Getting Rich In a Poor Market, Part IV

We’ve looked at two options for our portfolios if, as seems likely, we are entering into a period of historically low returns: more aggressive allocations to equities, and taking better advantage of illiquid assets. We now turn to the question of alpha.

“Alpha” is a measure of risk-adjusted performance. If a manager outperforms an appropriate benchmark while exposing its capital to the same or less risk as the benchmark, the manager has produced alpha.

Unfortunately, true alpha is very rare. Most managers, whether they are long-only or hedge funds, rarely produce alpha over any extended period of time. Long managers tend to be benchmark-huggers, producing returns that are very close to those of the benchmark in gross terms but trailing the benchmark net of all costs and fees. Hedge fund managers typically charge for alpha but actually deliver beta.

Thus, under ordinary circumstances spending a lot of time seeking alpha, especially among long-only managers, is a fool’s errand. But of course we’re postulating that we are entering an era in the markets that is far from ordinary – and that will be unordinary on the downside. If an index exposure to stocks is likely to produce no more than three or four percent, suddenly the search for alpha becomes much more compelling.

But is there any reason to believe that alpha will be any less rare than it has been in the past? Yes. One important reason why producing alpha has been all-but-impossible over the past eight years is the dominant role of central bankers in driving the performance of equity and bond markets. The Fed wanted stock prices to go up to create the “wealth effect,” and so it manipulated the equity markets to make that happen.

During this period any brain-dead fool could buy an index fund and look like a genius. Talented managers who searched hard for value were left in the dust. Many good managers, both hedge and long-only, simply threw in the towel and closed up shop. Others continued to plug away, producing indifferent results, and found their reputations sullied and their assets under management shrinking. But now that the Fed is finally exiting QE, these managers will not only return to form, but instead of being closed to new investors they will be eagerly seeking capital – and in many cases their fees will have dropped.

Where are likely places to look for alpha-producing managers? Here are some hints:

• In the private equity world – venture, buyouts, mezzanine, special situations – good manager performance tends to be more persistent than elsewhere. PE is therefore a good place to start. But beware: the PE world is changing rapidly and many formerly best-in-class firms (Kleiner Perkins, e.g.) are now second rate
• Of the more than 8,000 hedge funds in existence, only a few hundred are worth looking at. But those managers are very much worth looking at and, as noted above, many of them are now accepting new investors and reducing their fees.
• In the long-only space, most managers are benchmark-huggers, that is, they intentionally build their portfolios to have very high R-squareds (a measure of correlation to a benchmark) because they don’t want to risk having several very bad years of performance in a row. These managers are to be avoided like the plague. Look instead for managers who have been in business for a long time and who are doing something quite different from the benchmark – ideally, those with R-squareds well below 90%.
• Specialized managers in general are good places to look for alpha. These managers might be organized in private equity format, hedge format, or even long-only format, but they are working in narrow sectors of the markets where they have special skill and insight. These sectors won’t always be interesting, but when pricing seems attractive specialized managers can do very well.

For investors to prosper during a prolonged period of low investment returns, our old ways of doing business will need to be jettisoned – indeed, will in many cases need to be turned on their heads. Index investing has worked brilliantly since the Financial Crisis, but going forward it will merely deliver unacceptably low returns. Finding managers who can deliver alpha has been for years a hopeless activity, but looking forward it will be both essential and a lot easier. In a world in which beta won’t meet our investment needs, we need to search for alpha.

Next up: Getting Rich in a Poor Market, Part V