courses long.