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.”

Fund Fees: What are you paying for?

It’s probably safe to say that anyone with money to put into a hedge fund doesn’t mind paying a high percentage management fee as long as you’re getting a phenomenal return. It all comes down to value.

Same goes for Manhattan real estate – if a broker shows you your dream townhouse, but you have to pay a 20% broker fee, you wouldn’t blink. You’d be ecstatic that you could stop sifting through all of the unsuitable apartments, and the value of finding what you’re looking for would justify the expense attached to finding it.

In both of these scenarios, the ends justify the means. Unfortunately, for less risky investments, the returns are not high enough to eliminate the question:

What are you paying for?

In the case of mutual funds and pension funds, which, by design, are not typically risky investments, of course the rewards are not usually as exponential as might come from a hedge fund investment. Yet, they have more hidden fees attached to them than Paris has boy-toys. The lack of transparency in fund administrator services and 12b-1 fees as well as management fees, loads, expense ratios, turnover rate, taxes…goes on and on.

(Is your head spinning yet?)

The unbundling initiative that is being largely lead by the independent investment research world would likely help alleviate some of these incurred costs, while also putting money back in the pocket of the Portfolio Managers (PM).

Say what?

That’s right. The guy making you money, should make good money. No one disagrees with that statement. His management fee – if he’s made you 30% this year - is a non-issue. The part that should be called to question is – what other fees are you paying that are unjustified, or being billed to you for unused or under utilized resources?

Like that $150 gym membership you pay each month to have access to something you don’t use – at some point it’s time to reassess the fees you pay and ask: What exactly am I paying for?

Bundled research – the research provided as an ‘add on’ to execution - falls into that camp. This research is often redundant, lacking of value, and gets as much use as your dormant gym membership. Yet it continues to be purchased because it is as common practice in the industry.

Part of the reason this cycle has yet to be broken is that PMs fear unbundling would create more work for them. Though it may take some work on the front end to seek out the top providers for execution and research, respectively – the pay off on the back end of having insightful, actionable research on one hand, and best execution on the other would alleviate headaches for both PMs as well as investors.

The clock is already ticking for PMs to jump on the unbundling bandwagon. Regulators are taking a look at how unbundling can help paint a much clearer picture of incurred fund fees and now it’s only a matter of time before requirements are enacted here in the US as they have been in the UK.

Unbundling could potentially revolutionize the way that funds do business, and bring in some serious revenue for those who embrace it. In a business where being late to the game can cost you everything, we think we will continue to see firms jump on board the unbundling bandwagon.