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Thursday

Alpha innovation

Alpha becomes beta? Some economics professors say consistent skill cannot exist. Reminiscent of the patent clerk a century ago who said he didn't see any future for his profession as "everything" had already been invented. There are many trillions of dollars of alpha to be generated in the future.

Total alpha sums to zero so that puts emphasis on extracting it from OTHER market participants. Given the tens of trillions of dumb dollars in the global markets there is vast opportunity for capturing and redistributing that alpha to the few that know what they are doing. Alpha can only diminish if the markets became efficient but the fact is markets are MORE inefficient than ever before.

Many strategies have been invented. These range in performance and value from newspapers ACTIVELY picking stocks, commonly known as "passive" index tracking eg S&P, FTSE or Nikkei, to strategies developed by Renaissance Technologies for the Medallion Fund. In between there are many of varying levels of worth and sophistication of which some are used in long only funds and many more in hedge funds. But there are numerous new methods of making money waiting to be discovered and those will be NEW sources of alpha.

New strategies have emerged as a consequence of growth in the variety of underlying products that can be traded and the relationships between them. Complexity and innovation in assets, hybrids and their derivatives offers investment and arbitrage opportunities and I see no reason why financial product innovation should cease any more than other technological field.

Whether it was NDFs, CFDs, variance swaps, ETFs, credit derivatives, commodity linked bonds, CDOs, SIV-lites, CPDOs, PIK toggles, carbon credits, freight, property derivatives or weather and catastrophe reinsurance, all these created opportunities for new investment strategies or NEW alpha. The FEW skilled will make money from these inventions while the MANY unskilled will lose money on them. Portable alpha? The redistribution of investment returns from the many fools to the few geniuses.

Then there is geography. New places become investible every year making more alpha available. I am in China this week and the range of things you can do as an investor here is increasing rapidly. Despite being here I just bought some cocoa options today because of information I received today from contacts in Sao Tome and Principe and Cote D'Ivoire. The global village we now live in and the technological interconnectedness is a GROWING source of alpha.

Whether by asset, strategy or geography, ALPHA IS NOT IN SHORT SUPPLY. When a new hedge fund sets up I regard it as neither a threat nor a competitor to other funds. They are not going to affect alpha generation as their strategy should be unique. They are in a peer "group" of one or should be. If a strategy gets crowded then do the opposite!

Of course some strategies are now mature and in the public domain and THAT alpha is limited. As with any product a hedge fund manager must always be developing new strategies and enhancements to their existing strategies and protecting their intellectual property as long as possible. A copied strategy is a dinosaur strategy unless your edge lies in implementing the strategy better than others.

One thing is certain. We are NOT running out of alpha and there will be plenty around in the future. I don't usually reveal future product ideas but no-one is managing a Mars "global" macro fund...yet.

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