Redefining Alpha: “the Inertia Concept”

July 28th, 2010
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These days everyone talks about alpha. If one attends any of the well-known investment/hedge fund management conferences they will find that a large part of the discussions are devoted to the difficulties that these fund management companies have in locating managers than can generate alpha. While these discussions are of great interest, few have taken the time to find out whether alpha can in fact be accurately calculated.

Numerous methods have been used to determine whether someone is generating alpha, but the overall consensus is that if an investment manager, be they a traditional money manager or a hedge fund manager, is able to generate returns, risk-adjusted, that are in excess of their peers, or a specific index, then they are generating alpha.

This would all be fine, except that the risk parameters used to determine whether the returns were in fact superior to others are in fact completely faulty. For example, if you mistakenly allocate too high a risk to manager A who has generated the same nominal return as manager B, then they would be deemed to have not generated alpha.

Add to this problem the fact that most investors - be they individuals, high net-worth, or institutional - who place their assets in the hands of third-party managers have no idea how the performance of their manager has in fact been calculated. They usually have to rely on the star ranking provided by Morningstar, the investment consultant reports, or the hedge fund managers themselves, which usually provide some sort of Sharp Ratio.

The reports, in their original format, are highly technical and very difficult for anyone but an actuary to understand. This would still be fine if they were accurate. The fact is that we cannot derive correct risk measures for valuing simple shares, let alone portfolios of shares. And, of course, when you are dealing with hedge funds that invest in multiple asset classes then the models are simply ineffective.

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