I became interested in how alpha had gotten harder to find during the 2007 quant crisis. Traditional asset managers, which I had been covering since 1998, always tell investors and reporters the same thing when markets fall: Markets can be irrational at times, so keep your head down, keep dollar-cost averaging, and your portfolio of equities and bonds will work in the long term.
In August 2007 investors discovered that a huge number of quantitative long-short hedge funds had been using the same supposed secret algorithms to trade a handful of big stocks. When all these hedge funds got a sell signal from their algos at the same time, the markets cratered. To Andrew Lo, a finance professor and head of the Laboratory for Financial Engineering at the MIT Sloan School of Management, the quant crisis was a surprise and the first sign that something was different. There were no new big investing ideas. Every trade was crowded, and alpha might be dead.
No corner of the financial market was undiscovered country, says the peripatetic Lo, talking to me on his cell phone from the back of a cab.
I wanted to know how that had happened and what institutional investors were doing about it. I examined how innovations like target date funds which automatically divvy up investments among different types of equities and bonds had fueled blind demand for small-cap stocks. The investment spigot had been turned on for these stocks regardless of perceived value and driven prices up and expected returns down. I talked to investors who were looking for untrammeled corners of the investing world that could provide additional diversification and new sources of alpha.
But when Lehman Brothers Holdings filed for bankruptcy a year later, exploring the concept of too many investors running good investment ideas into the ground seemed laughable. Once the financial crisis was unleashed in its full fury, I dropped the subject of whether alpha was dead and reported instead on how the financial services industry could survive.
The crisis turned out to be a watershed moment in investors struggles to find excess returns. What had become common wisdom and the science of markets suddenly didnt work. One case in point was the endowment model, made famous by Swensen: It stresses diversification into all types of equities and employs huge allocations to alternative investments like private equity and hedge funds. The model, which had produced stellar long-term investment returns for Yale, failed during the crisis. The mix of all those asset classes did not provide any cover from the losses in the public equity markets, and investors had to scramble to access other sources of cash once they got a real taste of what it meant for their funds to be locked up in illiquid investments. The research that went into the endowment model looked threadbare in the face of postcrisis structural changes like global deleveraging and unprecedented monetary policy by central banks around the world, not to mention the demands of aging populations for their assets to work harder.
Hoping to make sense of what had happened, I recently reached out to Suzanne Duncan, the 40-year-old global head of research for State Street Corp.s Boston-based Center for Applied Research. I first met Duncan seven years ago, when she was a rising star at the IBM Institute for Business Value. She always has a counterintuitive insight when I call her about an idea I want to explore. When asked about alpha, investors copying one another and the effect of the 200809 meltdown, she tells me that the financial crisis has forced the industry to rethink basic assumptions of Modern Portfolio Theory, such as normal distributions, market efficiency and risk-free rates of return. Investors and providers alike are recognizing inherent weaknesses in these assumptions, which they have come to realize are not so basic at all, she adds.
Duncan is excited about my research on alpha. She cites a joint paper from the Center for Applied Research and the Fletcher School of Law and Diplomacy at Tufts University that found that less than 1 percent of 2,076 U.S. mutual funds tracked between 1976 and 2006 achieved superior returns after costs. She also refers to a working paper from the University of Maryland that reports that before 1990, 14.4 percent of equity mutual funds delivered alpha, whereas in 2006 only 0.6 percent of the managers could say the same thing. The authors define funds that produce alpha as those having stock-picking skills sufficient to provide a surplus beyond recovering trading costs and expenses.