Thursday, January 10, 2008

Alpha or Artifice?

A story titled “And God Created Alpha” from the January 5th edition of The Economist, knocks some fund managers off their high horses by making an important point about replicators and other tools/products being developed to mirror the returns of well-performing funds:

“…If those returns can be reproduced by a set of mechanical rules, is skill really involved?”

We’re not here to throw under the bus any fund managers who’s masterpiece-like returns have made them the idyllic poster-children for knock-offs and frauds, but investors should know that the faux-Picasso and the Canal Street Prada purse have found their way to the fund industry. The difference here is – if the returns are the same, will anyone care that it’s a fake? Probably not.

In a volatile market where hedge funds themselves are not able to generate the same volume of returns, can replicators really find their place in the market? Or will it be survival of the fittest, where only the top performing hedge funds will survive, the rest will fold, and replicators will vacuum up the dollars left behind by the vacating failed funds and go on to match the leaders?

Is there such a thing as ‘alpha’? If replicators succeed, will ‘alpha’ find itself thrown into a category with wives’ tales and urban legends? It could be a true concern down the road, but for now, replicators can’t win if they don’t have great fund performance to replicate. So, at very least, the top-performing funds won’t be closing their doors anytime soon.

However, with these new competitors trying to steal a piece of the pie, there won’t be any room for mediocre performance amongst hedge funds that have been riding the gravy train of ‘hedge fund’ allure. Where artifice substitutes for alpha, there will be abundant failure.

Securing Alpha

The surest way to ward off replicators is to outperform the indexes. Funds that find top-quality research and information to set them apart from the pack will be crucial if they are to outperform ‘synthetics’.

As The Economist story points out, “it’s certainly not a crisis yet…but it ought to be a long term worry.”