Tuesday, July 12, 2016
Two views for how alpha can be exploited
Everyone talks about alpha, but there is often a shortage of explanations for why alpha exist. I am not talking about the problem of measurement of excess returns after accounting for beta, but the reason for why there can be excess returns in the first place after accounting for risk premiums.
A simple framework could divide the rationale for alpha into two schools or world views. One can be called the structural school and the other the behavioral school. The structural school can also be called the limits to arbitrage view. In the structural school, markets will be efficient except for structural impediments. The structure of markets will affect their relative efficiency. Those managers who can offset these structural impediments will be able to profit and generate alpha. The behavioral school states that managers are able to generate alpha because they can take advantage of the behavioral biases of others. Those with behavioral biases, sometimes classified as noisy traders, create market inefficiencies if they represent a sizable amount of trade volume or capital. Prices may not immediately reflect information or overreact to news. The skilled hedge fund manager identify these market situations and will take advantage of these inefficiencies for gain.
The structural school leads to some clear ideas on where alpha can be found and exploited. It would be very hard for alpha to be generated in the most liquid markets which are followed by many analysts. There are no barriers to entry or trading so market competition eliminates any excess returns. Money can be made in those markets that are less efficient and may have barriers to competition. It could be complex securities that require specialize skills. It could be those markets which have higher transaction costs for most other traders. It could be markets that do not have large amounts of capital committed relative capital demanded or markets that have specific legal or regulatory restrictions. Nevertheless, if the structure of the market changes, excess profits could be eliminated.
The behavioral school needs ongoing behavioral biases from a sizable amount of other traders. The skill of the hedge fund manager comes from his ability to see or identify these biases in others or in a particular market and exploit them. The bias could be a market over-reaction or under-reaction to new information. The hedge fund manager may understand the value of a market and trade when biases lead to deviations from fair value. The bias could be situational as opposed to an ongoing structural issue. These biases could be ongoing, but also change with the market environment. More liquid markets can still be subject to behavioral biases.
Hedge fund managers may not be exclusive to one school or another and there may be other ways to classify alpha, but placing broad structure around the identifying characteristics of alpha may help define the advantage of some managers over others.