Thursday, September 03, 2009

People Lie About Alpha

This year's hot investment strategies are related to distressed debt, as reflected by a lots of inflows, and this highlights that anything that worked well recently are considered smart. They took 'good risks'. When one loses money, they simply were foolish, such as going long mortgages in 2007. If you went long these in early 2009 you weren't lucky, you were smart. Risk taking seems only to apply to past trades that worked out well, those that did not work are just dumb. This creates a lot of confusion as to the true nature of risk.

Last Friday, the WSJ had a long article on the meticulous risk management at Graham Capital Management, a hedge fund that had one of the best performances over the past 12 months. Nassim Taleb's 'long gamma' strategy is hailed as genius in November 2008, at the top tic of a long put strategy (funny, no update after the market rally and the VIX has come down from 80 to 25). 12 months is a very short time frame to evaluate any strategy, but for a journalist highlighting business geniuses, it's a lifetime.

One should remember that Enron was the subject of Harvard Business School case studies in 'best practices' management, they emphasized their 'risk management' and received plaudits there. (I think there's a strategy in going short any company who's senior risk officer wins 'risk manager of the year' from GARP or RISK Magazine). Golden West Financial won an award as 'best mortgage lender' from Forbes before its portfolio took down otherwise prudent Wachovia.

So after a disastrous 2007 and 2008 in distressed, a good 2009 leads to new lemmings. One can imagine the sales presentations to investors, as management highlights how their meticulous deal-by-deal analysis enabled them to score big gains this year. That is, they make a beta bet (long distressed securities) look like pure alpha. This is easy to do in distressed because invariably the benchmark is not as obvious as it is for a diversified US equity portfolio.

In my book Finding Alpha I describe these strategies, as they are built on the fact that alpha is a residual return, a risk-adjusted return, and as 'risk' is not definable, this gives people a lot of degrees of freedom. Further, it has long been the case that successful people are good at doing one thing while saying they are doing another. Augustus Ceasar was successful because unlike Julius Ceasar he appeased the senators by making it seem like he restored the Republic (where the senate is in charge), when in practice he had probably more power than Julius Ceasar. When unions are successful they promote their agenda by appealing to how they are helping their customers, assiduously maintaining quality via their exclusionary rules. Affirmative Action was successful because proponents said it definitely does not imply quotas. The key is that many large strategies involve duplicity.

And so it is that most asset managers say they are doing alpha X when actually doing a beta bet on Y. I was talking to someone recently who noted a mutual friend was making a lot of money 'day trading spiders'. I don't think anyone can make a lot of money day trading spiders, but hope springs eternal and lots of people like to believe that anyone who made money recently, made such money via alpha, not a dumb bet. It's a better story than the truth, something like being long mortgages, because we all know how risky that bet was.

Below are some other examples of alpha deception, from my videos:


ngogerty said...


Nice video, I wish there were more material out there like this deconstructing, not only individuals but orgnizational practices like the Alco comittee. thanks.

Anonymous said...

Nice video, too. Merkel reviews your book here:

Anonymous said...

Eric, you are kind of funny!

Plamen said...

Eric, did you know Stigma is also a letter (combination of sigma and tau) from the Greek Alphabet? Those folks may not have had alpha, but they got stigma [grin].

Senta said...

I agree with 95% of what you said, most people who claim alpha are deluding or deluded, but there are some people who do have alpha like Warren Buffet or John Paulson.

liquidjoe said...

Why couldn't risk be definable in the same relative fashion that alpha is measured by? Risk could then be definable, but only on a relative basis. Everything is relative.

bjk said...

Todd Harrison (in his recent autobio series) relates some funny anecdotes about Cramer. In one, Cramer is on the phone bragging about buying the market. Then Harrison tells him that in fact they're shorting . . . and Cramer gives him the thumbs up.