Investors are smitten with alpha, the portion of a winning portfolio’s return that beats the market and is thought to be attributable to the manager’s skill. And hedge funds, justifiably or not, are seen as the best proxies for alpha. That’s clear from the cash flows: Chicago-based Hedge Fund Research reports that net inflows into hedge funds in the first half of this year totaled $38.2 billion, after a $123 billion surge in 2004.
Yet beating the market (net of fees and transaction costs) is, by definition, a zero-sum game in a closed investment universe. For some portfolio managers to outperform the market, others must underperform it. Not all investors can be, like the children of Lake Wobegon, above average.
An outspoken skeptic about many hedge funds’ alpha credentials, Greg Jensen, director of research and trading at Westport, Connecticutbased Bridgewater Associates, a $72 billion-in-assets bond and currency specialist that also manages hedge funds, points to what he considers a truly damning statistic: the high correlation that hedge funds practicing the same strategy have to one another.
Studies by Bridgewater show correlations of 42 percent for equity market-neutral hedge funds, 63 percent for equity long-short funds and 66 percent for event-driven funds. Far from staking out unique alpha opportunities, most hedge funds appear to be making roughly kindred bets.
Feeling alpha fatigue? Why not, then, bet bigger on beta, or market return? “There is a sound case for increasing active risk, and hedge funds are here to stay, but the fact remains that there is a dearth of alpha,” argues Watson Wyatt Worldwide’s global head of consulting, Roger Urwin. “For many investors, doing beta better is a more realistic option.”
But how? Perhaps the most interesting development in beta gathering is a new group of indexes developed by Research Affiliates, a Pasadena, California based quantitative investment boutique, in alliance with London-based index provider FTSE Group. The catalyst was a paper by Robert Arnott, Jason Hsu and Philip Moore in the March edition of the Financial Analysts Journal. Hsu, head of research and investments at Research
Affiliates, says the trio’s inspiration was investors’ dissatisfaction with market-capitalization-weighted indexes.
“Following the bubble it was clear that when you cap weight you put more money in a stock that is overpriced and less in a stock that is underpriced,” Hsu explains. “When you think about it that way, it is pretty obvious it is not something you want to do unless you have a very gung ho view of market efficiency that says prices are always correct.” Case in point: Just five stocks -- Cisco Systems, EMC Corp., Merck & Co., Nortel Networks and Oracle Corp. -- were responsible for almost one third of the 9.1 percent loss of the Standard & Poor’s 500 stock index in 2000.
Hsu, Arnott and Moore, who all work at Research Affiliates, began by exploring different measures of fundamental value. They settled on four: price in relation to equity book value, cash flow, gross sales and dividend payouts. They used a composite of these gauges to create an index of the biggest 1,000 U.S. stocks and back-tested it to 1962 against the cap-weighted S&P 500.
The hypothetical index beat the S&P 500 by 2.2 percentage points on an annualized basis. More striking still, it did better in rising and falling markets and regardless of the interest rate or business cycle.
“The returns didn’t surprise us,” Hsu says. “It makes sense that you should do better relatively than market-cap-weighted indexes where prices overshoot fundamentals on the way up and the way down. But what did surprise us was how robust the results were across a range of market and economic environments.”
Similar trials in international markets were even more impressive. Data soon to be released by Nomura Securities will show that a comparably constructed international index, the FTSE RAFI global ex US 1000, would have bettered the MSCI world index by 3.2 percentage points since 1962 on an annualized basis. Mark Makepeace, chief executive of FTSE Group in London, says that the U.S. index -- the FTSE RAFI 1000 -- and the international version will be introduced in the next few months.
“This index is designed to be transparent in its methodology and readily replicable,” Makepeace says. “All the contact we have had from the big indexation specialists suggests they will look to offer this product alongside their existing market-cap-weighted index products.”
Comments Watson Wyatt’s Urwin: “We think fundamental indexes are a valuable contribution. Alpha is all the rage at the moment, but there are beta opportunities being left on the table.”
Commodities indexes are often overlooked. Although some of the world’s most sophisticated institutional investors, such as Dutch pension funds ABP and PGGM and the Ontario Teachers’ Pension Plan Board, readily invest in commodities, these and other institutions generally steer clear of commodities indexes. One reason: Many are reluctant to use derivatives.
Commodities, in addition to offering diversification -- they typically have a negative correlation with the S&P 500 -- have benefited from exploding demand stoked by a booming China. The Goldman Sachs commodity index (GSCI) gained 18 percent in 2004. This year through the end of August it returned 31 percent.
For an investor in commodities indexes, the best strategy since August 1998 would have been to track the Rogers International commodities index, which debuted that month. The index’s return through the end of July was a cumulative 187.6 percent, compared with 21.3 percent for the S&P 500.
Yet as Michael O’Brien, head of European relationship management at Barclays Global Investors in London, admits, institutional investors are tepid toward commodities indexes. BGI’s funds tracking the GSCI -- an ETF, a U.K. closed-end investment trust and pooled funds for institutions -- have raised only slightly more than $600 million since 1996.
“Funds see the diversification benefits, and we argue that commodities are a good beta to add to your portfolio,” O’Brien says. “But there is no consensus that commodities are a good thing, while most funds espouse the merits of alpha.”
Jim Rogers, who developed the eponymous commodities index, knows all about alpha: He was one of the founders of hedge fund legend George Soros’ Quantum Fund. Yet Rogers was so convinced that there would be a secular bull market in commodities that he sought to capture the beta of that asset class through his index. Commonly known as RICI, it corrects a common complaint about the Goldman commodities index -- that it overweights energy. GSCI gives a 75 percent weighting to crude oil, diesel, gasoline and natural gas; RICI’s equivalent heft is just 44 percent.
“Like all successful investors, Jim is a pragmatist as well as a visionary,” says Lionel Motière, chairman of Lausanne, Switzerlandbased Diapason Commodities Management, which licenses the index and manages $1.5 billion tracking it. “Alpha is the new El Dorado, but for many investors it will prove to be equally elusive.”
