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Wednesday, June 21, 2006
Can Managed Alpha Returns be Replicated?The dependency between two random variables is perfectly characterized by their joint distribution. One can nonetheless study the marginal distributions separately from the dependency structure by means of a statistical tool: copulas. This copula function contains the whole information about the variables' dependency structure.
Here's a thought; given the nature of copulas, could managed alpha be replicated by asset catagory? - picture a model that replicates, say...managed commodity returns.
Thoughts..?
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As you may be aware, I've blogged before about what I consider to be the inevitable restructuring of the alternative investment community. This restructuring is inevitable as excessive profits are not sustainable in an environment with relatively low barriers to entry - those who have ever worked at a hedge fund know exactly what I'm talking about. What is less certain is how this shakeup will occur.I see three possible scenerios: 1) a crash caused by fund managers taking on extraordinary risk in order to cull the returns demanded by their clients - other factors would be at play as well. 2) textbook consolidation led by commercial banks, increased economies of scale and the subsequent lowering of fees. 3) a soft landing caused by a flight of clients fed up with high fees and average to below average returns.
Consider the following from the Financial Times:
Hedge fund managers are increasingly refusing to make risky investments for fear of losing customers and their sky-high fees, according to GAM, the world's biggest hedge fund firm. GAM, a fund of hedge funds specialist based in Zurich, said it was hard to find managers prepared to take the levels of risk needed to produce the high returns wealthy investors demanded.
David Solo, chief executive of GAM, which manages $55bn for private clients including $23bn in hedge funds, said the change in managers' risk appetite stemmed from their success in raising money from pension funds, endowments, insurance companies and other institutional investors.
With typical management fees of 2 per cent a year on large amounts of assets, there was more incentive to retain assets through cautious management than to seek additional performance fees from outsized returns.
The sector's profile has changed as institutions have poured money in and driven worldwide hedge fund assets to more than $1,000bn. Institutional investors such as pension funds have demanded that hedge funds in which they invest reduce their risk levels.
With mature hedge funds taking a conservative approach, GAM has been forced to invest in start-up hedge funds, typically staffed by former investment bankers who are prepared to take big risks until their fund reaches critical mass.
Hedge fund performance had also been hit by the weight of money coming into the industry, which had led to "overcrowding" in many strategies, he said.
Interestingly, the article says that mangers are, "refusing to make risky investments for fear of losing customers and their sky-high fees." - this is the crux of their problem. What kind of returns can a hedge fund produce by taking less risk? Put another way, will clients pay an alpha premium for beta returns? I don't think they will.
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Just finished a great research report from IBM Business Consulting Services regarding what they called a "Financial markets renaissance." I think their assessment is spot on in many regards. Of particular note, is the role risk will play in defining the financial institutions of the future.
They argue that firms have long benefited from the edge provided by proprietary information access and market insight, but these advantages will come under significant pressure over the next decade as two inexorable trends accelerate: transparency and speed. As these two forces approach their limits – transparency can’t exceed the point at which everyone knows everything, and speed can’t move beyond the instantaneous – many of today’s profit engines will stall, while new value engines will begin firing on all cylinders.
In the not-too-distant-future, firms must be able to succeed in an environment where analysis, not knowledge, is the value creator, and where it’s not seconds that count, but milliseconds. Power will shift from the traders who have benefited from merely facilitating transactions to the buyers and sellers that take positions on either end of the trade, and the way that firms create value will likely experience a renaissance as transformational as anything the industry has ever witnessed.
The fundamental task for firms going forward will be to develop a clear perspective on risk. Value will be created in two ways: by effectively assuming and managing risk, or by mitigating risk, either by taking it out of the overall system, or by reducing it for their clients. Today, we characterize industry segments in terms of buy side, sell side and processors out of convenience. However, as value bifurcates on the risk dimension, this terminology may eventually become irrelevant.
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