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Three Sources of Alpha: A Call for Small Manager Investment

By Karl Rogers, ACE Capital Investments I recently finished a multi-strategy fund of hedge funds build for an institution where I focused on three sources of alpha: small manager, equities and commodities. Small Manager Alpha Given that “small” managers have been found to outperform their larger peers[1], why do many large investors not allocate to them before they become large from an AUM perspective? I propose a simple formula to enable investors, institutions, and large asset managers to access this small manager alpha: Small Manager Alpha Access = 2-year live Track Record + (Daily Liquidity + Managed Account Setup) Return Robustness –> 2-yr Live Track Record A primary hurdle for institutions investing in small or emerging manager is the uncertainty surrounding robustness of returns due to their “short” track record. With a “short” track record, it can be difficult to gauge performance under different market conditions/environments for long-term investment. For example, being live from 2012–2014 shows your performance under one macroeconomic market condition only. This holds true for the majority of the last decade-plus. However, we now find ourselves in an ideal time to analyze performance under multiple macroeconomic market conditions by using only two years of live, audited returns. When we look at the past two years of live returns, we see that fund managers have navigated through Q4 2018’s volatility, followed by a significant year-long beta bull-run which saw the S&P 500 gain 28.88%, followed by the market’s historic COVID-induced market drop [the quickest move into a bear market in history], and finally they have navigated through a persistent high-vol environment and V-shaped equity index recovery [greater than a 50% return] leading the major US equity indes in positive territory for the year in 2020. When we look at macroeconomic market conditions at ACE, we divide them internally into three categories:

The past two years have given witness to all three of these previously mentioned macroeconomic market conditions. Not only that, but these two years have witnessed 63 individual days within our high-vol defined market condition[2] –from 2010-01-01 to 2018-09-17, in which only one day has been within that high-vol threshold. A separate advantage is the benefit from increased net profits due to preferred fee terms which later investors do not get access to. Liquidity & Operational Risk –> Managed Account Setup A non-investment-related red flag that halts institutions from investing is a mixture of operational risk combined with liquidity risk. Most “small” managers have a seed/anchor investor and therefore have investor-based risk. Investor-based risk refers to the risk of investor redemptions large enough to disrupt the manager’s operations (i.e., the manager does not have enough revenue to keep the strategy operational or even execute the investment strategy as planned. Given that standard hedge fund liquidity terms mean investors are generally locked-in for a year with quarterly redemptions, large managers and institutions do not want to invest given the liquidity/investor-based risk during that lock-in and redemption period. Operational and liquidity risks are mitigated when investing with managers who offer both daily liquidity and a managed account setup. There are many small managers operating markets and strategies that fit this liquidity and trade setup. They can be found in managed futures strategies across equities and commodities running both discretionary and systematic strategies. If the manager runs into any operational problems or has an anchor investor pull, institutions can stop the underlying manager on that account and redeem the following day. In other words, the institution avoids a situation where an allocation with an operationally inadequate manager is tied up for months, or even years. There are a number of small managers who operate profitable strategies in high-capacity markets, providing uncorrelated returns that are only small as a function of the inefficiency and pitfalls of the institutional allocation process, despite deriving strong returns from different risk-types and in a liquid market: “AUM attracts AUM” as they say. Shouldn’t it be “Strong performance in an uncorrelated manner in liquid markets attracts AUM?” Allocation inefficiency at the institutional level causes strong, small managers to fall through the cracks, which leaves them ripe for allocation to access that small manager alpha. I would trust a small manager’s returns having navigated the past two years’ multiple, severe market conditions in a stable manner over that of a manager who has a seven-year track record from 2010 -2017 any day of the week! Equity Market Alpha The CAPM is a common model used within the investment arena. Managers quote their alpha generation based on that model. Let us compare the CAPM and the risk-types: CAPM: Return(i) =                          Beta(i)              +              Alpha(i) Risk Types: Return(i) =        Systematic Risk(i)    +     Idiosyncratic Risk(i) By using basic algebra to the two equations above, we can see: Alpha = Idiosyncratic Risk By using the active management spread trade set-up equity market-neutral, we cancel out the systematic risk/beta of the underlying components and concentrate on managers that can isolate the idiosyncratic drivers of the underlying spread components. This leads to alpha capture in an unrelated behaviour to long-only equity products. Commodity Market Alpha Although commodity markets are generally driven from different fundamental drivers than the traditional markets, they are cyclical in nature versus the long-term increasing nature of the equity markets; the equity markets benefit from survivorship bias, fiscal, and monetary support with the incentive of growth. This means that a long-only, highly beta-exposed equity product makes from both a diversification and return expectancy viewpoint to a portfolio however for commodities, long-only, highly beta-exposed manager makes sense from a diversification perspective only and not a return expectancy standpoint. By adding active managers that can both buy and sell during the commodity market cycles, we keep the diversification benefits of adding those fundamentally different market drivers that move the commodity markets, while also keeping our portfolio’s return expectancy intact due to the variable net nature of the strategies imposed during the market cycles. The Bottom Line One of the common questions that I frequently see within the industry articles and within industry topics is how do investors and fund manager extract reasonable yield in this low-interest rate environment? Taking on the equity market alpha and commodity alpha referred to above will provide investors uncorrelated yield, however one way to magnify the yield level returned to investors is by accessing this small manager alpha. Market conditions and institutional inefficiencies are aligning at present and are offering this small manager alpha opportunity, which was not present, at least on a risk-adjusted basis, over the past decade. By using the simple small manager alpha formula from the beginning of this post, institutions, large asset managers, and other investors can extract higher proven yield in this low interest rate environment. [1] This has been widely researched and found to be true – Links: [here, here , here & many more] [2] Based on 20-years’ worth of volatility and equity daily data

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