Roughly a year ago, I wrote a post discussing the concept of alpha (that rare and valuable thing) which becomes less rare and eventually commoditized into beta in time. Here’s a bit of what I said at that time:

Isn’t alpha supposed to be the returns from a strategy that is based on market inefficiencies? If so, then shouldn’t these market inefficiencies disappear as other players enter the field? This line of thinking is discussed in this paper available on SSRN:

By the way, this paper was written by market participants. At the time of its publishing, the authors worked for ABP Investments which, according to its website, is the 2nd largest pension fund in the world. This paper discusses how investment processes can be divided into two groups:

Traditional beta which they call “commoditized beta”. This is based on exposures to various markets and is the classic definition of market risk.

Traditional alpha which they call “non-commoditized beta”. This is based on other risk factors not associated with market exposure.

Basically, the writers of this paper sum up things well in four points (bottom of page 4) provided here ad verbatim:

1. Any investment process which today generates return by taking exposures, which are not well known, will become obsolete progressively, as the exposure premium reduces or the exposure is commoditized.

2. As exposures become commoditized, the space to generate additional alpha return (from the residual) decreases, and the space for beta return increases.

3. There is practically no alpha based exposure, which cannot be commoditized.

4. The investment problem which originated in finding exposures to generate alpha will gravitate towards becoming the process of analyzing when to take a specific commoditized beta exposure.

They go on to say that the alpha versus beta debate is irrelevant. “The eventual investment problem is therefore not to now generate exposure combinations, which would generate alpha, but to be able to time the betas of the existing exposures. We therefore believe that active management will devolve to an exposure based allocation process, where the objective is largely to allocate to different forms of beta, and where alpha does not actually exist. Portfolio diversification is then just the diversification obtained by applying the forecasting process to more than one beta.” This is basically a rewording of point #4 above.

A key point from the above I believe is this: ” … where the objective is largely to allocate to different forms of beta.”

Remember, this was written by some portfolio managers who were at ABP, one of the world’s largest pension plans. They’re trained and compensated to care about the long term horizon, not the short term. But it seems like what they’re saying is that not only should one NOT stick to only investing in the plain vanilla betas (broad market index exposures … let’s just call that the very large, broad, market-cap weighted ETF behemoths which generally come with low management fees) but in fact must allow for the niche exposures personified by the newer and more controversial ETFs that have higher fees. I’m assuming that these niche ETFs provide the required “different forms of beta” mentioned above. The writers say that alpha does not actually exist in these areas (this could be sector or regional exposures). They even go so far as to say that the investment problem should focus on the timing of the beta exposures.

Let me be clear: The moment you talk about timing beta exposures, you’re talking about actively managing your ETF holdings. I’m not sure if this is what the original ETF pioneers were thinking about roughly 15 years ago but I don’t believe that this paper I was referring to was written by two dummies. I have great respect for this philosophical exercise in thinking about alpha and beta.

Why do I bring this up today? Well today, I spoke at the Hedge Funds World Canada conference here in Toronto. I led a session in the afternoon focusing on matters related to beta within an alpha centric world (it’s a hedge fund conference in case the event’s title wasn’t clear). The session following mine focused on alpha but since the two greek letters are very much related in portfolio theory, there was some overlap.

Aside: Interestingly enough, I found the term “beta” used just as much (if not more) than “alpha” in this first day of this conference. There was a session on 130/30 programs. These mandates are engineered to remain extremely constrained so as to continually have beta of 1.0. Again, at a hedge fund conference. Beta 1.0!!! Isn’t that an index fund?! Well not necessarily but it kind of blurs the line between hedge funds and mutual funds. At the least, it certainly makes me think what Jones, Soros, Robertson and other “old school” hedgies would think about a mandate with a target beta of 1.0 being discussed at a hedge fund conference. 130/30 programs also called a variety of other names including “Active extension strategies” and are commonly discussed in many other events both related to hedge funds, ETFs and well just about any investment related conference these days. Think of it, currently anyway, as the rock star of the institutional investment community. Well, I don’t know about rock star … why am I picturing a bunch of pension actuaries dressed up in leather like Kiss for their office Halloween party? Note to self: Too much coffee at the conference today.

Well, from one of the discussions today, I was reminded of the concept of alpha as simply un-commoditized beta. And when I got back home, I found an email from HSBC about a new set of indices:

HSBC has announced the launch of its Global Climate Change Benchmark Index, together with a family of four investable global climate change index products.

The HSBC Global Climate Change Benchmark Index, developed by CIBM’s Global Research team, is a global reference index which has been designed to reflect and track the stock market performance of key companies that are best placed to profit from the challenges presented by climate change. The performance of the benchmark has been tracked back to 2004 and has outperformed the MSCI World Index by around 70%.

From this benchmark, HSBC has established four investable climate change indices that can be used to create portfolios for a diverse range of investment needs such as long only funds, hedge funds, exchange traded funds, discretionary funds and structured products. The indices are:

• HSBC Climate Change Index

• HSBC Low Carbon Energy Production Index (including: solar, wind, biofuels, geothermal)

• HSBC Energy Efficiency & Energy Management Index (including: Fuel Efficiency Autos, Energy Efficient Solutions, fuelcells)

• HSBC Water, Waste & Pollution Control Index (including: water recycling, waste technologies, environmental pollution control)

In creating these indices, HSBC has responded to changing investor sentiment in global equity markets. The HSBC research team has looked at a wide range of stocks and identified approximately 300 companies that are well positioned to benefit from the challenges of climate change.

Group Chairman Stephen Green said: “HSBC has long recognized the importance of climate change and has shown real commitment to addressing the risks and opportunities it brings. In developing tailored climate change indices we are providing real investment solutions which enable our clients to incorporate climate change into their investment decisions.”

By the way, attached to the email was a 24-page report from HSBC’s Global Equity Quantitative Research group and the lead analyst’s name is Joaquim De Lima. Please don’t ask me for this report as I don’t even know how I suddenly got on their mailing list. I provide this bit of info so that you can go to HSBC and make your own inquiry. Now my thoughts.

What can I say … another set of new indices. Am I surprised that again we see something introduced to the market within the realm of climate change? Not really. The entry of alternative energy related ETFs has shown no signs of slowing down and I have discussed this area several times in the past. By the way, have you seen how PBW has been doing?

Up nearly 40% year-to-date and despite some ugliness in concert with the markets this summer, a strong rebound in recent weeks.

Getting back to main topic, what I find interesting is that this sector, or perhaps parts of this sector, should be (only my opinion, of course) the domain of hedge funds. Although not a significant part of the above release from HSBC, ask yourself if the related space of carbon emission credits is really an efficient market. Take any of the above HSBC indices and ask yourself if there is an army of CFA/MBA/PhDs as well as Average Joes at home looking into these markets in the same way as Citigroup or Microsoft. No way … it’s just too new.

[FYI and another aside: I know that carbon trading is a hot topic and I’ve just mentioned it in passing here. According to the HSBC report, the sector breakdown of the overall Global Climate Change Index shows only three stocks (0.29% weighting in the index) to financials of which two (0.22% weight of index) positions are further classified as carbon trading. So basically, don’t think of this index or sub-indices as a strong play for the emissions trading market.]

Despite the fact that these new markets are relatively new, underdeveloped and lacking in the kind of information flow similar to most global large cap equities, I find it interesting that the commoditizing of what should be alpha-centric markets is happening with greater speed. This does not take away, of course, from the fact that within these markets there will certainly be traders, some of whom will be winners and likely many more who will be losers. Some will be alpha providers (losers) and some will be alpha takers (winners).

Thus, with new markets (relatively speaking when I use the term “new”), there will be opportunities for those with a beta point of view (assuming something like an ETF is quickly produced to commoditize that market) as well as those who are alpha-focused. This is not unique and goes simply back to the active versus passive debate which one must consider when investing in any asset class. My comment here, and what I find unique, is simply the observation that the commoditizing of alpha can be faster than one might imagine simply due to the evolution of the ETF industry away from broad market exposures and towards niche markets.

But coming back to the guys formerly at ABP: According to them, the beta point of view is actually a rather active set of decisions (timing beta) and thus leads to much less differentiation from the pure active point of view which is the hedge fund.

Confused? Then the newer niche ETFs likely have little meaning for you and a disciplined buy-hold strategy with a longer focus on the “hold” applies. Not so confused? Then maybe I’ll see you next week in Scottsdale Arizona for the “World Series of Exchange Traded Funds -West” conference where I hope to explore this topic and others in greater detail. Furthermore, for those in the Far East, keep your eyes on this blog as I’m hoping to get a spot in an indexing conference in Hong Kong as well as a fund conference in Seoul both in late November.

Hey, just thought of something. I just said that the speed of bringing an area of the capital markets to beta (that is, commoditized to beta in what would seem to be a healthy space for alpha oriented investors) has significantly increased. If that’s true then why is it that we’re only seeing the first international fixed income ETF coming to market now? Well, the shape of yield curves globally didn’t help as well as a nearly five year bull market whose growth rate looks steeper than what we saw in the 90’s (not including Nasdaq in the years before the top). So the commoditizing of alpha into beta is a concept which can not be gauged solely by monitoring the ETF marketplace. But it certainly does give a strong argument for the value and purpose of the many new entrants (and soon to be entrants) within the ETF community.

Thoughtful and significant exposures that have a real purpose within a portfolio construction process. If this is what new entrants in the ETF industry provide with their new product offerings, then I think it’s a good thing. As usual, the market will decide this.

Although based in Toronto, I focus so much of this blog’s content on the US marketplace simply due to the massive amount of industry development in the area of ETFs and derivatives. Of course, there is also news in this space that comes out of Canada, Europe and other regions of the world, but for some reason, I don’t seem to get the same amount of information flow.

In recent months I have spoken at ETF related conferences in the US but since beta (and alpha) are global beasts, I’m trying to gain some added exposure outside of the US. So, in a bit of self promotion, I’d like to comment here on two events I’ll be speaking at here in Toronto.

The first is the Canada Cup of Investment Management scheduled fo June 12-13. Here’s the link to the event’s website. But before I comment on the conference, I thought it might be interesting to give some insight to the history (albeit short) of this conference as I attended the first one in 2002. That conference was called “The Canada Cup of Indexing and Related Products”. If you follow this link, you’ll see that five years ago the world, or at least Canada, had a sophisticated view of the beta world. Of course, if you read the names of the speakers, you’ll note that this was a primarily institutional event although there were many sessions for the retail adviser/investor audience. For retail advisers/investors interested in the ETF/indexing space, I highly recommend that they try to attend these types of “institutionally oriented” events to keep up with what is happening at the leading edge.

In time this event has morphed into the Canada Cup of Investment Management. When this name change occurred in 2004, the byline was “where active and passive management meet”. So it wasn’t a complete departure from beta and this agenda from the 2004 event still shows the focus on indexing and ETFs and related products. In other words, I’d say that it was at around that time in 2004 when indexing became rather mainstream. It makes sense. It was at about that time when BGI and SSGA began to see the beginning of a new wave of competition in the ETF industry. It’s only been in the past year and a half when things have begun to grow rather exponentially.

Coming back to 2007, we have the following agenda for the coming event. I provide the links to the agendas for these events to give you the following insight:

• the list of sessions gives you an idea of what are the hot topics of that time.
• you get a general direction of the trend in the industry and the perception of beta and alpha as drivers of portfolio performance.
• people - who are the experts of what
• new asset classes and strategic thinking

You’ll note that I moderate a discussion on, what else, ETFs (Tuesday, June 12, Track B, 1:45pm) and speak again later that afternoon (3:00pm) on how financial advisers can think about building model portfolios based on what institutions are doing. Both are pretty broad topics and I’m excited about the speakers who I will be working with.

The second event I am involved with is the Hedge Funds World Canada conference (October 9-11, 2007). This event is quite a few months away so the agenda is incomplete in terms of the speaker listings however it does give an idea on the broad topics to be covered. Many may believe that the hedge fund industry in Canada is limited to stock pickers going long and short while focusing on a small group of industry sectors such as oil & gas, gold and uranium. Although there are many who specialize in the commodities complex, this conference agenda shows that the talent pool in Canada is quite broad although perhaps likely not as robust as in the US and Europe … it’s just a matter of time I believe.

I think it’s interesting that the Canada Cup of Investment Management is an event that has a significant level of content related to beta (indexing, derivatives, ETFs, etc.) based on its history, whereas Hedge Funds World Canada focuses more on issues related to alpha as opposed to beta, and rightly so. Everyone has been talking about the separation of beta and alpha over the past several years but it has been common to see philosophies and methodologies pop up recombining the two. Portable alpha is the most common term thrown around.

Perhaps it may be in the group of sessions on the first afternoon of the Hedge Funds World Canada event where this type of discussion will bring some new thinking in this area. The last three sessions of day one of this event fall under the broad heading “Alpha Beta Portfolio Construction”. Note that I’ll be leading the discussion for the first panel discussion on how beta relates to alpha. Here is what’s shown on the latest version of the online agenda for the afternoon section:

ALPHA BETA PORTFOLIO CONSTRUCTION

Panel session: How does beta relate to alpha?

· Beta sources – identifying the sources and choosing benchmarks

· The availability of exotic beta

· Getting comfortable with derivatives – financing costs, leverage and liability

· Rebalancing

· Liquidity

Panel session: Identifying alpha

· How to identify alpha in a hedge fund

· What is true alpha vs alternative beta?

· Hedge fund replication

· The combination of alpha & beta; implementing a 130/30 strategy

New opportunities from new strategies: Hedge fund replication and alternative beta

· Alpha and beta: an ever more blurry line

· What aspects of hedge fund should actually be replicated?

· A review of four different replication approaches

· The prospects of hedge fund clones

Not one mention of portable alpha. That would not have been the case over the past few years. Instead, 130/30 funds and hedge fund beta (commonly termed as alternative beta) are front and center. I have commented on the growing field of hedge fund replication strategies in the past with these postings:

· The Latest In ETFs Makes Me Think: “Are We There Yet?”

· Index Providers: Commoditizing Alpha To Portable Beta

· Merrill Lynch Releases New Hedge Fund Replication Index

· Hedge Fund Replication Strategies: What’s Under The Hood?

· Harry Kat And The Art Of Replicating Hedge Fund Performance

As a practitioner involved in the inclusion of alternative investments and hedge fund programs within a broader portfolio, and more generally also as an asset allocator, I find the evolution of ideas within this area to be both exciting and yet leading to many broad philsophical questions. Where will this lead in terms of the way the largest of defined benefit pension plans think about beta and alpha? Will they think of the asset mix problem differently in the future? I can list other broad questions but the devil is in the details and although many large institutions have already implemented 130/30 type programs, I wonder how hedge fund replication strategies will fit into the mix. For those interested in digging deeper in this area, a further source of information is All About Alpha, a blog I’ve mentioned before also based in Toronto. By the way, Alpha Male, the blogger at AAA will be leading the discussion during for the 2nd panel right after mine.

Risk Magazine isn’t what I would consider standard reading in the financial services industry, as the last few sections of each monthly publication breaks out the math. I’m talking about equations that have few numbers and a ton of greek letters. Despite this, there is the occasional article that covers relevant industry developments for the non-quant. There is one article that discusses the recent push of products aiming to replicate hedge fund return distributions.Both Alpha Male at the blog, All About Alpha, and myself have commented on this topic and the work of Harry Kat, Andrew Lo, Bill Fung and Lars Jaeger (among others). But I find this article I find to be unique as it introduces the new term of “portable beta”. I’ve actually heard this term applied before within the context of the portable alpha framework. Basically, if you can transport an alpha engine (long-short emerging market equity, for example) on top of some beta component (S&P 500 index), it’s both the alpha AND the beta that can be transported and mixed in countless ways.

But in this case, we’re looking at research that has resulted in the application of beta in some unique and somewhat complicated fashion (combination of longs and shorts to various degrees in any number of different futures markets) in the attempt to replicate a certain hedge fund style/strategy’s performance characteristics.

There’s no argument here … the providers of these new products/services agree that what they are providing is beta, not alpha. And this is of little surprise when you see how correlated various hedge fund indices have been relative to standard benchmarks such as the S&P 500. If many (not all) hedge funds have high correlations with the broad capital markets, there’s little choice but to:

1. Be highly selective of the hedge funds one chooses in the hopes of having them deliver true alpha (at a cost).
2. Focus on gaining the beta exposures related to hedge fund investing at the lowest cost possible.
3. Do nothing and hope that the relatively high beta exposure that seems to have spread from the mutual fund industry to the hedge funds is a trend that reverses as the current bull market potentially/eventually comes to an end.

According to Steve Umlauf of Merrill Lynch:

“We do think there is alpha available out there through good fund managers. And if you can identify it and get access to it then it’s worth paying for. But if it’s just beta you’re getting, then it should be sold like an index fund - that is, in a liquid, low-cost, transparent format.”

Sounds pretty close to an indictment of the hedge fund industry from one of the big banks. Like other banks, ML must have hedge fund clients, in addition to their own alternative investment programs, so those words must have been massaged by more than a few people internally.. As an academic, Harry Kat of the Cass Business School in London has more freedom to speak his mind which he does here:

“Based on our research, we estimate that in 70-80% of the cases, a hedge fund manager’s contribution to the after-fee bottom line is zero or negative. Investors basically allow the manager to make a very good living using their money without getting anything in return. Unless one is genuinely attracted to this form of charity, in these cases it is worth replacing the manager in question by a synthetic fund.”

Harry has his own software program to go up against the big industry names so you can understand the direction he’s coming from. But like AlphaSwiss and Partners Group, you really have to wonder if the numbers used for all of these products has more of a bias based on recent data, specifically the bull market since 2002. The real question is how will these replication programs behave versus the comparable hedge fund strategies they aim to mimic?

If we are in the middle of a correction more serious than that experienced last summer, I’m afraid we will likely separate the men from the boys, so to speak. I doubt many funds with an absolute return mandate will do well. I’m not saying that there won’t be winners, I’m just betting that the vast majority will be losers. Just remember, there are a lot of hedge fund managers out there and they clearly all can’t be winners. The likely scenario will be a relatively small number of big winners with a relatively large number of “not so terrible” losers. Just my opinion.

This still leaves room for manager selection, but that sport is obviously getting tougher every day. Thus, this new area of hedge fund replication or portable beta should get broad acceptance if things continue as they’ve been. In reality, this development is just the transfer of indexing strategies to the hedge fund space but without it being the investable hedge fund index programs that were attempted a few years back with not much success. According to the Risk Magazine article, Lars Jaeger of Partners Group suggests “it is only a matter of time before more big investment banks and some of the index companies launch their own offerings in this market. Indeed, some participants predict portable beta could make up 40% of total hedge fund assets in just a few years’ time.”

It seems that anything (even hedge funds) that is considered alpha can and will be commoditized to beta in time as inefficiency becomes efficiency due to competitive forces. And this comment further confirms my thought that index providers and ETF manufacturers are catering more to the active investment crowd rather than the traditional passive investor. Index providers don’t need to promote an index for pensions to benchmark certain asset classes to … it’s been done to death and institutions are already there and may be considering moving away from that and to a portable alpha/liability driven investment framework. My guess is that the index providers are spending considerable resources in joint work with ETF manufacturers and other non-traditional work, including portable beta. They may not be working jointly on a hedge fund ETF … I’m just saying that index providers have focused a lot of their attention on ETF related business in recent years.

Getting back to the main topic, some questions that both the index providers and interested investors should consider regarding hedge fund replication strategies: Will they adequately replicate the underlying hedge fund strategies? Precision will be based on what comparison? If a particular hedge fund strategy (or strategies) does poorly in a bear market environment, will the replication strategy behave properly i.e. just as badly in that scenario? On the other hand, if replication strategies perform well in a continued bull market, will it build a strong following as investors dump high cost hedge funds that provide more beta and alpha in a rising market?

In any case, it’s getting tougher to be a hedge fund manager. It will be very interesting to see the performance numbers for February and even more interesting to see what happens in March.

Aside: VIX is roughly at 19. Looking at the short-term chart, you’d think that it’s high and it is since it’s spent many recent months closer to 10:

But if you look at the longer term chart you see that it’s actually fairly close to what would be considered it historical norm.

Like this past summer, it will be of little surprise to see asset class correlations spike up with the rise of VIX. Bonds and cash will provide some buffer but generally, exposure to beta of any sort will be painful if momentum builds. As I write this, the US equity markets are moving down but nothing like overseas markets. But you can feel the tension as investors consider the plug to be pulled. As VIX climbs higher, we move more towards an active investor’s environment. If you’re paying someone to make profitable decisions, you’ll want to make sure they’re not on vacation right now. If you are a long-term oriented investor, this is one of those times when your faith in long-term thinking will be tested. Take another look at that long-term VIX chart. We’ve recently seen historical lows with VIX spending some time below 10. Historical highs well above 40 haven’t been seen since the bottom of the bear market. Despite VIX’s recent climb, it still has the ability to move much higher.

Maybe there’s something to be said about the fact that there are too many ETFs. According to this column from HedgeWorld:

In the past 12 months 252 new exchange-traded funds were launched worldwide and ETF assets increased globally by 46%, according to research by Merrill Lynch. There now are more than 665 equity, bond, commodity, and currency ETFs, with combined assets of $525 billion.

We’re still far from comparable mutual fund numbers, but the growth is quite staggering. A fairly synchronized global bull market since late 2002 provided nice fuel. A similar pattern in growth can be found at the other end of the investment spectrum: hedge funds. Wikipedia may not be a suitable authority on the hedge fund industry, but the site is quite up-to-date on statistics in general and in this case provides data from a good source of industry information, Hedge Fund Research Inc. From the Wikipedia entry on ‘hedge funds’:

Assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006 according to the recently released data by Hedge Fund Research Inc. [HFR]. This was up 19% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR.

Hedge fund data is notoriously opaque in nature so don’t consider the data above as “hard numbers”, but you get an idea of the scale involved in terms of size and growth. On the one hand, you would think that the strong bull market over the past 4 years would explain the ETF boom — but not the hedge fund boom. However, perhaps with such great returns (aside for the hiccup this summer), comes increased risk taking. Thus, the assertion by many that hedge funds are not so much a “defensive” instrument meant to truly hedge certain risks from a portfolio but are “offensive” to enhance overall returns.

Hedge funds are extremely diverse. Some are meant to provide low volatility. Others are the opposite. So it’s critical to know what you’re buying. In a way, there’s nothing different in this one aspect from knowing the differing characteristics of a bond ETF versus an emerging market ETF.

I can’t say yet that I am overly concerned about the growth in these two areas, although there has been some talk in recent years of a bubble in the hedge fund industry. Despite my lack of overall concern, I would say that having too many funds in a particular area does cause me some unease. For example, how many energy sector ETFs or large cap US equity ETFs do we really need? Similarly, there are a lot of US equity long-short hedge funds competing against each other with surprisingly (or maybe not so surprising) high amount of overlap. What I do like however, is the idea of new ETFs and new hedge funds finding new areas to explore. These new areas may even overlap amongst the ETF and hedge fund entities. For example, the area of carbon trading (a recent article of mine covered this) could be structured in the form of an ETF even as a growing number of hedge funds begin trading them in an opportunistic fashion.

Further to the above, what follows are some further observations with many references to the terms “beta” and “alpha”. Risk and return go hand in hand. Think of beta as the risk/return associated with the movement of the market. Think of alpha as the risk/return associated with deviating away from the market (i.e. active management):

1. Having too many ETFs in the same space is not a very big concern. Those that are not accepted by the market simply get shut down voluntarily. This has happened here in Canada as well as in the US. I’m sure it has happened in most countries with a substantial ETF market.

Too many hedge funds in the same space - a whole other story. In the best scenario, competing hedge funds in the same or very similar underlying strategy simply realize that their efforts in a saturated market are not worth it in an economic sense and shut their fund down. Nothing different here than in the similar ETF case. In a more dangerous scenario, hedge fund managers strive to push on and beat the competition. This can include the application of leverage to “supercharge” returns. Of course, this also brings the potential for “supercharged” risks and is the reason why leverage is almost always the main factor in sizable front-page blowups. As well as hubris. Let’s face it: The hedge fund industry is considered to be the elite of the industry. Top tier education. Track record of performance from sandbox to current YTD returns. Massive bling as proof of past success… and hopefully not as a result of fraud as in a few scary cases. If performance fees are not enough of an incentive, then simply a long history of success provides the drive or arrogance to continue on. It makes the fall just that much greater and some Nobel prize winners (awarded in 1997) from the LTCM blowup (of 1998!) are probably the best example of this.

2. It should be of little surprise that the concept of beta/alpha separation is being accepted by ALL investor types, both individual and institutional, as demonstrated by the increased use of both ETFs (exposure to beta) and hedge funds (exposure to alpha — and I’ll get back to this point in a minute).

With investors becoming more knowledgeable, one area of concern has been the costs embedded in mutual funds. Management fees are fine, but not when the vast majority of a fund’s return is dependent more on beta than alpha – recall my definition of alpha as ‘the risk/return associated with deviating away from the market’ and then think about your mutual fund holdings. Hopefully, they’re not closet indexers.

Getting back to management fees, they are often considered a form of “negative alpha” since it is a factor determined by the fund manager/sponsor that negatively affects returns. So, instead of holding mutual funds, a well accepted alternative is to hold a combination of ETFs and hedge funds. For example, if you have a variety of mutual funds for US equity exposure, this could be replaced by a broad and inexpensive US ETF like VV, VTI or SPY. Overlaid on this would be a portfolio of hedge funds that would presumably be beta-neutral, in other words provide only alpha with no beta. This last assumption is rather unrealistic, but even if close to beta-neutral would at least align the portfolio better in terms of performance attribution and aligning fee structures (low for beta, higher for alpha) in a more appropriate manner.

3. Point #2 above generalizes ETFs as a means to beta exposure and hedge fund as the means to capture alpha. A third area of massive growth is in the use of derivatives. This is subject of a whole other blog entry, but it’s key to note that derivatives are a key component to both beta and alpha. Large institutions use swaps and futures instead of comparable ETFs for various broad market exposures/hedges due to the even lower costs. But of course, the use of ETFs is still an integral part of the process. In the past, I’ve mentioned the Yale Endowment (as have many others) and their significant use of alternative investments but there’s very little discussion of them in regard to beta exposures and specifically the use of ETFs. I recently discovered a site via the Kirk Report that lists some holdings from various “Pro Portfolios”. You’ll note some familiar ETFs in the list of Yale’s holdings. Hedge funds implement macro decisions and often apply the use of leverage through the use of various derivative strategies. In this case, the main selling point is not the low costs of derivatives but the massive liquidity available 24/7.

4. Although the concept of beta/alpha separation is relatively new to individual investors, but not so in the institutional investment industry, the concept can become quite blurred. The previous discussion on derivatives is one example. In my recent posting Can Retail Investors Profit From Hedge Fund Access?, I described how the ETF world is starting to evolve as greater levels of active management creep into this space. First we moved away from classic market cap weighted indexation to various alternative forms of indexing. Now we see ETFs allowing for private equity exposure.

Hedge funds traded on an exchange are the next step - although not technically an ETF these really are funds that trades on an exchange so the term does make sense… semantics really. If this trend continues, ETFs will no longer be an instrument for broad market exposure more associated with the concept of beta.

5. (Still with me?) Point 4 ends with ETFs moving from the beta world to the alpha world. I’ll confuse things further by letting you know that a new area of increased research in the academic world surrounds the replication of hedge fund returns using various passive exposures. The removal of active management from hedge funds?! First ETFs moving to alpha … now hedge funds built from beta! What is this world coming to? The end of bling? Relax, this is mainly in the research stage with very limited application in the real world as far as I’ve seen. Rest assured, there will always be a search for alpha. An industry built on fees based on competition and success within that competition revolves around a scarce commodity. That’s alpha.

6. In another previous posting, I discussed how the use of ETFs in a variety of creative ways, and especially through the use of inverse ETFs, allow investors to turn their portfolio into more of a “hedge fund”-like vehicle. As noted in my top-most link, the author from HedgeWorld.com notes that “Hedge funds are heavy users of ETFs, whether for the purpose of hedging positions or as a way to get easy exposure to a market.” Again, some blurring here of the beta and alpha worlds. However, in reality there’s nothing new here. Hedge funds have been trading beta exposures for the exact same purposes by way of derivatives for decades. All I’m saying in my post from earlier this summer is that the ordinary investor can trade beta in the hopes of capturing alpha.

I want to return back to point #1 above, where I mentioned briefly investor concerns of how mutual fund returns are dependent more on market returns versus the skills of the fund manager. Investors seem to be turning to ETFs as the low cost alternative where returns are very similar to the vast majority of comparable mutual funds. I also commented on hedge funds providing investors exposure to alpha, this being returns not associated to the oscillations in the capital markets but as a result of actions taken by a fund manager. But I said “hopefully”. This comment was made because greater evidence has been found, especially in more recent measurement periods, that hedge fund returns also have significant levels of beta. This is an even worse predicament as that found in mutual funds. Paying 1% (or whatever is the management fee for your typical mutual fund) for beta when you can get a comparable ETF for a fraction of the cost is bad. Paying 1% + 10% or 2% + 20% (management fee based on assets under management plus performance bonus based on returns over a certain hurdle or benchmark) for beta just plain sucks.

It’s important to note that the level of beta in the vast majority of hedge funds is nowhere close to that of mutual funds. What is of concern is the level of beta exposure in certain hedge fund strategies as well as the trend (potentially increasing). With a relatively low barrier to entry into the hedge fund industry, the amount of available alpha needs to be divided between an ever growing number of market participants. Thus, alpha becomes ever harder to find. For many practitioners, including myself, the exercise of “seeking alpha” is found through the strategic and sometimes tactical allocation of beta. In other words, I put greater emphasis on a certain type of timing (beta timing) versus stock or bond selection.

Truthfully, there is an aspect of securities selection in terms of finding exposure to new areas not covered in existing holdings in my portfolios. As mentioned numerous times in my previous entries, the addition of new positions (ETF or not) is to add a further bit of risk management to the overall program. An example would be my repeated emphasis on alternative energy considering the significant exposure to commodities, especially oil, found in broad Canadian indices. Of course, we adjust allocations when required as the effects of diversification has its limits. But this brings me back to the top and the proliferation of ETFs: A good thing whether you are a conservative buy-hold simpleton; an asset allocator seeking out new corners of the investment space whether it be country, sector or even strategy; or the next hedge fund manager opportunistically seeking true alpha.

The main theme of this piece is the separation and re-combining of beta and alpha. One common term for this is “portable alpha”. It just so happens that a great site, in fact one of the only sites, for more information on this area is from a fellow Torontonian, whose online alias is boldly “Alpha Male”. Here’s his site.

I’m just going get this out of the way and say it: There’s no alpha in ETFs.

That may be a given for many, but with all the new products being launched based on some sort of active management (including some rather “black box” mystique within the ETF space), I thought a discussion of the concept and perhaps definition of alpha was required. Furthermore, as a market participant very much interested in the management of betas (different market exposures), this topic is really about what I do. Consider that some disclosure on my bias in this matter.So you can go from market cap weighted indexation to fundamental weighted indexation. You can call a product an Intellidex or Alphadex or some other term that seems to meld the idea of active management implemented within some form of index fund or ETF. But I can’t get around the fact that it’s just not alpha.

If what is being proposed is a US large cap equity strategy (or whatever) based on some set of rules that, in the long term, beats the S&P 500 Index (or the relevant benchmark index), that may be deemed as alpha. It certainly could be evidence of a strategy that over a certain period of time beats a market cap weighted index. This is “alpha” in a statistical context based on portfolio theory such as CAPM. [As an aside, there was considerable debate about the merits of CAPM but generally most market participants now agree that the flaws (due to generalizations and required assumptions) of CAPM make it simply good theory but weak on application. Do a Google search for “CAPM is dead” to find out more on this discussion.]

Thus far I’ve discussed what can be defined as statistical alpha. But is it really alpha?

To me alpha is a very rare thing. Stepping away from a mathematical definition, I look at alpha as returns that can not easily be duplicated. It would be a rare finding in which a market participant can truly exploit an inefficiency in the market. I would agree with the observation that there’s less alpha now than in the past. There’s certainly more market participants out there trying to uncover every stone to find their elusive alpha. There are more hedge funds whose purpose is to provide alpha … we would hope it’s “pure alpha” if they specifically aim to perform strongly in both good and bad markets. Perhaps there’s no change in the amount of alpha out there, but because of so many participants, especially hedge funds, there’s simply less to go around “per capita”.

What I’m getting at is that there are really two definitions of alpha. One is the statistical definition. If a manager or investor can beat their benchmark index by X% on average every period, that’s their “statistical” alpha. So for every XYZ Capital Management out there who has shown that kind of result, they can calculate their alpha or outperformance over the index.

However, the other definition of alpha that I am trying to focus on here is that which relies more on a qualitative rather than quantitative due diligence on a manager or instrument including certain ETFs that are loosely classified as “quasi-indexing” which I list below. By the way, I’m not sure what the right term for these is, but I don’t see anything wrong with quasi-indexing.

Isn’t alpha supposed to be the returns from a strategy that is based on market inefficiencies? If so, then shouldn’t these market inefficiencies disappear as other players enter the field? This line of thinking is discussed in this paper available on SSRN:

By the way, this paper was written by market participants. At the time of its publishing, the authors worked for ABP Investments which, according to its website, is the 2nd largest pension fund in the world. This paper discusses how investment processes can be divided into two groups:

Traditional beta which they call “commoditized beta”. This is based on exposures to various markets and is the classic definition of market risk.

Traditional alpha which they call “non-commoditized beta”. This is based on other risk factors not associated with market exposure.

Basically, the writers of this paper sum up things well in four points (bottom of page 4) provided here ad verbatim:

1. Any investment process which today generates return by taking exposures, which are not well known, will become obsolete progressively, as the exposure premium reduces or the exposure is commoditized.

2. As exposures become commoditized, the space to generate additional alpha return (from the residual) decreases, and the space for beta return increases.

3. There is practically no alpha based exposure, which cannot be commoditized.

4. The investment problem which originated in finding exposures to generate alpha will gravitate towards becoming the process of analyzing when to take a specific commoditized beta exposure.

They go on to say that the alpha versus beta debate is irrelevant. “The eventual investment problem is therefore not to now generate exposure combinations, which would generate alpha, but to be able to time the betas of the existing exposures. We therefore believe that active management will devolve to an exposure based allocation process, where the objective is largely to allocate to different forms of beta, and where alpha does not actually exist. Portfolio diversification is then just the diversification obtained by applying the forecasting process to more than one beta.” This is basically a rewording of point #4 above.

Yikes. Does this mean that hedge funds and the search for alpha are synonymous to money down the drain? No, I would say this is like any analysis of market efficiency. It’s definitely not black and white. The US market is highly efficient with thousands of participants providing tons of analysis and many more putting their money where their mouth is. You have less analysis and less market participation in certain developing markets (in addition to other factors like government regulation) which creates a less efficient market environment. So in the US, there’s a far greater argument to use ETFs than for any given emerging market exposure. At some point in time, with greater “commoditization” you move from a market that looks more like India (for example) to one that looks more like the US. This would seem to agree with points 1 and 2 above.

Similarly, with hedge funds, there simply has to be some evolving where one form of alpha has to be replaced with another. Hedge funds (and especially “fund of funds”) and multi-strategy funds are in the business of finding the next alpha. Whether this is something that can be done successfully and on a repetitive basis is a very good question. Like anything else, the market will decide.

But this leads to point #3 above. As alpha is exploited, it will be commoditized and become some alternative form of beta. In my opinion, this is the real key point of this paper. Alpha will eventually become beta. If it’s a good idea, a set of rules can be force fed into a computer model that can run it on autopilot. (I will admit that not every strategy can be transformed into a quantitative model and thank goodness because there’s got to be some active management left for the industry! Many pros rely on performance fees. This makes me wonder … performance fees are a good reward for true alpha. Should quasi-index ETFs charge performance fees if they truly provide alpha?)

Strategies on autopilot. Is this not what these ETFs listed below are all about? All of these ETF’s have in some way turned a systemic market “inefficiency” into a commodity:

PowerShares Dynamic Market Portfolio (PWC), PowerShares Dynamic OTC Portfolio (PWO) and the various other Intellidex based ETFs from PowerShares

The various FTSE/RAFI ETFs from PowerShares and Claymore

WisdomTree ETFs

First Trust DB Strategic Value Fund (FDV)

I am not negative on ETFs such as these which I would broadly classify as quasi-index ETFs. I simply don’t think that they provide alpha. They provide what may loosely be considered as alternative forms of beta or broad market exposure. Traditional ETFs have been based on traditional market cap weighted indexation. These new (some not so new) offerings provide a change, and in this case I think change is good because we are getting new forms of broad market exposure. However, some clearly, or at least in my opinion, provide better value to the investor than others. That’s another discussion.

Facetious my title certainly is. Truth is, however, that with tools that exist today, and in the ever-expanding ETF world, any investor can be their own hedge fund.  [Interesting side note: News out recently has shown that regulation on the hedge fund industry may not be tightening at first thought: See “SEC Hedge Fund Registration Rule Struck Down by Court” from Bloomberg News.]

There have been numerous hedge fund debacles globally, leaving many investors, some of which should have never been in anything close to these instruments, completely devastated. A few serious ones have created big news up here in Canada over the past year. Despite this, hedge funds are proliferating like flowers (I was going to say weeds but it would be unfair to generalize). With recent evidence of no increased regulation on hedge funds, which I broadly define as mutual funds with fewer constraints, should we be getting worried?

Naaahhh, let’s all get out there and make tons of money! Seriously, we’ve all heard stories of ordinary people quitting their day jobs to become day traders back in the last 90’s. A similar migration has occurred in the past five years or so where traditional money managers have moved to start up or join hedge funds.

Why not? More freedom from reduced investment constraints. And the performance fees don’t hurt. Hey, I started in this industry managing directional strategies on equity index futures as well as long-short US equity programs. I’m not going to just flatly trash hedge funds. However, as I’ve said in an earlier entry, there is a clear problem in hedge funds that isn’t actually that new. Similar to many mutual funds that have been and are criticized for charging relatively high fees for what is essentially “closet indexing”, we now see hedge funds also providing more “beta” and less “alpha” than what was promised in their marketing material.

Unlike my previous “weed versus flower” comment earlier, I feel justified to generalize here: far too many mutual funds behave like indices. My fear: the same problem develops in hedge funds.

Many hedge funds state that they aspire to perform well in both good and bad markets. In other words, their performance should be independent to what’s going on in the market. The technical term is being “beta neutral”. The problem is that recent returns have shown that this may not be generally true. In fact, I observe that more and more, hedge funds as a whole have behaved more like “closet indexers”. I don’t think this problem existed prior to around 2003.

Here’s a recent story related to this problem from Sweden, but hedge fund industry watchers are noting this disturbing trend in other areas of the globe. (Note: registration to this site may be required but is worth it if you are interested in getting free news related to the hedge fund industry).

If you don’t want to sign up and are willing to do some research, dig up some of the data available on hedge fund indices and see how they compare to the broad market indices. Long term they differ, but in the past year or so, you see the strong similarities.

Although generally I’ve seen that a lot of broad hedge fund indices (not sub-indices specific to a certain strategy like “long-short equity” or “convertible arbitrage”) have beaten the broad market indices (S&P 500, MSCI World Equity Index, Lehman Aggregate Bond Index) by anywhere from around 1% to 5% in the first five months of 2006, the trend of returns during the strong up movement in the first four months and strong down movement in May provides compelling evidence that hedge funds are following the indices.

I can only surmise that after roughly three years of poor returns, in what has basically been a straight line up in the equity markets, hedge funds have had no choice but to expose themselves to beta while alpha has been (perhaps temporarily due to low VIX or countless other reasons) hard to find. I hope this trend does not continue. Perhaps we will enter a new market environment that is more akin to earlier periods when hedge fund strategies were more viable. As with mutual funds, perhaps there are also simply too many hedge funds. The market (investors) will have to let their money do the walking. With limited alpha, many hedge funds will simply have to die.

* * *

Let me now shift gears and bring us back to the ETF world of today, and what is clearly a significantly different place than where we were just one year ago. We now have many more ways to play the domestic and international equity markets through the recent explosion in non-market cap weighted ETFs (quite a lot written about this in the past few weeks!). In a previous entry, I’ve stated how I think these are not that innovative since the research behind them is quite similar to what Dimensional Fund Advisors have spoken about for decades.

What I find more significant and interesting is the introduction of the new inverse ETFs from ProShares (PSQ, SH, DOG, MYY) … for those of you who know ProFunds, Rydex and the like, these are the ultimate “Futures for Dummies” tool. With these new ETFs, and I can only expect that Rydex will be following up with their own version, the ordinary investor can treat a part of their portfolio in a “hedge fund” like manner. Hey, it’s just leverage. And shorting. Or a combination of both. Hey, should we be getting worried?

Well no. Earlier I stated my worries for a hedge fund industry that has had numerous blow-ups and has too many participants striving to find this thing called alpha. The problem, just like when we bash mutual funds for underperforming some benchmark, is the effect of management fees (along with other costs within a fund like legal, audit, custody and other administrative expenses) on returns. For the do-it-yourself investor, these do not apply. So why can’t the DIY investor have the same tools as the pros? I can’t really think of a good reason. Institutions for decades have had the ability to program trade so that they could adjust a portfolio with just a few keystrokes. We don’t really think of it now, but selling QQQ and buying SPY basically does the same. So what should we expect now?

I think that investors should be able to play the emerging markets, commodities and other asset classes both ways (long/short). There’s nothing stopping them now from shorting EEM or DBC. But for the many investors who do not feel comfortable with the concept of a margin (leveraged) account, this is a good first step. I also wonder if particular investors, including certain institutions with constraints that do not allow them to hold short positions or use derivatives, will see this as an opportunity to make tactical decisions within their portfolio.

Bottom line: Through ETFs, investors have many means to have various broad market exposures. With short (and levered) ETFs, they can also allow certain parts of their portfolio to become “hedge fund-like”. But perhaps it doesn’t have to go to that extreme.

As Roger Nasbaum has recently suggested when discussing these ETFs, perhaps only as a short-term play and with relatively small proportional holdings within the total portfolio, these tools are enough of a hedging tool to add to the overall strategy menu. I would only add that for most investors, the use of this kind of tactical defensive strategy does not have to be used often: major market downturns should be the focus, not the common oscillations that are a common component of short-term market action.

Against what Wall Street, and in particular the self-direct brokerages will tell you, trading frequency is inversely proportional to a portfolio’s overall performance. I just don’t want to have a repeat of seven or eight years ago except it’s now: “Yeah, I’ve dumped that dead-end job. I’m now running my own money as a hedge fund.” Please.

As mentioned in my previous (and first) entry, I actually started in the industry at a highly specialized hedge fund (separate managed futures and long-short equity mandates) although we never called ourselves a hedge fund. Now I am more focused on traditional long-only, no leverage, broad global asset allocation mandates.Weird, I know. Everyone else is dumping their mutual fund manager job to start up a hedge fund. Can’t blame them. Sure there’s the money. That’s a reward for being smart, good, lucky or some combination of this and more. However, the truth is that what any type-A personality in this industry wants is independence. What is a hedge fund but a mutual fund with lesser constraints?

Ask any manager what is more important: Being right or making money? I’m pretty sure they’ll say making money. But to make money, you better be right. As a mutual fund manager, you can be right but still perform poorly. In sharp down markets, without the ability to tactically allocate to cash or even short, it’s tough to protect the investor. Rather, it’s all about relative performance in that world, thus the argument that most mutual funds are “closet indexers”. For most readers, everything thus far is nothing new.

What concerns me is that we’ve just seen a very interesting month in May. Comments have been made that it’s the worst month for the S&P 500 in 22 years. To me, the price action of the S&P 500 is nothing like what’s happened earlier in Iceland, New Zealand and markets in the Gulf region. Can we expect more? Possibly, but my concern in particular is oriented towards the performance of active managers, specifically hedge funds. Big down returns in index funds especially for specific areas like emerging markets and commodities are fine. Hey, if you didn’t know these were volatile asset classes or that they had a nice long and fairly stable run up that past few years, welcome to class! But hedge funds should have made a killing this month. After at least two years of unspectacular returns (blame low VIX, low interest rates or whatever else you want) they must have been waiting for a month like this.

However, the word is out that hedge funds in general did not have a good month. I’ll wait to see what the various hedge fund index providers send out later in June for the May numbers, but this would be a great surprise to hedge fund investors. Or should it be? Hedge funds had very decent returns in the first quarter of 2006. VIX was still relatively low and there weren’t any big market events tossing things around. Basically, things were quite boring with decent broad market index returns.

Can we simply conclude that many hedge funds had substantial long positions in commodities, equities and other broad asset classes? That would be too simplistic an answer so I’ll ask it differently. After years of relatively poor returns, have many (or most) hedge funds exposed themselves to broad beta exposure due to the relative scarcity of alpha during the market run up from early 2003 to early 2006? The answer is yes.

Don’t get me wrong. I’m not anti hedge fund. But if hedge funds and “fund of funds” market themselves as “performers in good and bad markets” that implies market neutrality or specifically beta neutrality. There has been significant discussion, especially in the institutional world where costs for beta exposure matter, that hedge funds in general have had higher than expected beta exposures, and specifically to the S&P 500.

So, mutual fund managers said that they manage their funds well to outperform their target benchmark index but have in aggregate been more like index trackers. The question to ask is: Are hedge funds falling into the same trap?

My answer is no. I think that they’re doing what they have to do. Being right or making money? Well, I think they’ve realized that 2003-2006 was basically a desert for returns. Their quest for an oasis has led them to beta exposure. That’s part of being opportunistic. If their strategy (whatever it is whether some form of arbitrage or directional trading) has not worked as in the past due to the current market environment, what choice did they have? Again, they say that their job is to be “performers in good and bad markets” not just “performers in bad markets”.

The only question now is whether their beta or market exposures are so high that they their returns are highly correlated with market returns, especially on the down side. If this correction continues with hedge funds returns moving lock-step downwards, then there will have to be some serious rethinking of their value added by investors as well as some reflection by the hedge funds and “fund of funds” of their own philosophies and processes.