A continuum from “easy to separate alpha and beta” to “very difficult”

Siegel and his co-authors provide the following illustration, showing asset classes and the ability to separate alpha from beta:

Exhibit 1

Continuum of difficulty in separating alpha and beta

A market-neutral, style-neutral, and everything-else-neutral hedge fund consisting of liquid securities is at the “very easy” end of the continuum, although in practice such funds rarely exist in this pure a form. The proper benchmark is cash, and the return in excess of cash is all alpha. One can debate about whether a given alpha produced in such a manner is due to skill or luck, but it is alpha nonetheless.

An index fund is also at the “very easy” end. The whole return is beta, with no alpha.

Traditional portfolios (including long-only and long-short funds) are usually amenable to regression on a benchmark or mix of benchmarks, and thus easy to analyze in terms of alpha and beta. There may be some debate about which benchmark or mix of benchmarks is the right one to use, but the analysis can still be satisfactorily performed.

Hedge funds, particularly if they employ a multi-strategy architecture or lack transparency, are harder to analyze in terms of alpha and beta exposures. One must rely on a mix of the description of the strategy offered by the manager, and regression on various benchmarks, and subjective analysis, and it may not be possible to achieve estimates in which one has confidence.

The menagerie of private investments in the rightmost column of Exhibit 1 has betas (and thus alphas) that are conceptually there, but we have no data with which to estimate them. However, empirical estimation is not the only tool we can use. We can also use subjective judgment, asserting that, for example, a given private real estate partnership has a beta that is closer to one – relative to a hypothetical private real estate benchmark – than to zero. (A zero beta would imply that the real estate partnership is an absolute return investment, a claim we can easily dismiss by noting the fluctuations of the real estate market and recognizing that just about any investment in that market is affected by these fluctuations.)

The order of the asset classes in the diagram is not clear cut; many hedge funds are harder to analyze, in terms of their beta and alpha exposures, than many private investments. But, as the authors note, “we are sure that the betas – and hence the alphas – are “there,” whether or not we have data (or subjective analysis) that we can use to put a number on them.”

On hot dog stands and carbon credits

Ronald Coase won the Nobel Prize in 1937 for his theory of the firm, which essentially stated that companies exist because they can produce goods and services more efficiently than individuals on their own. But, isn’t that exactly what some exotic hedge funds and limited partnerships are doing? Let’s consider some examples, one silly, one serious.

Some time ago, about 1964, there was a craze for hot dog stands in Istanbul, Turkey. At first this foreign influence was opposed, and teenagers had to sneak out of their parents’ sight for this tasty new treat. After a while, even the parents were eating hot dogs. This new business made a high return on capital for a while. Is this high return alpha or beta? Siegel and his co-authors argue that it is clearly beta, since all hot dog stands were roughly equal all you had to do was “be there.” We don’t know of any funds that were organized to participate in these lofty returns, but investors should have been willing to pay quite a high fee to get into such a fund, properly viewing the fee as an “assembly charge” for making hot dog stands in Turkey into an investable asset.

More recently, a prominent hedge fund manager has made a business by buying carbon credits earned by free tillers in India and selling them to industrial polluters in Belgium. The fund charges a 2-and-20 fee for what obviously would be considered beta, since anyone can enter this business and earn roughly the same return. So why don’t others compete and eliminate the “exorbitant” fee? For one thing, competitors would need to understand the dynamics of free tillers in India, and would have a tough time negotiating a good deal on carbon credits. A 2-and-20 fee is a low price for the convenience of not having to learn this new trade while still being allowed to keep most of the return from it. This is the same reason plumbers and car mechanics charge, and more importantly receive, high prices.

Siegel, Waring, and Scanlan argue that most of the return from these activities, where all you have to do is “be there,” is beta. There is an assembly process that needs to be undertaken to make these cottage industries into investable assets. However, the assembly process, while requiring skill, does not require alpha generation. It does not require the way-above-average skill it takes to beat other managers, and thus earn alpha. Yet it is worth a high fee.

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