The Whole Ineichen Interview

All About Alpha Exclusive: An interview with Alexander Ineichen, author of “Asymmetric Returns”

7 March 2007

With their perfectly-timed trains and neatly-arranged homes, the Swiss are big fans of symmetry. This makes UBS’s resident hedge fund guru Alexander Ineichen all the more of an anomaly. His book Asymmetric Returns has been garnering a lot of attention not because it espouses order and regularity, but because it so vocally challenges the status quo, refutes conventional wisdom and, well, questions symmetry itself.

Before addressing a record crowd at an AIMA Canada event in Toronto earlier today, Ineichen (rhymes with Heineken) sat down with AllAboutAlpha’s Alpha Male to discuss issues including: 130/30 strategies, alternative beta, ”peak alpha”, the CAIA designation and recent attacks on the CAPM.

AM: You are a founding board member of the Chartered Alternative Investment Analyst (CAIA) designation. Has the dramatic growth of the CAIA designation surprised you?

The growth of the program has exceeded my expectations. The institutionalization of hedge funds has always been a major theme of my research and it has also helped power the growth of the designation. The CAIA is a unique program that includes material not covered by the CFA. I’m often asked if it’s a substitute for the CFA. My response is that if you’re unmarried, then go ahead and do a CFA, but if you’re married and have kids, then the CFA may be just too much work.

AM: What did you learn after writing your first book Absolute Returns that compelled you to write this latest book?

Absolute Returns was based almost entirely on my UBS research reports “In Search of Alpha” and “The Search for Alpha Continues”. But Asymmetric Returns is based largely on new research conducted between 2003 and 2005. The motivation was to explore whether alpha and beta alone captured what we do the in hedge fund industry. A piece I wrote in 2005 called “A Critique of Pure Alpha” argued that alpha and beta don’t fully capture the value proposition of alternative investments.

Alpha is a term from the 1960’s. It relies on a linear model that is now somewhat outdated. Now we think, model and manage in a non-linear environment. While alpha and beta are convenient, I think perhaps we need to move on. Asymmetric Returns attempts to define this space beyond the CAPM.

AM: It seems to be in vogue these days to attack the CAPM. Behavioral economists such as James Montier of Dresdner Kleinwort and academics such as Tuomo Vuolteenaho of Harvard have recently argued that high beta does not necessarily translate into high returns.

I saw that debate between Peter Bernstein and James Montier. I think Bernstein is spot-on when he says CAPM shapes the way we think about markets and about managing money. I’d argue that the whole idea of benchmarking comes from that sort of thinking. But we now need to move on. I’d argue that there is something beyond these ideas from the 1960’s. I attempt to address this by writing a book - but it contains just one point of view. It’s certainly not going to replace financial textbooks. But we need to move beyond orthodox finance which argues that markets are perfectly efficient and random. That is so untrue it hurts.

AM: You make an interesting observation in your book. You say that the US equity market is perhaps the least efficient market in the world. How so?

Yes. That comment was a little tongue in cheek, but an argument can be made that a bubble represents the “ultimate inefficiency” because it cannot be easily arbitraged away. It’s like Keynes used to say, markets can stay irrational longer than you can stay solvent. I believe you can view the tech bubble of the 1990’s as a massive market inefficiency. But inefficiencies in smaller markets can be arbitraged away much easier and faster.

AM: You said in the book that “there is no skill involved with managing large cap equities” because those funds tend to hug the index and provide mostly beta with very little alpha. How do you respond to those large cap managers who admit to a high r-squared but point to portfolio holdings that are still materially different from the index?

I articulated that argument in the extreme to make a point. In reality you do have good large cap investors both in the hedge fund and long only space. I just want to focus attention on the difference between complexity and liquidity premiums (beta) as distinct components of the mutual fund value proposition.

AM: But generally speaking you do go against the grain in your book by questioning the value of long-only management. How was this line of argument received by your employer UBS.

I have actually been pleasantly surprised by the intellectual freedom I’ve been given at UBS. I think clients may also be surprised that I am allowed to write what I write. And they appreciate it. It’s extremely important in the institutional investing world to have a sustainable credibility and intellectual integrity. In other words, as an institution you can and should have differing views because no one knows exactly what the future holds. Sure, we have people within UBS that predict what the next five or more years will bring us, but these are just different viewpoints. From a business perspective, contrarian viewpoints need to be taken seriously to provide the business with strategic options no matter how the future unfolds. For example, what if I’m right? As a business, we need create a sort of “optionality” that means we’d already be in the right markets with the right services and investment options in that eventuality.

AM: A lot has been written recently about “130/30″ strategies. What is your take on this trend?

That’s an innovation coming out of traditional asset management which, in my view, is a direct response to absolute return investing. It rests on the argument that constraining a skilled manager is bad for performance. That’s a very powerful argument and cannot be refuted.

AM: In your view, is “30″ a magic number?

No. It started as “120/20″ and morphed into “130/30″. But even that’s not fixed. Some in the hedge funds of funds industry are actually responding by launching their own products called “170/70″!

AM: Is the concept of portable alpha becoming passe?

That term is being somewhat overtaken by other labels. But the ideas remain the same. I’ve always felt that portable alpha clients were our happiest clients. Their returns expectations were almost always met because they expected, say 300-500 basis points from their alpha engine. And guess what, that’s what they got. A lot of other institutions that invested in funds of hedge funds solely to outperform long-only equities starting in, say, 2003 might have been disappointed with their returns relative to long-only equities during this period. But over the long run, funds of hedge funds have outperfomed equities by a mile. In other words, some investors tend to look too closely at the recent past.

AM: Has risk appetite changed over this time period?

Yes. Appetite for volatility has been increasing a lot recently. In fact, I remember a time in 2001 when investors wanted a market neutral product with a volatility of 2.5% and a capital guarantee. Now, they want 130/30 which has equity-like volatility! So within only five or six years we’ve gone from one extreme - volatility of 2.5% with capital protection - to equity-like volatility.

AM: You write quite a bit about behavioral finance in Asymmetric Returns. How do concepts like prospect theory and loss aversion play a role in your thesis?

I included these ideas in the book to challenge the dogma of standard financial theory - to challenge the orthodox economics from Nobel Laureates that is taught at business schools. Over the last 10 years, behavioral finance has emerged to challenge the assumptions behind the existing theories. But unfortunately, behavioral finance does not provide any new all-encompassing theories to take their place.

Still, one of my favorite papers was one written by Andrew Lo of MIT a couple of years ago called the “Adaptive Market Hypothesis“. In it, he argued that one doesn’t actually have to make extreme assumptions like perfect rationality. Instead, argued Lo, economic subjects are driven by their wish to survive - like in nature. This is true regardless of whether you are an employee with a pension, a hedge fund manager, or a corporate investor. So this idea really appealed to me. Is it a widely accepted new theory? No. Not yet. In fact, it might be 10 years before this thinking wanders into the textbooks of a CFA or MBA program.

AM: Do you believe that what you call “subjective economics” is the engine that drives the non-economic players on the other side of various hedge fund trades - the farmers, oil companies, even the lottery players to which you refer in Asymmetric Returns?

One of the assumptions behind efficient markets theory and other orthodox ideas is that everyone has the same time horizon. But a pension fund has a different time horizon than a hedge fund. Because we assume the same time horizons, we conclude that alpha generation is a zero sum game. But if you assume that not everyone has the same time horizon, then everyone can win by synchronizing their portfolios with their own particular objectives. Time horizon would be just one part of this unique list of objectives. Then, in theory, everyone could win by moving their portfolios closer to their own risk objectives.

AM: If hedge funds produce alpha in aggregate, then the universe of non-hedge funds must, in aggregate, give it up. So are hedge funds better structured to harvest this alpha?

I’m actually trying to move away from the term “alpha”. If everyone maximizes their own unique risk & utility functions, then we shouldn’t really be talking about alpha moving from one party to the other. Obviously, in an extreme case such as a mispriced convertible bond, a quantifiable amount of alpha moves from one party to another. But if you move beyond this very constrained model of alpha and beta, then all investors could come out better off.

AM: You refer to hedge fund replication advocates as a “fraternity” in your book. You also say that “the idea of factor modeling is to play around with the data long enough until one finds empirical evidence to prove one’s preconception”. Would you like elaborate on this?

That’s a bit tongue in cheek obviously. But even if it’s not 100% true, it has an element of truth. In finance we get awfully excited if we have r-squareds around 0.5 or 0.6. But natural scientists don’t get excited with anything below 0.95. Some people even call factor modeling “alchemy” or “pseudo-science” because it’s often not very accurate. So I’m not sure if drawing conclusions based on these r-squareds is a very smart thing to do.

AM: You pose the question in your book “If the asymmetric return profiles advocated in this book can be obtained passively, then why pay an active fee?” and then you go on to show that passive replication actually underperforms hedge funds substantially. But research by Professor Harry Kat seems to suggest that a passive replication of hedge funds using dynamic trading strategies actually outperforms hedge funds 80% of the time. What are your opinions on this approach to hedge fund replication?

The problem is that you didn’t have these passive products ten years ago. For example, if you bought an autobiography of Steve Jobs in the mid 1990’s and then programmed a computer to replicate Jobs’ strategic thinking, then your computer would have missed out on the iPod.

Don’t get me wrong, quantitative work is extremely important. It helps you ask questions and it provides performance attribution. But it’s not forward looking.

AM: Lars Jaegar has recently predicted huge growth in the hedge fund replication business. He says that passively replicated hedge funds might make up 40% of the entire hedge fund industry in 5 years. Do you think that’s an exaggeration?

Not necessarily. In the US long-only industry, about 30 to 40 percent of assets are invested in passive strategies. I think he is just applying that logic to the hedge fund space. He could be right. But I wouldn’t go as far as to argue that replicated hedge funds are a better product.

AM: Is the world running out of alpha?

I think the counter argument to the “peak alpha” theory is that we have had a lot of new markets coming on line in the past decade and one could say that opportunity set for risk capital has never been greater.

AM: Final question. In your book you said “in April 2004, we once head someone say at a hedge fund conference that ‘whenever Main Street falls in love with what Wall Street has to sell, there’s a correction in the next 12-36 months’” At the time of writing, you were 24 months on. Now we are 35 months on. Is there a hedge fund bubble that risks being burst?

Sure, there’s an element of cyclicality mixed with a fundamental structural change in the asset management industry. I’m not trying to advocate that human nature doesn’t have a tendency to “overshoot”. But this still leaves us with a paradigm shift in the asset management industry that is changing the way we think about risk and asset allocation. And that’s secular, not cyclical.