Wealth Manager

Many if not most investors accept the
equilibrium of alpha as a zero sum game.
And so it is for investment returns generated
from a specific opportunity set, such
as the stocks in the S&P 500. But what
happens if we add risk into the equation?
Does alpha still sum to zero in risk-adjusted
terms? Not necessarily, at least
not all the time.

That’s the message from a small but
assertive group of investment strategists
including Max Darnell, a partner and chief
investment officer at First Quadrant, an institutional
money manager in Pasadena,
Calif. that specializes in quantitative strategies
including global tactical asset allocation.
A sampling of Darnell’s reasoning
appears elsewhere in this month’s issue
(see "Rethinking Zero" above) in a story
that explores the idea that the supply of
alpha may not be as limited as convention
suggests. After interviewing Darnell,
we decided that his extended comments
should receive a fuller airing on what is for
some a controversial subject.

Readers may or may not agree with
Darnell, but all strategic-minded investors
are likely to benefit from listening
in on the discussion. Alpha, after all, is
at the center of all investing. Some seek
it, others avoid it by design through indexing.
But one way or another, alpha has
everyone’s attention. Investigating the
nature of alpha’s existence in the investment
universe is likely to be a productive
debate, if only to test and perhaps
strengthen one’s assumptions about how
the capital markets operate.

What follows is a conversation on just
that, courtesy of Darnell, who joined First
Quadrant in 1991 as manager of derivatives
research, a post he held until 2000,
when he was named director of research
and, two years later, CIO.

Q: You maintain that alpha’s not a zero sum
game. Is that an academic view, or does
it also have relevance in the real world?

A: It’s more than an academic exercise. Depending
on how you answer the question,
it should make a lot of difference in terms
of how an investor sets his objective.

To make sure I don’t run into any terminological
issues, I’m using the term “alpha” loosely.
What I really mean is “value added.” When
people talk about alpha as a zero sum game,
they’re trying to figure out if they can do
something to add value. Technically speaking,
alpha should be referred to as idiosyncratic risk.

Q: Meaning something other than beta?

A: Yes, something other than beta. There are
really two basic ways to add value. You can
play the game of trying to improve your
returns through idiosyncratic risk. Or,
you can do it through the management of
beta across time. That is, you can vary your
exposure to beta over time, or you can arrange
the betas in a way that you expect
will lead to a superior outcome.

Real world examples include the endowment
funds of the Harvards and the
Yales of the world. They’re choosing a
configuration of betas and alphas that
work to their advantage vis á vis other
market participants. Foundations and
endowments can live with a longer time
horizon. They also have a smaller asset
size to manage than the biggest institutional
pension funds. So endowments
and foundations have flexibility and different
objectives that distinguish them
and allow them to take on risks that others
might not.

The sell-off in August is a recent example.
Consider two types of investors. One
has a relatively short-term horizon and
is unwilling to bear short-term liquidity
issues. Examples include some hedge
funds and individual investors who may
react with shorter-term horizons even
though they shouldn’t.

On the other side are the foundations
and endowments, which may see others
selling because of liquidity issues and
decide that it’s just a blip, a momentary
event. These buyers may have very different
objectives, and so they can wait for
a return of liquidity. Is a foundation or
endowment generating alpha or adding
value by buying assets that looked risky
to one person but didn’t look risky to another?
Absolutely.

Q: Because…

A: Because they recognize that they have a
set of differences that vary with other investors
and decide that they’re going to
take advantage of those differences. And
so they recognize that they ought to be

That view tends to favor investors with
a longer-term view on risk. Examples
include some individual investors, particularly
those with a lot of wealth that
they may be expecting to pass on to
subsequent generations. They may be
in a position to behave like longer-term
investors. Very often that means doing
the most uncomfortable things, like
buying assets that have been beaten up.
Meanwhile, there’s a whole set of investors
who don’t want the ugly looking assets
in their holdings list—mutual funds,
for instance. Or, maybe it’s a hedge fund
with a very short-horizon objective; or
an absolute return fund that’s trying to
hedge its downside risks and so it can’t
bear further declines.

The bottom line: There’s the potential
for trading between these two kinds of
investors that’s good for both.

Q: Is that because one is laying off risk
while the other is embracing it, and so
that ends up being a net gain for both?

A: From the perspective of their objectives,
the answer is yes. It’s not necessarily a
gain in the return space for both, but in
risk-adjusted return terms it very well
may be [a gain for both].

Q: Does thinking in risk-adjusted terms go
to the heart of why alpha isn’t necessarily
a zero sum game?

A: Yes, and that’s the way people ultimately
have to think about their objectives. One
simple example: If you’re an individual
without a lot of wealth, and dependent
on that wealth for surviving one or two
years out, you need to think about the
risk side of the equation because if you
hold more risk than you can financially
bear, your life could change dramatically.
You may not be able to pay the mortgage,
etc. So you may be able to improve the
risk-adjusted quality of your returns by
selling assets that have recently become
more risky.

Q: So alpha sums to zero for straight returns
relative to a benchmark, but the
principle doesn’t necessarily hold if you
add risk to the equation.

A: That’s right. It’s on that risk side that we
all distinguish ourselves. That’s why the
foundations and endowments are so different
from individuals of modest means.
What really distinguishes the institutions
is the ability to bear investment risk over
different types of horizons. And that’s
critical in the investment puzzle.

Here’s one way to think about it. You
always have a set of investment choices.
Let’s take two assets that you think have
similar return opportunities and similar
risks. You’re invested in one, which starts
going up. What should do you do? You
can switch over to the one that has the
risk/return profile that you can bear. It
doesn’t necessarily mean degrading your
return, but it does mean adjusting the
risk/return profile.

If you ignore the risk side of the equation,
this whole argument goes away. If
you’re living in a return-only world and
ignore the differences between investors,
which are risk differences, then return is a
zero sum game, if you will.

Q: Assuming that alpha sums to zero
seems to be the conventional wisdom.

A: From an academic perspective, a heroic
assumption is made that risk is the same
for every investor. We all value return in
exactly the same way and so the return
side of the issue is uninteresting when
you say there’s heterogeneity among
investors. But when you move to differences
in preferences, it’s all about those
differences in risk and objectives and constraints.
And so the academic literature—
and I think this is the big flaw in the zero
sum game argument—generally starts
with an explicit or implicit assumption
that all investors look at risk in the same
way. But they don’t. Your readers are remarkably
different from institutional investors,
for example.

Q: If someone accepts the idea that alpha’s
not a zero sum game, how does that inform
investment strategy?

A: One example is thinking about how your
risk profile and objectives differ from
other investors. In the past, pension
funds often had similar asset allocations.
But that was a mistake. How could they
make that mistake? They assumed that
there were no differences in their risk profiles
and so they assumed no advantage
in exploiting the differences.

Q: They assumed alpha was a zero
sum game?

A: That’s right, and so they behaved similarly
to the funds considered to be their
cohorts. A classic example was in the U.K.,
where there were dramatic differences in
the duration of the liabilities of the pension
funds. Yet they were all holding 70/30
mixes of stocks and bonds—or roughly so.
That shouldn’t have been the case. But
they assumed their differences away and
decided that there was no value in distinguishing
their objectives, which allowed
them to hold conventional allocations.

Q: If alpha doesn’t sum to zero, how does
that view square with the principle that
all investors can’t be above average?

A: If we limit that comment to idiosyncratic
risk, it’s absolutely true. But idiosyncratic
risk is so boxed in, if you will,
because we accept a benchmark and it’s
valued in the same way by everyone. In
that sense, generating return in excess of
the benchmark means taking that return
from someone else.

Meanwhile, compare that to a real world
case that’s topical. Fundamental
indices, for example. [Benchmarks that
weight securities by “fundamental” factors,
such as dividends and earnings,
and are considered alternatives to traditional
cap-weighted indices.] You can
say that investors with formalized liabilities
may place a higher value on more
fundamentally oriented-type stocks in
their portfolio. And while they may or
may not get a return advantage from
holding those stocks, they might get a
greater utility advantage because they’re
holding something that is a match for
their liabilities.

Q: So investor utility helps explain why
alpha isn’t a zero sum game.

A: You just can’t get away from it [investor
utility]. If you say that not all managers
can beat the benchmark, that’s only true
in a return-only space. I accept that argument
all day long if we’re talking about
return only. In that case, alpha is a zero
sum game.

Q: The question is whether that’s how to
look at investing in the real world?

A: No, not even close.