Threats to hedge fund managers’ ‘secret sauce’

‘Alternative beta’ strategy replicates active managers’ returns
© Philip Wolmuth

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Hedge fund managers are arguably the celebrity chefs of the money management industry. They are best able to whip up returns that make investors drool. But financial engineers are unpicking their secret sauce and finding new ways to sell it by the bottle.

The biggest trend in the money management industry is the shift towards passive investment.

About $3tn is now in index-tracking and exchange traded funds that only seek to replicate the returns of a broad market, such as the S&P 500, the Barclays Aggregate bond index or the FTSE 100. The basic return of a market is known as “beta” in financial jargon.

In contrast, hedge fund managers attempt to deliver “alpha”, the returns over and above the market itself, through a staggering array and diversity of strategies, ranging from betting on global currency movements to surfing on the corporate acquisitions boom.

The promise of this alpha is what induces investors to pay extra for the services of the alternative asset management industry.

But analysts at banks and investment houses have over the years examined the returns of money managers, crunching them with computers and unpicking various “factors” that drive returns. Now some say they have reverse engineered many popular high-octane hedge fund strategies, and can replicate them more cheaply.

“We are now realising that a lot of what we thought was alpha is actually an alternative form of beta,” says Yazann Romahi, the head of JPMorgan Asset Management’s quantitative investment arm. “This will transform the hedge fund industry.”

JPMorgan Asset Management estimates that the “alternative beta” industry’s assets have grown from about $2bn in 2010 to roughly $50bn today.

M&A arbitrage is a good example of a highly specialised hedge fund strategy that the “quants” now say they can mimic. “Arbs” place bets on whether corporate acquisitions will fail or succeed. When a company makes an offer for a rival, it will typically offer a premium price — but there is always a danger that the deal collapses, so the shares typically trade slightly below the offer price.

Skilled arb funds — typically stuffed with corporate lawyers, antitrust experts and former investment bankers — buy the shares of targets when they think the deal will go through, and short the ones where they think the deal will fizzle. The risk is in practice binary, and the better the fund, the more accurate its predictions.

Enough deals go through that even average M&A arbitrageurs should make money over time, as they capture what Mr Romahi calls the “deal failure risk premium”.

But quants now think they can do even better than simply systematically buying acquisition targets, by studying history for what deals go through and which fail, and automatically weighing their bets accordingly.

For instance, Yin Luo, the chief quant at Deutsche Bank, says the single biggest determinant of whether a deal completed is its age. In other words, the longer it drags on the less likely it is to go through.

But he has identified a multitude of factors that affect the M&A strategy’s success rate, using the same statistical techniques that doctors use to determine how long a cancer patient has to live.

As is often the case with quants, they are confident that their mathematical approach produces better results than human intuition. The traditional M&A arbitrageurs are “good but often not very accurate. Our model has actually proven more accurate than the arbitrage funds”, Mr Luo says.

M&A arbitrage is just one of many popular hedge fund strategies whose secrets quants say they are now deciphering. Others include global macro — betting on the ebb and flow of international interest rates and currencies — and even activist strategies pursued by the likes of Dan Loeb’s Third Point, Bill Ackman’s Pershing Square and Carl Icahn.

The implication for the industry could be significant. Mr Romahi says the data show that some hedge fund managers only generate “enough alpha to pay themselves”, and expects the growth of cheaper to run exchange traded funds to beat down fees in the hedge fund industry over the coming years. “The hedge fund industry is bifurcating, between the ones that are truly active and those that merely generate alternative beta,” he says.

Of course, there is always a danger that even with the right recipe, an inferior chef will struggle to replicate the dish of a master.

While the quants have crunched their numbers through supercomputers their models for what works are based virtually entirely on “backtesting” against historical data. The financial crisis showed how a slavish adherence to modelling can spectacularly blow up in real-life markets, either immediately or eventually.

“I have very little regard for these hedge fund replicators,” says Robert Frey, chief investment officer at FQS, a fund-of-hedge funds and a quantitative finance professor at Stony Brook University. “They all fail miserably when the market regime shifts.”

Nonetheless, the view that the epochal shift from active to passive investment will also shake up the hedge fund industry is gaining adherents.

“We’re at the very early stages, but you can see how the active versus passive story will have a separate arc into alternatives,” says Jeffrey Knight, head of asset allocation at Columbia Threadneedle.

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