Thursday, November 12, 2015

Strategic Alpha - the effective use of funds and financing

The terms alpha is thrown around somewhat casually by many investors. Who does not want alpha? If a manager can broaden the term, he can argue that he has the ability to provide it. On the other hand, smart investors have become more wary of what is alpha. They have spent more time refining benchmarks in order to more precisely separate alpha and beta.

Now there is a new term being used; strategic alpha, as provided by the treasury function of the hedge fund firm. There is return to be gained by better managing cash and financing. I agree with this alpha concept and expect a rapid improvement by most firms. 

There is a competitive advantage for firms who better manage financing. It can add incremental return that is unrelated to the underlying market risk of a strategy. For those who now engage in better treasury practices, it will add relative return. If all managers improve their treasury practices, there will still be a gain relative to existing beta. This should be something everyone does.

The regulatory environment makes financing more difficult and expensive. Banks are dropping hedge fund clients, FCM’s are dropping derivative firms. Forming better alliance with brokers and clearing firms is essential for the livelihood of many firms. Without a good FCM or PB, a hedge fund will be alpha constrained. 

Banks and FCM’s do not want hedge fund cash and they want to squeeze more return form their hedge fund clients. Money market funds have more restrictions that make it riskier for hedge funds to park short-term cash. This means that cash management is  firm critical for any fund manager. Managers avoided this function because it as not core to their business, but in a changing environment, what is core is being redefined. With excess returns falling, every extra basis point that can be gained is important.

The example of a managed futures fund is illustrative given their high cash collateral levels. It used to be that cash invested in Treasury bills would cover much of the management fee costs of the firm. Take the simple case of 5% bill rates and 2% management fees. The fund would be “ahead” by 3% before trading. Now with rates down to zero, performance is negative before trading begins. FCM’s do not want the excess cash. There is more risk with segregated funds given some FCM failures. Banks do not want the extra cash, and institutional money market funds have new regulatory rules which constrain returns. Managing cash more effectively is valuable even in a low rate environment. Currently, this value may be limited, but if the Fed starts to normalize rates there will be value in moving out the yield curve and managing cash alternatives. 

Watch for firms changing their cash practices and hiring specialists in financing. Generating and counting every penny will be a required alpha source. There is alpha in the details of how money moves.

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