Tuesday, March 4, 2008

Good Money is on the Alpha Bet

Alpha is a huge buzz word in the fund management industry these days, as noted in the Special Report on Asset Management in this past week’s issue of The Economist.

Similar to how people default to call a tissue a “Kleenex” or a cola a “Coke”, the true meaning and value of alpha, it seems, is being diluted as it becomes overused and overextended.

There’s a lot of chatter out there about how ETFs, hedge fund replicators, and other relatively new investment vehicles are being designed to match the returns of hedge funds, and that perhaps alpha is a farce, and that if returns can be replicated without the implications of management fees and huge payouts to fund managers, then that is of course a more desirable way to invest.

We whole heartedly disagree.

While in theory it may sound great to get all of the upside reward of fund returns without the overhead/management fees, the logic is slightly flawed.

Consider this:

You invest with a managed fund – mutual fund, hedge fund, or other. Let’s say for argument’s sake that the average fund returns – meaning, the average return of a grouping of funds – is about 8%.

But, as an astute investor, you of course don’t want to invest with a fund that is just making the average. You want a fund that will outperform its peers, its index. On the high end of the scale, there are firms who have returned somewhere in the range of 20%. Perhaps this fund is run by a tried and true manager, who has mastered his skill. Perhaps he’s a pretty lucky guy this year.

Or perhaps, he’s got better, more exclusive information and analysis than everyone else to base his trading decisions upon.

This small pool of highly skilled managers who fall into the latter category seek out exclusive information that helps to ensure that they stay out ahead of the pack. This is where true alpha exists.

Of course we understand that the higher the best performer comes in, the better the index as well, but investors looking at fund investments typically see “average” as a four-letter word.

So, while the media, fund replicators, index funds, and funds with mediocre returns would very much like to lead investors to believe they can access alpha and the returns it generates by taking these various short cuts, we think outsized returns from managed funds - generated by alpha - will continue to speak for themselves.