Achieving Alpha: How Do Traders Do It?

All traders talk about it, but how are they actually achieving alpha? Several buy-side traders say the key is creating long-short funds that enable traditional firms to act more like hedge funds.

It's probably too early to herald the death of the long-only manager, as some on Wall Street already have done. But there unquestionably is a demand among institutional investors, fund managers and traders to achieve better returns on their portfolios. This interest is accompanied by the simultaneous rise of index-tracking equity funds and an increasing comfort with more-aggressive alternative investment strategies that once were solely reserved for hedge funds.

The numbers tell a pretty clear story. According to a recent TABB Group report, the compound annual growth rate (CAGR) in invested assets across the broad mutual fund universe is expected to be 11 percent from 2003 to 2010. Assets invested in hedge funds are expected to grow at 43 percent CAGR. Although hedge funds still hold just $1.6 trillion in assets versus $21.8 trillion held in mutual funds, it's clear that the broader market is interested in the kinds of returns promised by hedge funds -- but they don't necessarily have the appetite for risk that investing in most hedge funds would require. Enter active-equity strategies, which include so-called "active-extension" or "long-short" strategies. Assets invested in active-equity strategies are expected to grow at more than 141 percent CAGR, from $140 billion in 2007 to $2 trillion by 2010.

At the core of this movement of fund traffic is the quest for alpha -- returns on investment that are above those in the broad market of investable assets, which in U.S. equities is usually measured by an index such as the S&P 500 or the Russell 2000. Most portfolio managers seek to outperform these benchmarks. The preponderance and popularity of passively managed products, such as index funds and exchange-traded funds (ETFs), has meant that simply keeping up with the market-achieving alpha of zero -- or a beta (the measure of risk correlated with the index) of 1 -- is not something for which investors are willing to pay extra. So managers must now find new ways of achieving alpha to grow investments and charge fees -- particularly performance fees, typically 20 percent or more -- that a passive manager would have a hard time justifying.

"The equities business is very defined by indices and benchmarks," says Larry Tabb, founder and CEO of TABB Group. "That is one of the problems with the business. Rating agencies such as Lipper and Morningstar have taken a lot of the creativity out of the market because they kind of group mutual funds together according to their strategies -- is it a growth or value or healthcare-sector fund? Because of that, it becomes challenging to have a growth stock in a value fund."

As such, a sector fund can end up looking like an index fund. This gives the manager limited flexibility to think outside the box and acquire securities that may boost alpha in the short term but have too high a risk profile to keep for the long haul because they do not reflect the fund's strategy. Meanwhile, traditional managers' hedge-fund brethren, with no such constraints, are cleaning up, charging percentages of profits plus management fees, Tabb notes.

Active-Extension Funds

To take advantage of short-term investments, firms such as Barclays Global Investors, AXA Rosenberg Investment Management, State Street Global Advisors, Nicholas-Applegate Capital Management and others have begun to plow resources into creating active-extension funds, often labeled by the ratio of long-term to short-term holdings, such as "130/30" or "120/20." These funds can be configured in a number of ways. One common way is a "negative bet" -- a manager who favors the stock of Company B and wants to hold it as a long-term investment buys 20 percent more of that company's stock than he actually has cash to buy -- the 20 percent overweight is funded by "shorting" the stock of company A, which the manager sees as a poor investment. [Shorting involves borrowing a security from a broker and selling it with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker.] Hence, 120/20.

The strategies run the gamut of risk-aversion and alpha-generation. In some cases, these funds are correlated within a sector -- one could bet the fortunes of Ford versus GM, for example -- or by indexes, overweighting the top 10 percent best-performing shares and shorting the bottom 10 percent, for example.

At State Street Global Advisors (SSgA), which has used what it calls "short-extension strategies" for three years, Arlene Rockefeller, head of global equities, has portfolio managers running $12 billion in assets in 14 short-extension strategies across 24 portfolios. She sees the rise of these funds as less of a response to the success of hedge funds than they are a "more aggressive implementation of a long-only strategy." "It's in the risk range of long-only strategies, with a beta of 1 to the benchmark and the same industry exposure as the benchmark," Rockefeller says. "What's changing is that investment approaches that were previously considered value-added are now just considered exposure."

In other words, if you are doing something everyone knows how to do, such as matching an index, you can't charge extra for it. Further, it's more difficult to maintain competitive advantage because of the fluidity of information -- constant innovation is required, Rockefeller adds. "When everyone was excited about quantitative investing, everyone copied everyone else," she says. "Now those strategies have the potential of being reclassified as beta."

This isn't to say that SSgA is not answering the shot off the bow from hedge funds. Another strategy for competing with hedge funds without starting one is a so-called "hedge-fund beta" fund, for which SSgA has created proxy investments that follow the investment patterns of successful hedge funds yet are backed by the compliance and research rigor investors expect from traditional asset managers. "We analyze what hedge funds own ... and get passive exposure to those markets," Rockefeller explains. "If they are long in emerging markets and short on developed markets, we would do the same -- we wouldn't hold the same stocks, but in aggregate it looks like a hedge-fund fund of funds with less turnover, volatility and fees."