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ARP Observations

Year of the Alpha

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See all articlesThe Absolute Return Letter

At Absolute Return Partners we distinguish between four types of risk – beta, alpha, gamma and credit risk. Beta risk is market risk – plain and simple. Credit risk is precisely what is says on the tin. Gamma risk is a mixed bag of various types of risk away from market and credit risk.

Alpha risk is the contentious one. 

The way the vast majority of investors think of it is as the risk of underperforming the markets, i.e. doing worse than you would do through sheer beta exposure.

But, there is more than one way to think of alpha risk. According to the Blu Family Office, alpha risk is the risk of mispricings, and that would include inefficiencies. In Blu’s terminology, you can only generate alpha if you can extract the mispricing through the opening and closing of opposing trading positions.

A major source of returns in recent years has been the so-called illiquidity premium. Tie up your capital for five years, and suddenly (expected) returns spike, but there are obviously risks associated with such a strategy. We often come across investment managers, who proudly tell us they generate plenty of alpha but, quite often, what those managers actually do has nothing whatsoever to do with alpha, whether you define alpha one or the other way.

They generate solid returns because they have identified a way to benefit from taking other risks (in this example liquidity risk). From our experience, those managers who cannot articulate precisely which sorts of risk they take, and why they generate the high returns they do, often revert back to the mean (or worse) in terms of performance.

I believe there will be little to gain from taking beta risk in 2017 – in the US or elsewhere.

One challenge you will quickly run into is that the vast majority of investment managers with a decent track record take a considerable amount of beta risk along the way. It is certainly the case in the equity long-only space, where all managers take substantial beta risk, but the majority of equity long/short managers are guilty of the same.

Alpha is by definition a zero sum game before fees. For every underperformer you come across, there will by definition also be somebody who outperforms. When people say that “nobody outperforms anymore”, it is sheer nonsense. If somebody underperforms, somebody else must outperform.

In the early days of the alternative investment industry – back in the 1980s and 1990s – it was possible to pick up a considerable amount of alpha by merely buying and selling the same security on different exchanges. Back in those days many investment bank proprietary desks and hedge funds delivered stellar performance.

That has all changed.

The amount of alpha generated by alternative investment managers in recent years has been very disappointing, and I think there are at least a couple of reasons for that.

Firstly, there is far more capital chasing the same mis-pricings today, making margins harder to come by and secondly, technology has changed dramatically. Algorithmic-based trading now accounts for a large percentage of total volume on all major exchanges, and inefficiencies are harvested in nanoseconds rather than days or weeks, as we saw back in the golden years.

However, alpha will not disappear entirely, so long as markets don’t go up and down in straight lines.

The perception that nobody outperforms these days is probably a combination of two factors – high fees (frequently 2+20 or even worse) combined with the fact that the absolute level of outperformance today is lower than it was years ago. This has caused many to underperform after fees.

That brings me to the final point on risk factors – how to benefit from gamma risk. Being exposed to gamma risk is about exposing yourself to convex return profiles and not relying on the markets (i.e. beta) to generate returns. Here you have to look for the more qualitative input factors employed.

Gamma risk is present in both liquid and illiquid investment strategies. I mentioned illiquidity earlier as an important gamma factor, but gamma factors can also be employed in the liquid space - volatility being one example. The beauty of gamma risk is that you can turn that risk up or down as you see fit without it affecting your beta exposure.

About the Author

Niels Clemen Jensen founded Absolute Return Partners in 2002 and is Chief Investment Officer. He has over 30 years of investment banking and investment management experience and is author of The Absolute Return Letter.