(Bloomberg View) –
I feel like there were maybe a couple of decades when “alpha” and “beta” were useful terms for talking about investing performance, but now we are reaching the end of that golden age:
“We are now realizing that a lot of what we thought was alpha is actually an alternative form of beta,” says Yazann Romahi, the head of JPMorgan Asset Management’s quantitative investment arm. “This will transform the hedge fund industry.”
That’s from an article by Robin Wigglesworth about how quantitative-finance groups are increasingly trying to replicate and compete with hedge-fund strategies. “The basic return of a market is known as ‘beta’ in financial jargon,” writes Wigglesworth, but obviously that can’t quite be the sense in which Romahi is using the word.
The modern sense is that “beta” is anything a computer can get you, while “alpha” is anything it can’t. (More formally “beta” is the set of coefficients of whatever regression you happen to like to describe the connection between risk factors and returns, while “alpha” is the residue; as you find more factors to shove into your regression, more of the world becomes explainable by those factors, and the residue gets smaller and smaller.)
You can have high-risk strategies and low-risk strategies and high-performing strategies and dumpy low-performing strategies and they can all be “beta.” For a hedge-fund manager to set herself a goal of generating “alpha” now seems positively quaint. (Similarly, criticizing hedge-fund managers for not achieving “alpha,” as measured against some risk-factor model designed to replicate hedge-fund strategies and minimize residues, seems a bit unfair.)
Anyway one hedge-fund strategy that seems to have been solved is mergers-and-acquisitions arbitrage:
For instance, Yin Luo, the chief quant at Deutsche Bank, says the single biggest determinant of whether a deal completed is its age. In other words, the longer it drags on the less likely it is to go through. But he has identified a multitude of factors that affect the M&A strategy’s success rate, using the same statistical techniques that doctors use to determine how long a cancer patient has to live.
As is often the case with quants, they are confident that their mathematical approach produces better results than human intuition. The traditional M&A arbitrageurs are “good but often not very accurate. Our model has actually proven more accurate than the arbitrage funds”, Mr. Luo says.
The counterargument is of course that these models are based on historical regressions, and if the relationships change in the future, the hedge-fund-replicating strategies will break down. “They all fail miserably when the market regime shifts,” says a fund-of-funds investor and quantitative finance professor.
This counterargument would have more force if there was a lot of evidence that, as historical relationships change, non-quantitative human hedge fund managers are particularly good at changing their strategies. But it seems like lots of people also manage to fail miserably when the market regime shifts.
One thing that we sometimes talk about around here is the notion that investors who meet with a company’s executives can gain insight into the company’s future performance by interpreting the executives’ “body language.” I always sort of half-think that “body language” is a euphemism for, like, the executives just tell the investors what the next quarter’s margins will be or whatever.
But, no, apparently ”body language” is a real thing and even computers can notice it:
James Cicon thinks they can. A finance professor at University of Central Missouri, Cicon built software that analyzed video of the faces of Fortune 500 executives for signs of emotions like fear, anger, disgust, and surprise. The emotions, he found, correlated with profit margins, returns on assets, stock price moves, and other measures of performance at the associated companies.
It turns out that bad emotions are good for the company:
Although fear, anger, and disgust are negative emotions, Dr. Cicon found they correlated positively with financial performance. CEOs whose faces during a media interview showed disgust–as evidenced by lowered eyebrows and eyes, and a closed, pursed mouth–were associated with a 9.3 percent boost in overall profits in the following quarter. CEOs who expressed fear–raised eyebrows, widened eyes and mouth, and lips pulled in at the corners–saw their companies’ stock rise 0.4 percent in the following week.
Dr. Cicon pointed to psychological research to explain why investors interpreted negative emotions as a sign of positive movement in share price. “Fear is widely recognized as a powerful motivator. Thus it is not surprising to find that a CEO who appears fearful under interrogation is perceived by the market as a CEO who will work harder to increase firm value,” said the paper, which was co-authored by Steve Ferris of the University of Central Missouri and Ali Akansu and Yanjia Sun of New Jersey Institute of Technology.
I have trouble believing that explanation. But if you do believe it, it is a wonderful data point about late capitalism, which apparently extracts more value for shareholders in proportion to how much it immiserates, not just workers, but also CEOs.
Also it is a good advertisement for aggressive shareholder activism: The more fear a Bill Ackman or a Carl Icahn inspires in CEOs, the better those CEOs will apparently perform. Though actually it is even a better argument for disgusting shareholder activism.
There is a market niche for a Sloppy Eater Activism Fund, where you have lunch with the CEO, spray food everywhere, and he is so disgusted with you that he goes and achieves great prodigies of profitability. I’d like to see a quant fund try to replicate that! That is pure alpha.
Too big to etc.
Is Neel Kashkari laying the groundwork to run for elected office? I mean, he ran for elected office before; it didn’t go that well. I don’t know how much precedent there is for a regional Fed president to be elected to the Senate or whatever, but we live in unprecedented times. In any case his speech Tuesday about breaking up the too-big-to-fail banks, followed by a media tour where he talked to Bloomberg Television and the Financial Times and the Washington Post and Reuters and CNBC, is maybe a bit more populist than I would have expected from the president of the Minneapolis Fed?
From the Financial Times:
In an interview with the Financial Times, Neel Kashkari, who took over as head of the Minneapolis Federal Reserve at the start of the year, warned that the Fed needed to work harder to rebuild public trust and communicate with American citizens. Economic anger, he said, was “all around the country and it is non-partisan”.