Institutional alpha expectations remain (relatively) benign despite hype

8 April 2008

Information is freer flowing than ever. As a result, gaining an information advantage – the foundation of alpha generation – is becoming notoriously difficult. Despite what the media says about institutions seeking fantastic returns from alpha, most institutions are painfully aware of how hard it is to beat the market over the long term (i.e. to produce true alpha). Far from being dreamers who have fallen under the spell of money managers (as some have accused them), institutions remain remarkably pragmatic.

A recent survey by consultancy Greenwich Associates hits the point home. The firm surveyed 583 institutions and found that the average expectation for alpha was actually a paltry 1.2% per annum.

As the chart below from the report shows, small public pension plans have the most optimistic view of their manager’s skill-level. Conversely, small private pension funds have the least rosy view of their managers’ ability to deliver alpha (chart shows annual alpha expectations in basis points)

While small in relation to beta returns, Greenwich says that even 121 bps is pretty high and “not in line with historic results.” (which according to the firm are below 100 bps). But a look under the surface yields some interesting observations about different asset classes and investor types…

In contrast to popular perception, institutions also don’t expect their hedge fund investments to outperform their traditional investments. In fact, overall return expectations from hedge funds were about the same as the expectations from US equities.

However, this is not to suggest that institutions see both of these asset classes producing the same level of alpha. According to the survey, endowments expected over 1.5% alpha per annum, higher than both public and private pension plans - and perhaps not coincidentally, Greenwich also found that endowments also had the highest allocation to hedge funds.

Comments the report:

“Institutions’ optimism appears to reflect a basic confidence in the new products and strategies they have incorporated into their portfolios.”

“It’s hardly a surprise that institutions are ratcheting up their alpha expectations after implementing new strategies designed to boost risk-adjusted returns. “There are tools for institutional portfolios that are much more efficient than the traditional equity/fixed income asset allocation model,” says Dev Clifford. “And to some extent, the changes in investor outlook reflect pensions’ realization that these products and strategies often work as advertised.”

The report also contains a chart titled “Alternatives No More” showing how institutional allocations to private equity, hedge funds and 130/30 have taken off over the past year. This, as the firm points out, may be one of the key drivers behind the (measured) alpha optimism.