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A Gamut of Alternatives
Peter Douglas, GFIA Pte Ltd

January 2004

The asset management industry is changing fundamentally, and aligning itself much more with investor needs. One facet of this is the increasing importance of absolute return managers providing a pragmatic mix of alpha and beta.

Conventional managers are tied closely to market risk ("variance" away from market risk is considered risky) and therefore by definition are precluded from generating much alpha. However, fees have historically defied the empirical and intuitive evidence, and have been high. Now they are falling rapidly.

Index managers by definition deliver pure beta, less their fees, and compete both on the accuracy of their index exposure and the fineness of their fee. In other words, pure beta is available very cheaply.

An alpha strategy aims to generate positive returns independent of market movements by exploiting a particular investment opportunity which almost inevitably has a huge (and welcome) variance from the market, but with a lower incidence of negative returns. This is difficult and one of the last bastions of human excellence-and therefore expensive. And investor demand will ensure that the cost remains high.

Why do investors like alpha? Because it is independent of market movements and therefore appears to be more robust than beta. And because there is a growing disillusionment with relative return strategies that-naturally-have lost money as markets have been weak. Furthermore, it is a truism that, on average, investors must underperform the market (since, on aggregate, they are the market; but they have transaction and other costs), and investors are unwilling to pay for returns that are statistically likely to underperform.

Lastly, and mostly powerfully, the best investment is always the one that matches the liability profile most closely. And while no investor that we can think of has a liability profile corresponding to market risk, many do have a liability set best served by consistent positive returns-a much more "alpha" profile.

The big limiter, of course, is capacity. While market risk is plentiful, and the conventional industry's mix of beta with a sliver of alpha is broadly scalable, most non-correlated strategies have a finite capacity to attract investor assets.

Like any goods, increase in demand will tend to increase price and create supply, and vice versa-though the relationship is rarely linear. We are seeing the following changes in demand, price, and supply:

demand price supply
pure beta increasing already very cheap unconstrained
beta+ (conventional asset management) decreasing decreasing unconstrained
alpha increasing expensive constrained

Absolute Return

There is a fourth category of manager who has been around a long time-though not always that visibly. In Asia at least, the absolute return universe is flourishing. Managers who do not hedge or hedge only at the periphery of their portfolios-but have no interest in market benchmarks-are attracting assets and attention. A good absolute manager will understand how to benefit from the power of a rising market, often has a real skill in understanding fundamental mis-pricings, and has the experience and skill to defend the portfolio in falling markets. Because they do not have the constraints of a short book, and usually little or no leverage, they have holding power and can trade over a longer cycle than many hedge funds.

And they are in an increasingly powerful position.

We recently attended a client meeting with a major absolute return manager, who has managed to increase their aggregate (institutional) fee significantly last year while doubling assets under management; the meeting was to discuss the amount of increase for the coming year. What conventional manager would be having this discussion currently?

The best of the long only managers offers a very attractive proposition to investors. For example, one of the Japan managers we track has delivered a net return of 23% to investors since inception in 1999; this during a period when the Nikkei 225 has fallen 40%. Another Asia regional fund has delivered a 202% return since its inception in 1997 during a period when the MSCI FE ex-Japan has returned broadly zero. Interestingly, this latter fund's "benchmark" is a 20% p.a. nominal return. Both these managers are conservative, conventionally trained, and well disciplined money managers working in small partnership-like organisations.

Like hedge funds, absolute return funds have many different characteristics but no clear definition. Typically however, they fall between hedge funds and conventional managers in fees, liquidity, capacity, etc., but resemble hedge funds in their organisational structures. Up till now, the client bases have been more drawn from conventional asset management space-endowments, foundations, and of late more conventional institutions fleeing from the "Alice in Wonderland" world of benchmarked managers.

While capacity is limited, it is typically less limited than for a hedge fund operating in the same asset class, and, importantly, the long-tail risk is much less as most absolute return funds operate without leverage, and-with a long only mandate-cannot be squeezed or have stock called back. For example, an Asian long/short fund operating in small or mid-cap stocks would wisely limit capacity to US$100 million or US$200 million. But there are a couple of Asian small-cap absolute return long-only managers with funds in excess of US$1 billion. Although market correlation is necessarily higher, overall risks in well managed absolute return funds are, in our opinion, broadly in the same range as for a hedge fund.

Increasingly, these managers are seeing interest now from what would more usually be hedge fund investors-family offices and funds of funds.

A global bear market persisting into early 2003 has helped equity investors realise the constraints of beta. And persistent low interest rates mean that any risk premium is applied to a low nominal base, and that returns in the future are likely to be lower … hence cost-effective strategies are at a premium.

In other words, when interest rates were 8%, and the equity premium was (say) 5%, an unambitious equity portfolio over the long run would converge on a 13% return, allowing for 2%-3% a year in fees and expenses to be taken out and still give the end-user a double-digit return. Now, with interest rates at 2% and the equity risk premium arguably around 3%, that same portfolio is trending to a 5% return, making the end-user acutely sensitive to fees and charges. Customers that decide they do want simple market returns are seeking more cost-effective routes, such as index funds and ETFs, than conventional money managers.

However, the demand for alpha-driven strategies is such that there is little fee sensitivity for the manager that consistently delivers absolute returns-hence the substantial fees earned by hedge, real estate, and private equity managers. One of the longer-standing Asian equity hedge funds recently closed its existing 1% and 20%, monthly notice fund, and opened two new share classes, one with three months' notice and a 1.5% management fee, and a second, to take capital when the first new share class is full, with six months' notice and a 2% fee.

We talk to retail investors who are being offered funds of hedge funds. We read of the 40% growth in the number of institutions globally investing in hedge funds, and the growth in total commitments and proportion of assets held in these portfolios . We see the growth of multi-billion dollar funds of funds. Demand is undeniably accelerating.

The constraints however are very real. Consistent alpha strategies are almost all highly dependent on the size of investment, and cannot take large amounts of capital. Intuitively, this makes sense. If these strategies were fully scalable then they would eventually become the market … and hence alpha would become beta. More prosaically, to extract consistent and non-correlated returns from volatile and complex markets is not straightforward, and with few exceptions, managers succeed because of focus on one asset niche or strategy, beyond which they will not venture and risk performance.

So with increasing demand and capacity increasing at a lesser rate, if at all, alpha is going to become scarce. It is already expensive, and cannot get much more expensive without seriously impacting investor returns. Managers can and do ration capacity by choosing their investors and excluding others, imposing lock-ups and long notice periods, or simply closing to new capital.

As more investors come to understand the difference in types of return, and demand to include alpha-driven strategies, how can the industry deliver?

The Big Shift

Currently the asset management universe looks like this:

pure beta
indexers, ETFs etc
active beta
conventional money managers
absolute return managers
pure alpha

where active but index-relative managers dominate, with small outposts of cheap beta and pure alpha, but it is moving to:

pure beta
indexers, ETFs etc
active beta
conventional money managers
absolute return managers
pure alpha

where beta is cheap, active beta is still a subset but not dominant, and the alpha strategies are much more popular. Pure alpha becomes more desirable but is limited by supply.

What will happen is not of alpha drying up, but that aggregate returns will come down and higher returns will become available to a smaller universe of favoured investors.

Furthermore, most of these pots of return are packaged in separate industries. An index manager is unlikely to lunch with an absolute return manager any more often than a hedge fund is likely to chat to a conventional money manager very often.

The Future

What we are seeing is a huge shift in investment fashion from a world view that says:

"Markets go up, buy on the dips, never mind the fees, and your risk is in not being in the market"

to a world view that says:

"Markets are volatile and volatility destroys value, fees matter, and your risk is in losing money or not meeting your target return".

What that means for investors is a shift from using a few conventional managers to cover the main geographic asset classes, to using a much more fragmented range of specialists to weight the difference points of the alpha-beta spectrum in a more sophisticated fashion. But the constraints on pure alpha generators can only become more difficult.

What we believe will happen-and we are beginning to see this from some more sophisticated investors-is a shift towards portfolios constructed of a wide range of specialists, optimising not only the risks and returns, but also the costs of portfolio management. A typical fund of funds in the future is much less likely to remain dogmatically a fund of hedge funds. It will be composed of hedge funds, but also CTAs, and absolute return manager that do not hedge but aim to make money from high index variance.

We are beginning to see this. Talking to CTAs and managed futures managers, they are already seeing more funds of hedge funds including their strategies. And the better absolute return managers are filling their capacity with increasingly sophisticated investors. For these players, the handicap of fitting neither into the conventional nor hedge fund pigeonholes is turning into an advantage of offering a pragmatic mixture of returns driven by alpha and beta, with greater capacity and lower fees than pure alpha strategies.

The growth of the hedge fund industry is not infinitely scalable. We do not know where ultimate capacity is. The warning signs will be:

  • the acquisition of a major conventional asset management house with a few hundred billion of assets under management, by a hedge fund group with a few tens of billions of assets, in a stock swap;

  • two or three years of falling aggregate returns for the hedge fund industry masking increasing performance dispersion within strategy groups; and

  • the automatic inclusion of funds of hedge funds in every mutual fund manager's product range.
At that point, pure alpha-driven returns will self-limit, and the absolute return industry will fill the gap.

Furthermore the disillusionment of conventional allocators with paying full price for index+ management will stimulate further manager formation from conventional space into absolute return management companies. We already see this: good individuals from conventional long-only space do not only take their reputations to hedge funds; they take them to absolute return boutiques. This trend will pick up again as the hedge fund industry gets overcooked.

Peter Douglas is a Chartered Alternative Investment Analyst and the Alternative Investment Management Association's Council Member for Singapore. He is principal of GFIA Pte Ltd, a hedge fund research consultancy, and research partner of Dewey Douglas Ltd, a fund of funds consultancy.

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