How Reproducible is Alpha?

Is alpha, the Wall Street term for market-beating returns, sustainable? Or is it a unique, statistical outlier, indistinguishable from random chance?

I have been thinking about this a lot, lately. The relentless drumbeat of negativity about hedge funds, of which I am admittedly acontributor, is the underlying motivation for this line of thought. It has sent me on a hunt for those managers who consistently create alpha.

They are few and far between. You likely know their names. There is a short list of those who have 1) outperformed; 2) over long periods of time, and; 3) manage substantial sums of money. It’s impressive if you are on that list, but discouraging if you seek to invest institutional capital with this group.

This isn’t a secret. Jim Chanos of Kynikos Associates pointed out  that 30 years ago there were only about 100 hedge funds and just about all of them created alpha. Today, there are more than 10,000 hedge funds, and it still seems as if only about 100 of them generate alpha.

It isn’t just hedge-fund managers; stock pickers in general (hedge funds, mutual funds, pension funds, etc.) have been having a hard time of it. This is the “Paradox of Skill.” As more and more talented people enter the investment field, there is simply that much less alpha to go around. Financial researcher Larry Swedroe notes that only 2 percent of managers are generating alpha, down from 20 percent a few decades ago. That number seemed likely to keep failing.

Given all of the talent today in the zero-sum game of trading, it just might be statistically impossible for many managers to create alpha. But it would be wrong to say none do. There are a handful who have consistently made money on both a relative and an absolute-return basis. It is just that sustainable, long-term alpha is that rarest of all elements. The vast majority of institutional hedge-fund investors would have been better off (often much better off) with a simple low-cost index portfolio of 60 percent stocks and 40 percent bonds.

Perhaps it is true that, as the Economist noted in 2005, a hedge fund is just “a compensation scheme masquerading as an asset class.”

Maybe the single-most challenging task is untangling skill from luck. One way is to determine if a money manager’s returns are skill-based is to see if they can be repeated over long periods of time. Those managers who have developed a specialty that doesn’t lend itself to being arbitraged away are a good place to look. Howard Marks of Oaktree Capital, for example, has long-term returns in distressed bonds that are far beyond what could be reasonably explained by chance alone. The odds are low that luck accounts for annual returns of more than 17 percent over a span of more than 20 years.

On the other hand, there are plenty of managers who seem to be one-hit wonders through some combination of luck, skill and good timing. Where they stumble is when they try to reproduce those returns.

Wall Street Journal reporter Greg Zuckerman profiled fund manager John Paulson, whose wager against subprime mortgages and residential real estate netted his firm more than $15 billion. Since then, he hasn’t been as successful. Bad bets on gold and takeoversinvolving Allergan and Valeant have battered the fund. Others who also made winning bets on subprime have been similarly stymied.Kyle Bass did exceedingly well during the housing collapse, only to slip up on oil.

But were they one-hit wonders? Maybe. But having the courage of your convictions in the face of extreme doubt from clients, partners and friends, as Paulson and some others did, isn’t something many money managers could sustain. So give credit where it’s due.

There are signs that investors have wised up to the game of chasing alpha. Flows to hedge funds and other less liquid investments are slowing. A senior Blackstone Group executive on Wednesday said hedge funds might lose as much as a quarter of their assets. Consultants are being called to task for their role in steering investors to underperforming, high-fee alternative investments. Research has shown that financial consultants add no value through their selection of investment managers.

Understanding the costs of pursuing alpha, and how genuinely rare it has become, may very well determine what the next decade of capital flows look like.

Me? I’ll stick with beta.

Originally: If You’re Such a Great Investor, Where’s Your Alpha?