Professor Thomas Schneeweis, Editor of the Journal of Alternative Investments

Schneeweis on Alpha, the SEC and Hedge Fund Replication

11 April 2007

This is the second half of Alpha Male’s recent interview with Professor Thomas Schneeweis, Editor of the Journal of Alternative Investments, director of the Chartered Alternative Investment Analyst designation and founder of the Center for International Securities and Derivatives Markets (CISDM) at UMass. In this segment, Schneeweis addresses some of the burning questions facing the hedge fund industry today, including: Is alpha finite?, Does hedge fund replication work?, and most importantly, What the heck is the SEC thinking?

AM: Tom, do you believe the world is running out of alpha?

By the mid 90s, we knew that hedge funds and CTAs had underlying sources of return – that in fact every strategy was not actually unique. We knew that, because the market for ideas is efficient, everyone who traded equity long/short was trading essentially the same strategies in the same markets, using the same process. You see, everyone considers themselves to be different, but it’s amazing how when a particular strategy makes money, all the traders in the strategy make money; and when a particular strategy loses money, all the traders in that strategy lose money.

So we knew there were fundamental sources of risk that these strategies all accessed: market risk, credit risk, liquidity risk, and more exotic risks. That was an important finding because if you knew what risks were part of each strategy, you could put them together into a well diversified portfolio.

By 2000 we saw the first of the passive “style-pure” hedge fund indices. And by early 2001 we were already starting to think about passive index replicas.

AM: So these alternative risk factors (alternative betas) aren’t disappearing any time soon. But what about “true” alpha. Is that going to disappear as markets become more efficient?

It depends on how you define alpha. If alpha is generated by some wizard who wakes up in the morning and has the unique ability to give you a return absent of any risk, then that probably never existed. But if you are talking about an individual who is able to add together a unique set of risk opportunities that aren’t easily accessible via other sorts of vehicles - then that alpha does exist.

The CAPM was devised in 1964. But by the time I got my Ph.D. in the 1970s, we knew that model was not really measurable. It’s amazing how long it’s lived on. Now, we academics don’t even talk about efficient markets any more.

As a result, you really can’t tell if a traditional asset has any alpha. You might regress it against the S&P and get a positive result. But when you add in a sector index that positive alpha disappears. So if you have a very limited, underspecified model, you’re going to come up with an incorrect alpha. It still amazes me that people regress hedge funds against the S&P 500 even when a fund doesn’t even hold stocks!

AM: Are you saying that alpha is a catch-all for anything that just hasn’t been explained yet?

Well it can be. I really do believe that most hedge fund managers want to believe they are wizards. When in reality, all they are doing is accepting certain types of risk. Hopefully, those risk are a little more expansive in the alternative investment space than in more liquid and transparent traditional asset markets.

AM: With new liquid financial vehicles, are ideas being transferred from the alternatives market to the traditional market more quickly? In other words, is “alpha” becoming beta more rapidly today?

It certainly is. But I want to emphasize that this has been going on forever. There’s nothing around today that hasn’t already been traded on the prop desks of every major bank for the last 20 or 30 years. There’s not a lot new out there. I know we want to pretend there is. It’s “new” only to the extent that a new structure might now allow them to come to the surface. But in reality, we’ve always used derivatives to manage risk and return.

AM: You wrote an editorial called “Dealing with the Myths of Hedge Fund Investments” in 1998 - soon after LTCM. Do these myths still exist? Have they changed? And have any new myths have taken their place?

I’ll tell you one thing that hasn’t changed. We’re still hung up on LTCM. In reality, we probably won’t see that problem again. We’ve learned a lot from it.

But there are some things we haven’t learned. We have new risks today that haven’t adequately been analyzed or discussed. For example, we used to have market makers, but now we have more electronic trading. The last 4 years has been a period of relatively low volatility. But during this time, new securities and whole new asset markets have come into existence.

AM: What is your view of regulation of the hedge fund industry?

There is a fundamental tension between three competing view of the world: “government order”, “market order”, and “moral order”.

Firstly, the government sits there thinking that somehow, somewhere, in some way, somebody is trying to take advantage of somebody else, and that it’s their role to stop it. God bless ‘em if that was only case!

Meanwhile, the market says “Don’t worry, the market is big enough and there’s enough competition to help individuals see through it all. So these risks are minimal compared to most other risks in the marketplace. Ergo, any increase the costs of introducing new ideas into the marketplace (e.g. regulation) actually increases risk, instead of reducing it.

Finally, the moral order relies simply on trust. Can you trust some one to do something that is just right?

As far as the government order is concerned, I’m still amazed at how the SEC determines who should be able to invest in alternative investments. I believe that the criteria for investing in alternatives should not be based on how much money you’ve got but on your level of understanding. Perhaps there should be a small examination for investors.

Basically, if somebody has only a million dollars, I believe they should have the same investment opportunities as larger investors. It amazes me that people who have lesser amounts of money are relegated to non-performing stocks and bonds. They are not allowed – for some strange reason - to invest in various types of commercial real estate, private equity, CTAs or hedge funds that can provide them with an opportunity to get a higher long tern rate of return.

People forget that one of the greatest free lunches out there is diversification. Given two assets with different standard deviations, the one with the lower standard deviation is going to have a much higher geometric rate of return – a higher growth. This is because its very difficult to make up for a 20% or 30% loss.

Look at this way. The average volatility of stock in the DJIA is 30-40% per annum. That’s a whole lot higher than a typical hedge fund or CTA. If there’s a problem with hedge funds, it’s that the smaller ones don’t have a good back office. But if you invest in funds with over $150 million under management, you’re probably investing in managers with well-run organizations and reasonable oversight.

AM: Avoiding large losses is central to author Alexander Ineichen’s “asymmetry” thesis. What is your view on so called hedge fund “asymmetry”?

I believe that apparent hedge fund skewness often comes from mixing distributions that shouldn’t be mixed. For example, if you mixed results from the high volatility 1990s and the low volatility 2000’s, you might see skewness. But it’s actually a mixture of two different distributions.

As a result of this, a lot of traditional research is potentially incorrect. Some of the observations about the asymmetric distribution of hedge funds may exist in the empirical record, but that does not necessarily mean that it truly exists. Conversely, even if the data showed no skewness, that wouldn’t necessarily mean it wasn’t there.

AM: In other words, you’re saying that skewness in return distributions does not necessarily suggest a certain distribution at a static point in time?

Yes. A classic example is the ten year returns of any major hedge fund index. In the early 90s those indices were dominated by CTAs and global macro funds. By the mid 1990s, they were dominated by was distressed debt and convertible arbitrage funds. And by 2000, they were dominated by equities. So you simple can’t mix them all together and call them “hedge fund returns”. That’s not the right way to look at the world. They’re individual strategies with individual return opportunities and you don’t need 20 years of history to understand them. You just need the last 2 or 3 years and a clear understanding of their strategies.

AM: What are your thoughts on hedge fund replication – both factor-driven and dynamic trading approaches?

I don’t want to get into too much detail here. But I will say this: Don’t ever invest in a strategy that has not been proven out of sample. New so-called “passive indices” are trying to capture something we knew about 10 years ago - that at the portfolio level, most hedge funds are either: distressed, long/short, or event-driven. As a result, they have an equity exposure and a credit exposure - big deal! If I simply invest in a set of assets that have a lot of credit and equity risk, I can reflect their underlying return. That’s factor replication.

AM: What about the dynamic trading approach?

My question would be this: How good is it going forward in out of sample tests? You can’t simply say “Look how good my models are in representing returns over the past 5 years.” That is not good evidence of replication. True replication is being able to say “Here is a manager-based strategy. Here’s how they trade and the securities they trade.” If you can come up with a system that passively captures those fundamental return processes, on an out-of-sample basis, that’s replication. Anything else that doesn’t do that is just a nice story.

AM: What is alpha?

If I compare my managers returns against someone else’s, that not alpha. If I take my return and run it against a set of noninvestable factors, that’s also not alpha. Alpha is only something that I can show against a passive strategy that exactly replicates my strategy and my risks.

Going forward, I hope the market will start paying managers not on a benchmark or hurdle rate of zero or the risk free rate, but on a hurdle rate that reflects an investable alternative to their strategy. (see related posting)

AM: Final question. You studied music and history in university and then made a leap to finance. Do music and history still influence your thinking today?

Well, I still play the piano to relax. Piano teaches you about flow and mood and change and portfolios - because a chord is nothing more than a portfolio of notes. You can create new ones with different volumes, different flavors, and different flows. And to me that’s what hedge funds do.

History is important to the hedge fund industry because it offers a greater understanding of how dynamic the sector is. In this industry, you often look at the past to understand the present. But if you aren’t careful, you can get locked in that past when you should be looking forward.

AM: Spoken like a true historian. Tom, thank you for your time today.