A Mass of Alpha

John Mauldin | Thoughts from the Frontline
May 7, 2004

While there has been a lot happening in the markets, sometimes it is important to drop back and look at larger issues. This week we are going to explore a new way to look at (and perhaps find!) that most mysterious of all the creatures among the flora and fauna of the investment world - the elusive Alpha. This is a think-piece, so settle in for some new ideas. Plus, a Bull's Eye Investing update, as the book hits #10 on the New York Times Business Best-seller list.

The Yield Curve, Briefly Revisited

But first, I would like to re-visit last week's letter on the yield curve. First, I must admit a senior moment. I knew the original research on yield curves had been done by Dr. Campbell Harvey, who is now the Professor of International Business at the Fuqua School of Business of Duke University, and had corresponded on the subject with him. I simply could not find the reference in my five gigabytes of emails and data. As it turns out, that is to your advantage, as he gently reminded me of that lapse, and through an exchange, offers his thoughts on the ability of the yield curve to predict future recessions, which I share with you. Let's now upgrade the level of this weekly missive with some professorial thoughts from Campbell:

"I was the one that discovered the relation, and proved that the yield curve outperformed other forecasting tools in my 1986 dissertation at the University of Chicago. I published my dissertation in 1988 in the Journal of Financial Economics. In 1989, I published a follow up piece in the Financial Analysts Journal. Estrella and Hardouvelis picked up on the idea and published an article in 1989 and a few more.

"I applied my idea to the G7 countries in the inaugural issue of the Journal of Fixed Income in 1991. Estrella and Hardouvelis always cited my original contribution. However, in the 1996 Fed article -- Estrella failed to cite my work, which to today I do not understand.

"I keep current on the yield curve... it is amazing that the yield curve does so well -- even in periods where the short rate is being manipulated. You might argue [as I did -John] that the slope is artificially high today but there have been plenty of other episodes (the most famous being 'operation twist' in the 1960s) where the Fed is manipulating the curve.

"The Fed has manipulated rates many times - yet the yield curve seems to deliver an accurate signal. There are two interesting episodes. The first is the last 'false signal.' The five year [as opposed to the 90 day, which I cited last week - John] inverts December 66 through Mar 67. There is no official NBER recession declared. However, GDP growth in 1967 was only 2.4% compared to 4.2% in 1966 and 8.2% in 1965. This was a significant slowdown and many argue that there was a growth recession.

"The other is August 1998. After the LTCM crisis, the curve goes flat. With my indicator, you need to be inverted on average for one quarter to be called 'inversion'. For this quarter, the slope is basically zero. In my opinion, if there was no intervention the economy was fragile enough that a recession would have occurred. The intervention avoided this and the curve steepened -- and we had good growth in 1999. Just between you and I, perhaps a short recession in 1999 would have been optimal. We would have avoided the run up in the technology stocks and all of the overinvestment that resulted from that.

"What to expect in the future?

"The Fed has a difficult game to play. Consider the thought exercise. Suppose you are given data on a hypothetical country. You see above average GDP growth, good growth in personal spending and income, strong housing sector, good industrial production, excellent earnings performance, 1.5% PCE deflator, 2.5% GDP deflator, somewhat mixed employment but less than 6% unemployment. You are asked to guess the short-term interest rate and give a 95% confidence band. While my experiment is unrealistic, the 1% rate of today is outside the band.

"On the other hand, things are going well -- why upset a good thing. Indeed, there is no obvious 'cost.' That is the risk. In my opinion, we will see rate increases after the election (there might be a minor takeback in August, which I think is politically neutral).

"However, I see the curve shifting upwards -- if there is flattening it will be minor. I see lower demand for U.S. bonds from foreigners being a factor.

"It is important to realize a limitation of the yield curve model. It is good at predicting recessions and duration of recessions. It does less well predicting magnitudes of recessions. It does least well in telling us about the magnitudes of recoveries.

"I look forward to reading part VIII. I enjoy reading your weekly commentary (this year I recommended your commentary on my syllabus). -Cam"

Sidebar: One of the better investment dictionaries is at Campbell's home page. You can click on this link and then click on his 8,000 word Hypertextual Finance Glossary for the definition of almost any investment term you can imagine. The link is: http://www.duke.edu/~charvey/. Put it in your online favorites files, and then remember where you put it. (There is a lot more at the site, and I commend it to you.)

A final note on the yield curve for researchers: You might appreciate the dynamic yield curve presentation on Crestmont Research's website. It shows the yield curve for every year since 1900 (and other economic information) and automatically progresses through each year of the past century. Depending upon your screen resolution, there are two versions of "Dynamic History" listed as the first item on this page: http://www.crestmontresearch.com/content/irates.htm.

A Mass of Alpha

Two weeks ago, I hosted (along with my friends at Altegris Investments) my first annual Strategic Investment Conference in La Jolla. My friends Richard Russell, Rob Arnott, Martin Barnes of the Bank Credit Analyst, George Gilder, Mark Finn, Jon Sundt and Scott Burns, along with your humble analyst, all spoke on various economic and investment topics, as well as some very lively panel debates. Those familiar with the above names know that there was a very wide range of opinions represented, and none of them are exactly the shy type at expressing them. Some of these guys see debate as a blood sport, but it was fun, and I escaped with only a few embarrassing moments.

I am going to start an occasional series dealing with their presentations and ideas, and let you know the nature of some of the debate. I will intersperse it in the letter over the next few months.

For those who are wondering why they did not know of the conference, attendance was limited to those who have signed up at my accredited investor website and who also went through a suitability process. At the end of this letter, I comment on that process and how if you qualify, you can make sure to get an invitation to the next conference (which may be later this year).

The first presentation at the conference was by Mark Finn, the chairman of Vantage Consulting. Mark consults with large institutions and pensions funds on their portfolios, and is one of the smartest investment minds I know. I know from personal experience that sitting in a meeting with Mark will result in a blitzkrieg of investment wisdom that may take you days to absorb.

His speech was like that. He brought up what was for me maybe the most important new concept I picked up at the conference. Subsequent meditation and talks with Mark have helped me understand somewhat better what he was saying, and I am going to try and convey it to you.

First, let's look at two terms we throw around in the investment world - alpha and beta. Going to Campbell's dictionary we find the definition of Beta is:

"The measure of an asset's risk in relation to the market (for example, the S&P500) or to an alternative benchmark or factors. Roughly speaking, a security with a beta of 1.5, will have move, on average, 1.5 times the market return. [More precisely, that stock's excess return (over and above a short-term money market rate) is expected to move 1.5 times the market excess return).] According to asset pricing theory, beta represents the type of risk, systematic risk, that cannot be diversified away. When using beta, there are a number of issues that you need to be aware of: (1) betas may change through time; (2) betas may be different depending on the direction of the market (i.e. betas may be greater for down moves in the market rather than up moves); (3) the estimated beta will be biased if the security does not frequently trade; (4) the beta is not necessarily a complete measure of risk (you may need multiple betas). Also, note that the beta is a measure of co-movement, not volatility. It is possible for a security to have a zero beta and higher volatility than the market."

There is a component of investment returns (or losses) that can be ascribed to beta. Simply put, if you invest in an index or a broad market fund, the large majority of the rise or fall of your investment is due to beta or market conditions. It can be a stock index, bond index or hedge fund index. Other than the skill of choosing a particular index in which to invest, with beta risk you earn no more or less than the market (whatever the index measures) gives you. There is no additional investment skill.

Beta investments are relative return investments and you assume market risk. Your returns can be either positive or negative, depending upon market performance. You accept such risk upfront (whether or not you want it or like it).

Thus John Bogle has argued for years that you should invest in low cost indexes of various markets (specifically Vanguard Funds), because of the statistically demonstrable high degree of difficulty in beating any given market. And he can legitimately trot out a number of studies which show that the average mutual fund does not beat the stock or bond market indexes (indeed, 80% of equity mutual funds do not beat their indexes.) Therefore, if you are going to invest in the stock market, he contends you should stop trying to fight beta and just accept it and invest in the lowest cost way to get that beta.

Alpha, on the other hand, is different. Let me give you the official, text book definition from Campbell and then try to explain what it means in the real world.

"Alpha is the measure of risk-adjusted performance. An alpha is usually generated by regressing the security or mutual fund's excess return on the S&P 500 excess return. The beta adjusts for the risk (the slope coefficient). The alpha is the intercept. Example: Suppose the mutual fund has a return of 25%, and the short-term interest rate is 5% (excess return is 20%). During the same time the market excess return is 9%. Suppose the beta of the mutual fund is 2.0 (twice as risky as the S&P 500). The expected excess return given the risk is 2 x 9%=18%. The actual excess return is 20%. Hence, the alpha is 2% or 200 basis points. Alpha is also known as the Jensen Index (or Jensen's Alapha). Related: Risk-adjusted return."

Alpha is the excess return over the index (adjusted for risk, of course). If you or a manager exceeds any given index by 5% (at the same level of measured risk), then your value added or alpha is 5%. Alpha is (usually) a skill based return. The risk you take when you seek alpha is that the skill of the manager is not what you think it was when you invested. Past performance is not indicative of future returns is a more than a phrase. It is the mantra of alpha investing. With alpha there is manager specific risk, in addition to some of the market risk, even if the manager is trying to arbitrage out the market risk.

Now with these definitions let's go to Mark's speech. For Mark, alpha is an evolving mass. It is the return that can be captured by innovation and skill, but Mark thinks that in the short run there is a finite quantity of alpha (or excess return) in any given market, with every skill-based manager chasing and trying to capture some of this finite amount of alpha. Clearly, if alpha is finite, the more managers chasing it in any one market, the lower probable average excess returns for the managers.

In essence, the alpha gets arbitraged away because of too many managers chasing a finite amount of alpha. The very act of chasing the alpha lessens the amount of alpha available.

The Birds and the Bees, Investment Style

Alpha according to Mark can be thought of as a mass of bees flying through the countryside, constantly changing shape, but essentially staying relatively the same size.

I countered to Mark that cannot the bees return to the hive and busily create more baby bees, thus increasing the size of mass and potential alpha? Does not the emergence of new markets create larger potential for alpha, whether in India or other brand new markets? What about new investment vehicles in the US like convertible bonds or mortgage derivatives, which generated whole new classes of investment funds?

"It might," he countered, "except that birds are out there eating bees almost as fast as they can create new bees."

The potential for alpha is created by inefficient markets. The newer and more inefficient a market is, the more potential there is for alpha. As markets mature and become more liquid, the inefficiencies are harder and harder to find. Skill-based managers begin to arbitrage away the excess returns.

You can clearly see this in the convertible arbitrage market. The returns of convertible arbitrage funds were much higher ten and even five years ago. Everyone got excited and lots (I mean huge amounts) of money plowed into these funds. Now there average returns are down, as there is a lot of money chasing a finite amount of convertible arbitrage alpha.

That does not mean that such funds might not be worthwhile and appropriate for some types of portfolios. It is just that you cannot expect past performance to be replicated, not simply because of market risk and volatility which is always there, but because the amount of alpha which generated those returns in the beginning is now being arbitraged away and shared by more and larger funds.

Extrapolate from this one market to the markets of the world as a whole. Mark says that there is a limit to excess alpha returns over the beta returns. And the source of the alpha changes over time. It may be in emerging markets one year and France in the next.

In addition to there being a defined amount of alpha, Mark likes to think of the amount of total alpha as a "quantum amount." In quantum theory, the definition of or the observation of a thing can change the reality of the thing being defined. Defining or observing alpha in a market can change the amount of alpha available. Remember my statement above? "...the alpha gets arbitraged away because of too many managers chasing a finite amount of alpha. The very act of chasing the alpha lessens the amount of alpha available." Simply mass observations and chasing the alpha changes the nature and quantity of the alpha, so the analogy to quantum theory is an accurate comparison.

The best time to find alpha opportunities, Mark suggests, is at the beginning of a market because they are likely less efficient. Of course, that is also when they have the most risk. That is why the skill-based manager should out-perform the beta index. But that is also why the risk in such a market is manager risk as well as "merely" market risk.

This week, I met with an investment advisor of an emerging market country. He described his market as inefficient because of certain conditions and explained how he used standard techniques to produce alpha in his markets. He thinks he has found an exploitable edge. These common techniques provide little advantage in the US markets, but because few people use them in his country, he thinks he can create an edge for himself and a few of his clients. There are limits to this style.

Under Mark's thesis, if this strategy/technique becomes well-known in his country, the alpha it might generate will shrink or even disappear.

(By the way, he does not have an investable fund, nor was that the purpose of our meeting. It was a casual side conversation, but one I found useful for illustration for this letter.)

Is There a Limit To Alpha?

I agree there may be technical limits to alpha, but right now I think it is like saying that there are limits to oil production. We all know in the future, that oil is going to become a scarce quantity. Depending upon who you read last, that could be the next decade or the next five decades.

Yes, we have seen the top of oil production in the US. The large fields are all found, but small firms are still finding oil in odd and out-of the-way places. And there are huge sources of oil being found around the world.

I think alpha is somewhat like that. The "majors" or the large investment funds and banks have trouble finding alpha in the large markets, because they are not interested in some of the back-water markets that smaller, more entrepreneurial managers and funds might find of interest. There is always alpha somewhere. But as markets get larger and more liquid and efficient, it is getting harder to find. The "new" pockets of alpha mean that it will take smaller and more nimble funds to exploit them. Indeed, this may signal a major and structural change over the next few years to the very nature of investing in alternative markets. With all the new money coming into these markets, they cannot all go into the same large funds and sources of alpha and come anywhere close to expectations. And in ten years when the alternative markets have tripled and are running two trillion dollars? It is going to be a very difficult investment arena. And I don't think Mark would disagree with this thought.

All this was summed up in Mark's cautionary note to investors. This conference was quite frankly geared to hedge fund investors. Many of these investors were looking at hedge funds for what appeared to be lower risk and better risk-adjusted returns.

There is a great line Mark reminded us from an Eagles song of the 70's. "Every form of refuge has its price." By moving into hedge funds and other absolute return strategies, investors were not necessarily lowering risk. They were exchanging one type of risk (beta or market based risk) for another type of risk (alpha or manager skill-based risk).

As my friend Gary North taught me 20 years ago, it is not a question of risk or no risk. It is a question of what type of and how much risk?

Separately, my book argues that it is precisely this type of risk swap investors should be seeking. If we are in a secular bear market, as I argue, then stock market beta risk is precisely what you do not want. Beta or market based risk will yield disappointing returns in such an environment.

Further, as you look to make your investments, you need to think about the potential alpha in the particular area of the market in which you invest. While returns may have been excellent in the past, if too much money is rushing into a finite space, will your manager be able to maintain his share of the alpha, or will he be forced to share? Perhaps you should be satisfied with lower excess returns. Then again, that may not be your objective. But this exercise should give you some food for thought.

(Sidebar: I also argue that small investors can find alpha in the stock market, even during secular bear markets, by finding portions of the market where larger funds and investors avoid or more specifically the micro-cap markets. This lack of interest and participation creates inefficiencies in the micro-cap portion of the market. Of course, as you would expect, that means more and different types of risk as well as the normal market risk. See chapters 16-18 for a more detailed explanation.)

During secular bears, history suggests you should seek absolute returns or alpha. It is a totally different process than during secular bulls like we saw in 1980 and 1990.

I think the investment industry, and even the hedge fund industry, may be doing investors a disservice by comparing everything to the S&P 500 index. During a secular bear, the index you should be using is money market returns or t-bills. The question is how much potential return over a risk-free T-bill can you give me for a roughly defined set of risk parameters?

If we are in a secular bear, then almost by definition an index of absolute return strategies will beat the stock market. So what? The question is not whether you can beat a stock market that is losing money, but can you beat money market funds? Can you give me a return north of zero?

Of course, when valuations mean revert (and they always do) and the cycle changes, and as we move once again from a secular bear to a secular bull, then the type of risk you want is beta risk. It will once again be time invest in index funds, taking the volatility of the market. But I think we are years from that point, or at least I hope we are. I do not want to see quick reversion to low valuations, as that would imply a very sharp and precipitous bear market.

A final point for today. You cannot get returns above money market returns without taking some type of risk. Not in bonds, so-called guaranteed contracts, annuities or anything else of which I can think. Even in government money market funds, there is the risk of inflation and taxes eroding your buying power over time. There is the risk of the dollar dropping and the buying power of the dollar diminishing.

The question is not whether there is risk, but what type and how much risk do you want. And generally speaking, you do want some amount of risk, as to avoid risk means money market returns. But risk should be approached deliberately and with much thoughtfulness. Great pains should be made to avoid the risks you don't want and to accept the type of risk you do want. But that's a tale for another day, or for my book.

"Neither Bull nor Bear but Realist"

As a blatant plug, I spend much of my book, Bull's Eye Investing , talking about risk and explaining the concept of secular bear and bull markets. Quoting from a recent review by Johnmv on Amazon.com.

"John Mauldin has done the average citizen a great service by putting the economic environment and investment choices into an understandable and logical format. He guides our decisions by use of historical statistics that demonstrate the best probabilities of success in making and keeping money from investments. He is neither bull nor bear but realist, and in the process debunks the myth of 'buy and hold.' Because this book refers to so many sources of information, it must be studied, not glanced at. It is not a panacea; rather it helps the individual get a compass in a very complex world. However, it is rewarding beyond words if one reads and ponders the wisdom that lies within. We all have choices; this permits us to make wise ones."

Thanks, John. You can buy the book at www.amazon.com/bullseye or read the entire introduction at www.absolutereturns.net.

Now, at the beginning of this letter I mentioned my Accredited Investor Strategic Investment Conference. I know some of you wondered why I did not mention it here in advance. Attendance was unfortunately limited to accredited investors. The reason is simple: it is due to securities regulations, as in addition to the above named general speakers, we also had private hedge funds, commodity funds and other alternative investments making presentations. As these were private offerings, we are required to do a great deal of work determining prior suitability for attendance. Long time readers know that I think Congress should change these rules, as I find it fundamentally and philosophically offensive to exclude investors from various investments due to differences in wealth.

As I testified to Congress in May of 2003:

"I believe that the positive values that hedge funds offer to rich investors should also be offered to the middle class, within a proper regulatory structure. The current two class structure limits the investment choices of average Americans and makes the pursuit of affordable retirement more difficult than it should be. The rich have a considerable advantage in growing assets for retirement in that they simply have more assets to begin with. They should not also have an advantage in better investment choices.

"Specifically, why should 95% of Americans, simply because they have less than $1,000,000, be precluded from the same choices as the rich? Why do we assume those with less than $1,000,000 to be sophisticated enough to understand the risks in stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 90% of retail investors lose money), mutual funds (80% of which underperform the market) and a whole host of very high risk investments, yet are deemed to be incapable of understanding the risks in hedge funds?"

That being said, I explicitly follow the rules as they are written today. And that means attendance was (and will be for future conferences) limited to those who qualify under those rules.

For those who are interested and who qualify, I write a free letter on hedge funds and private offerings called the Accredited Investor E-letter. You must be an accredited investor (broadly defined as a net worth of $1,000,000 or $200,000 annual income - see details at the website.) You can go to www.accreditedinvestor.ws to subscribe to the letter and see complete details, including the risks in hedge funds. If you are an accredited investor and would like to attend future conferences, registering at this site and going through an introductory suitability process is the only way. In this regard, I must officially note I am a president and a registered representative of Millennium Wave Securities, LLC.

(I should also note that the risks in hedge funds are quite real. They can be volatile, are unregulated and much more. Investors should consider hedge funds only after researching the risks involved with each specific fund, as they all have different sets of risk associated with them.)

Anniversaries, Las Vegas, Vancouver and Tahoe

I write this letter a little early, on Cinco de Mayo. It is my anniversary, and I am running out the door a little early to celebrate with my bride. It is a good thing to have your best friend also be your life partner. It makes life so much more rewarding and fun.

I will be seeing some of you next week in Vegas at the MoneyShow. I will be in booth 323 and I invite you to come by for a chat. I will be speaking late Tuesday afternoon and Wednesday morning. I will be in Vancouver speaking at the World Gold Conference June 13-14 and in Tahoe this August speaking at George Gilder's annual Telecosm Conference (details to follow). I see a trip to New York later this month shaping up as well, although I do not have details yet - just some necessary meetings that must happen soon.

It is time to run and celebrate, and I leave you with this thought. In love and in our friendships, there is no limit to the alpha we can generate or the returns we can reap. Properly tended relationships have no beta risk. Would that it were so in the markets.

Your getting excellent risk-adjusted returns on his marriage analyst,

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