Lifting the hood

(November 2006) You invest in mutual funds, good, solid, long-only investments that everyone can understand. No surprises, no mystery. Market goes up — money is made. Market goes down — well, the fund’s active manager has presumably preserved wealth through defensive (tactical) positioning. Plain and simple.

Not so fast! Did you know that your plain-vanilla, everyday fund is really a hedge fund in disguise (partly, at least)? That’s one of the conclusions arrived at by Christopher Holt, president of Toronto-based Holt Capital Advisors and editor of AllAboutAlpha.com, a blog dedicated to alternative investments in general and alpha/beta separation in particular.

As you may know, the search for alpha, the “skill” component of active management, as opposed to beta — the “passive market” component of investing — is driving a lot of research and development nowadays. That’s because, as the argument goes, you should not hesitate to seek and pay for alpha, the skilful returns obtained by outstanding active managers. As for beta, the market supplies it anyway: So pay as little as possible for it, i.e., invest passively through an exchange traded fund or other index-based product.

The key here is the ability to separate alpha from beta, to wit, measure the relative weightings of alpha and beta in an investment. What percentage of your favourite mutual fund is alpha? Beta? And then, are you really index-hugging and paying too much for what amounts to a lot of beta?

That’s the approach Holt has pursued and his results are well worth your attention.

By borrowing from a well-known methodology developed by William Sharpe called returns-based style analysis, Holt simulates the “hedge fund” in using historical returns — an investment’s “tracks in the sand” as Sharpe described it — and regression analysis to strip out the components of a well-known Canadian fund.

What he shows is how to practically think about active money management. In brief, think of any actively managed asset as a combination of the relevant index and a hedge fund (being construed here as adding long and short positions to the underlying index weightings in the investment — the graph below, created from actual data from a large, well-known Canadian equity mutual fund, will illustrate).

Whether you like it or not, any active manager is in the ‘hedge fund’ business of taking long and short positions relative to the benchmark market index (you could even make a case that, relatively speaking, generating cash through underweights and then investing it in overweights is tantamount to leveraging the index positions).

The distinction is important: Although all portfolio positions are net long, underweighting a security with respect to the index is tantamount to shorting it, from a manager’s decisional point of view. It’s a matter of changing the perspective from a zero benchmark to the index benchmark.

This is compelling because it basically brings hedge funds and ETFs, two financial instruments of high current interest, into the continuum of investing and shows that there is nothing magical about making investment decisions.

Importantly, Holt stresses that hedge funds are not asset classes; they are part of the same old investing, focused differently (and with the extra degrees of freedom of shorting, leverage and derivatives, and arguably of ‘exotic’ investment strategies). This means you can think of traditional investments as a blend of an index (or an ETF) and a hedge fund.

In the institutional world, money managers actually combine index positions to alternative investments — it’s called an alpha overlay (adding an alpha-generating mix atop an index-based, or beta, substrate). High-end advisors have been doing this, at least implicitly, for wealthy investors for years. And this, according to Holt, is the shape of things to come.

As Holt likes to say, “hedge funds and ETFs were separated at birth and are now being reunited in the form of alpha-overlay and portable-alpha strategies.”

But an advisor may ask, so what? Holt believes that investors will migrate away from “index-hugging” mutual funds as they learn that these funds can be replicated by combining “off-the-shelf” components such as ETFs and hedge funds. As a former management consultant, Holt draws a parallel to another industry that experienced a similar upheaval a decade ago.

“The advent of travel websites undercut the travel agencies’ golden goose — proprietary reservation systems — forcing agents to focus on consultative advice and less on commissions,” he says. This may sound alarming to advisors whose bread and butter are mutual fund trailers. But, in part, it might explain the interest for fee-based advisory models where purchasing (cheap, no-commission) ETFs won’t jeopardize advisor revenue streams.

While major institutions have embraced the cost savings and flexibility of this approach, advisors needn’t pile their client’s money into hedge funds to realize its benefits. Along with a software partner, Holt’s firm is currently developing a tool that can calculate the amount of “embedded hedge fund” in a mutual fund, and uncover the price effectively being charged for this hedge fund (his research shows the MER for hedge funds embedded within major Canadian equity funds ranges up to 15%).

Advisors could then use this data to rank and select mutual funds. Eventually, they would be able to use ETFs to strip out the beta from a mutual fund and isolate the embedded hedge funds since not even the mutual fund manager itself would offer this “hedge fund version” of their core products.

But ultimately, advisors will win by having access to more tools in order to personalize client portfolios. And once this transition is complete, says Holt, the advisory function will be more important than ever.

Holt offers another way of looking at the separation of alpha and beta through vector analysis. He shows that one can decompose an investment’s return/risk drivers in an orthogonal mix of alpha and beta. It’s powerful because it can be graphically interpreted — you can draw a picture of it. Moreover, Holt gives a numerical example of how to ‘rebuild’ an investment (e.g., a fund) from its ETF and hedge fund building blocks.

This is an eye-opener as it changes your thinking on investments as ‘black boxes’, and worthy of further columns. In the end, focusing on the alpha/beta mix helps understand and focus on the sources of return, of risk, and the merit of the investment. This is a good thing.

This article originally appeared in Advisor’s Edge Report. Pierre Saint-Laurent, M.Sc CFA, CAIA is president of AssetCounsel Inc. He can be reached at PSL@AssetCounsel.com

(11/01/06)