Since inception, the iconic Nevsky Capital, a long-short global equity fund, has posted an impressive cumulative percentage change in $ terms of 1,213% over its 15-year lifespan from September 2000 to December 2015. The manager of Nevsky Fund, Martin Taylor, was shutting down the fund at the end of 2015, and returning all of the $1.5 billion capital to fund investors.
In his final letter to fund investors, Martin Taylor cited persistent challenges in the current market environment which led to such a decision. For over 21 years, a "broadly unchanged process" (i.e., one that marries the top down forecasting of key macro-economic variables with the bottom up forecasting of company earnings) had worked well for them. Until it doesn't anymore. What are we to make of this? Why can't alpha be made to last?
Turns out that alpha is rather ephemeral even for high-frequency traders, according to Jacob Loveless: “Imagine every day you have to figure out a small part of the world. You develop fantastic machines, which can measure everything, and you deploy them to track an object falling. You analyze a million occurrences of this falling event, and along with some of the greatest minds you know, you discover gravity. It’s perfect: you can model it, define it, measure it, and predict it. You test it with your colleagues and say, ‘I will drop this apple from my hand, and it will hit the ground in 3.2 seconds,’ and it does. Then two weeks later, you go to a large conference. You drop the apple in front of the crowd...and it floats up and flies out the window. Gravity is no longer true; it was, but it isn’t now. That’s HFT. As soon as you discover it, you have only a few weeks to capitalize on it; then you have to start all over.”
Since alpha is hard to come by, might it be worthwhile to reconsider the possibility of creating passive portfolios based on replicating hedge fund exposures to risks? Earlier research by Andrew Lo and Jasmina Hasanhodzic of MIT had examined just such a possibility, based on using a linear regression technique to identify common factors. However, the actual performance results of such “replication funds” in the real world were somewhat disappointing, and had not matched expectations. For example, the Diversifying Strategies fund, which was launched in 2009 and managed by AlphaSimplex, performed poorly over a three-year period during 2011-2013, especially when compared against the S&P 500 performance benchmark in a rising stock market. The fund was subsequently shut down in 2014. The strategy of replicating the returns of hedge-fund techniques had its limitations. Whether by linear regression or other techniques, it was again found that the real world financial markets are not so easily modeled after all.
Let’s think about the problem in a slightly different way, and ask: Is there a renewable source of alpha that traders can tap into? It so happened that David McLean of the University of Alberta and Jeffrey Pontiff of Boston College examined a total of 72 market anomalies (i.e., good old-fashioned money-making opportunities!) that appeared in academic journals between 1972 and 2011. They found that average returns went down 35% after publication. They also uncovered evidence that traders jumped in to exploit anomalies following publication, with trading volumes rising, and with short interest increasing for stocks on the wrong side of arbitrage opportunities. Curiously, the anomalies again start to produce improved returns after a few more years. It appears that traders have rather short attention span, and very likely have moved on to the next thing.
Here is an interesting question to consider: How might a “perpetual alpha fund” be organized? Does the trading firm do the same thing as usual, only different every day? Or does the trading firm do just one thing, the same every day but evolves along the way? What new framework do we need?
If this question sounds hard, then how about something a tad bit easier: How might a “perpetually flying paper airplane” be constructed? Here is an “instructable” that teaches how to build the “paper airplane that flies forever” and a video that demonstrates its perpetual flight characteristics along MIT’s famed “infinite corridor”:
No Magic: A shift in perspective is all that is needed.
- Loveless, Jacob (2013, October 16). Barbarians at the Gateways. ACM Queue, Vol. 11, Issue 8. Retrieved from: http://queue.acm.org/detail.cfm?id=2536492
- Lo, Andrew, and Hasanhodzic, Jasmina (2006, June). Attack of the Clones. Institutional Investor's Alpha, 54-63. Retrieved from: http://jasminah.com/Papers/Alpha_Pub_smallSize.pdf
- Hasanhodzic, Jasmina, and Lo, Andrew (2007). Can Hedge-Fund Returns be Replicated?: The Linear Case. Journal of Investment Management, 5(2), 5-45. Retrieved from: http://alo.mit.edu/wp-content/uploads/2015/06/CanHFReturnsReplicated2007.pdf
- Copeland, Rob, and Zuckerman, Gregory (2014, August 3). How Individual Investors Can Invest Like a Hedge Fund. Wall Street Journal. Retrieved from: http://online.wsj.com/articles/how-individual-investors-can-invest-like-a-hedge-fund-1407106285
- Lahart, Justin (2013, September 13). Arbitraging Academia. Wall Street Journal. Retrieved from: http://blogs.wsj.com/moneybeat/2013/09/13/arbitraging-academia/
- Moyer, Liz (2014, August 8). Taking Stock of Automated Advisers. Wall Street Journal. Retrieved from: http://online.wsj.com/articles/taking-stock-of-automated-financial-advisers-1407519771