Managers need to rediscover their mojo – and their alpha

Mon Feb 27, 2012

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It is more important than ever for managers to understand where their alpha-generating skill lies – and to be able to communicate, and show, that to their investors


By Nick Evans

Well, it certainly didn’t take long for the reverse-indicator properties of this column to reassert themselves in 2012.

Barely was the ink dry on my comment in January – highlighting the appeal to investors of systematic strategies in a difficult environment for discretionary managers and fundamental stock-pickers – than equity markets were taking off like a rocket, taking those very same fundamental stock-pickers with them and leaving quant-based funds trailing in their wake.

Long-biased long/short funds have been particular beneficiaries – none more so than value-based investors, most of whom were pulverised (again) in 2011 and who believe that market dynamics are now firmly back on their side after a prolonged period when fundamental value has been largely ignored by the market in favour of macro factors.

It may well be that these types of long/short equity funds are indeed the ones that are best placed to generate high returns – particularly if the risk-on surge fuelled by central banks flooding the system with cheap liquidity proves more durable than the rallies of last year.

For many investors, any additional beta exposure to equities – at a time of such acutely uncertain and changeable underlying market conditions, set against a cloud-covered macro backdrop – is the last thing that they need from their hedge fund managers right now.

But risk needs to be seen as a spectrum – and the beauty of hedge funds is that there is something for everyone, all the way from the low-vol, capital-preserving market-neutral type funds at one end to the bat-swinging, high-conviction risk-takers at the other.

And the key thing is for investors to know what they are buying – and, just as importantly, for the managers to know what they are selling.

For all the buoyancy so far this year, there is plenty of uncertainty around – and the bull and bear cases for markets look equally compelling. If bull markets do indeed climb a wall of worry, there is no shortage of that about.

Global economic prospects may look a good deal better than they did a few short months ago (in the US, in China and – for the time being at least – in Europe, thanks to the ECB’s LTRO quantitative easing lifeline). But geo-political developments – in Europe, the Middle East and elsewhere – look increasingly worrisome.

Fundamental stock-picking analysis may have reasserted itself again as the principal driver. But the macro driver hasn’t gone away.

In confused (verging on bi-polar) and very changeable markets, the need for true alpha is greater than ever. And it is more important than ever for managers to understand where their alpha-generating skill lies – and to be able to communicate that to investors.

Some managers are brilliant stock-pickers. Some are brilliant market-timers. But very few are good at both. And the biggest lesson of 2011 is perhaps that too many managers were trying to do both – and succeeding only in bamboozling themselves and their investors.

Finding investors who share a manager’s view and their tolerance for risk – and who are happy to have their money managed in the same way as the manager likes to run their own – is the greatest challenge for any manager, just as it for the investors themselves.

For managers, it involves understanding – and explaining – what you are good at, what you are not good at, what kind of a manager you are and how you are different from others. And that is a good deal harder and more complicated than it sounds.

Conviction is all very well, but conviction alone can be dangerous. And it requires more than just self-belief to earn – and retain – the trust of investors. Self-awareness, communication, honesty and humility are all important too – and yes, a degree of bravery too.

Those are hard things to practise and even harder things to convey to others. Analysing and communicating instinct is never easy. But that is what investors need to see. They need to feel that there is a process, or at least a psychology, that they can understand and which rationalise to themselves and those whose money they are also charged with managing.

Without it, the supposedly ‘back box’ systematic and quant-based strategies may actually be rather more illuminating, predictable and ‘transparent’ than the vagaries of what is going on inside a manager’s head.