Is the world running out of oil, err I mean alpha?
All About Alpha (via Abnormal Returns)has a post comparing the recent dearth of alpha in hedge funds to the now ubiquitous theory “peak oil,” asking if we have passed the “peak alpha.” Alpha Male points out that alpha is not market inefficiency but rather the result of market inefficiency. The demise of alpha would logically mean the markets are suddenly efficient. If you believe alpha exists (or at least used to exist as recently as a couple of years ago, then you also have to question whether alpha is (was) a finite or perhaps unlimited resource. Is alpha a zero-sum or perhaps more correctly a finite sum game? If it is, then alpha is a finite resource, and there may indeed be a peak alpha beyond which alpha is harder and harder to extract and is supplied in ever-diminishing quantities, and yes, the markets will finally be efficient. If alpha is not a zero or finite-sum game, then it is extractable in ever-increasing quantities, perhaps fueled by what others claim is the coming technological singularity.
Alpha Male points out that just like the Canadian tar sands may extend our oil supply longer, the ample supply of beta in the market may extend our alpha supply longer by “refineries” that convert alpha to beta. Yet hedge funds are already worried about the lack of volatility. Can volatility be harvested as alpha? If so, is it drying up too? If they have a spare $8,000, this report might help a poorly performing hedge fund find alpha. Perhaps portfolio financing is the answer.
The anonymous author of Hedge Fund thinks alpha is in perpetual supply:
Many new strategies have emerged as a consequence of growth in the variety of underlying products that can be traded and the relationships between them. Complexity and innovation in assets, hybrids and their derivatives offers investment and arbitrage opportunities and I see no reason why financial technological innovation should cease, anymore than other technologies. Whether it was interest rate swaps, credit derivatives, commodity linked bonds, CDO of CDOs or weather insurance, all these created opportunites for new investment strategies or NEW ALPHA…Whether by product, strategy or geography, ALPHA WILL NOT BE IN SHORT SUPPLY.
Similar views are expressed in this article:
Arne Hassel, Coronation’s chief investment officer, says that as competition for alpha increases, fund of hedge funds will become increasingly complex, requiring greater levels of skill and understanding.
Still others (Iluka Hedge Fund Consulting) claim that many hedge fund professionals don’t even know what alpha is and their investors don’t know if they are getting any or not:
One man’s alpha is always another man’s negative alpha. This is because, quite simply, the total amount of alpha available in the world is precisely nil. To say there is not enough to go around is an understatement—there is absolutely none. And thus it is always the case that an investor who achieves some positive alpha has done so at the expense of one or more additional investors. This is the stark reality of alpha, though the word is thrown around in the industry as if it were a minable resource available to all who make the effort to extract it. And it is the reason why alpha is so extremely difficult to “sustain”.
The argument in the article is that when the market increases by say 10%, that 10% was pre-destined and is simply divied up among the participants no matter how many exotic derivatives they come up with that supposedly allocate capital efficiently. In other words, financial innovations do not add any value, they simply transfer risk (or perhaps negative alpha) to someone else. Do I smell Efficient Market Hypothesis? The author concludes by saying “the decision to pursue alpha should be taken soberly.” Indeed.
I swear I was sober when I started this quest for excess returns, and I’m going to pursue it vigorously. The fact is, the supply of alpha despite being right in front of our noses in the markets everyday, be it zero, finite or infinite is much harder to quantify than oil which can be hidden twenty thousand feet underground or more. It’s fitting that I started my career programming computers to process data to search for oil, and now I program computers to process data to search for alpha.
Update: Alpha Male has another article countering the zero-sum alpha argument (alpha is not zero in the case where investors have different utility functions including differing investment horizons). Does this mean I can use the Kelly Criterion to generate alpha that was simply waiting for me?
Update II: CXO Advisory just highlighted a scientific paper on the subject. Some of the conclusions they highlight:
Excess returns correlate negatively with past flows mainly for the arbitrage oriented strategies. Only for event driven (ED) funds is the effect strong.
There is no general decline in the excess returns produced by the hedge fund industry. The growing supply of hedge fund capital has not exhausted the set of opportunities available from noise traders and investors with heterogeneous time horizons and objectives.
Update III: Alpha Male surveys the reponses.
Update IV: Alpha Male reviews a paper by Ibbotson Associates that finds alpha in hedge funds, at least the survivors.
Update V: See my follow-up post Adaptive Market Hypothesis: Yes, Virginia, there is alpha in the market. The Adaptive Market Hypothesis postulates that alpha will always exist.
Update VI: The debate about whether the stock market is a zero-sum game is raging.
Update VII: Is Peak Oil Theory Faulty?
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