May 1, 2013

Gaming Steroid-Free Markets: What’s an Advisor to Do?—Searching for Alpha for May 2013

Stocks may be on an uptrend, but home runs certainly aren’t. The most likely reason isn’t phenomenal pitching, or better defense, but the elimination of steroids from Major League Baseball. 

According to a 2008 article in the American Journal of Physics, the average home-runs-per-ball-in-play (HRBiP) was approximately 0.10 prior to the use of performance enhancing drugs, compared with 0.15 in the steroid era (1995-2003)—a shocking 50% increase. Author R.G. Tobin attributes this differential to the approximate 10% increase in muscle mass brought about by the use of such banned substances.

This observation leads us to attempt to explain the remarkable performance of hedge funds before 2007.  Even the most carefully constructed indexes showed the ability of hedge fund managers to produce equity-like performance with bond-like volatility. But in the last few years, the industry has seen its results whither in comparison to the raging bull market, which has seen stocks double since 2009.

Although difficult market conditions and a lack of available margin are certainly a factor, it should be noted that it’s simply harder to get one past the umpire. Self-reporting NAVs have gone the way of the dinosaur, the once-hot IPO market isn’t nearly as kind to flippers as it used to be, and insider trading has proven to be a dangerous pastime. Amid a more level playing field, hedge funds have found outperformance a very difficult proposition, especially considering their huge fees. 

So what’s an investor to do? In an effort to reduce volatility, the only game in town is diversification. Mixing stocks and bonds with alternative beta and managed futures can reduce tail risk and make portfolio returns smoother. Alas, it seems that the promise of hedge fund superiority is only plausible in those rare cases when the manager has a clearly defined edge. 

 

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