As the developers of investment products keep coming up with more and more diverse ideas, the correlations between underlying markets are getting closer.

Alpha is getting harder to find particularly since the credit market crunch of last August. The recent volatility has hit two of the major elements of returns: momentum and the small-cap effect.

According to Michael Gordon, Fidelity International’s London-based global head of institutional investment, after a long run up the big drivers of alpha are no longer as dominant. The median global manager in the Mercer universe of 189 funds (European domiciled) has outperformed the index by 180bps in the five years to March and 170bps in the past year.

Gordon, an expatriate Australian, is spending more time thinking about big investment trends and questioning some commonly held views about investment strategies and market behaviour. He stepped down as chief investment officer in London to take up his new role, which involves more client contact around the world, ex-US.

Fidelity has a separate US business with its own brand, Pyramis, for US institutional funds management. Gordon believes that asset classes are getting less diverse and part of the problem is the investment industry itself. Once investment bankers get their hands on an investment to package, securitise and benchmark, the asset starts to lose its historical characteristics.

For hundreds of years, for instance, people have been investing in violins and wind. In very recent years everyone has been able to invest in wind, not just those with use for a windmill. While wind has been securitised, through companies such as Pacific Hydro, and violins haven’t – yet – they would both start to look more like equities in general than the investments they may have been.

Even commodities are looking more like other markets as they are owned more by investors rather than businessmen looking for a hedge. “What is sold as diversity is bought as performance,” Gordon says.

Private equity draws his criticism too. He doesn’t question the underlying value of a private equity portfolio for long-term investors but he does question whether private equity general partners sell themselves as being skilful, having superior management, when most of the return will come from leverage. “Why aren’t people including (in portfolios) some things which are at 10-year lows?”

If alpha is getting more difficult to find there is at least some progress being made on measuring it. Gordon questions whether there is such a thing as ‘sustainable’ or ‘reliable’ alpha. “Alpha is not just skill,” he says. “You can’t prove skill. Alpha comes in many ways. There is a lot of portable beta being sold as portable alpha.” He also wonders whether something is “lost” when you separate beta from alpha.

The definition and measurement of alpha are different issues from what is often “sold” by zealous funds managers. And the progress is on the definition and measurement side rather than on getting funds managers to sell their wares in a more sober and transparent fashion. Alpha is added value.

The advances in thinking of the last couple of years have come about through the realisation that standard market benchmarks do not represent a fair line in the sand to measure the ‘added’ component. A better benchmark to assess alpha strategies is the appropriate ‘beta prime’ or what some people call ‘hedge fund beta’.

This is the underlying driver of a strategy which can readily by replicated through a quant model. ‘Activist’ strategies, which are increasingly popular in the US but not yet available in Australia, should similarly be judged not against a standard S&P 500 or Dow Jones Index but rather against an event-driven index.

An event-driven index would involve a model whereby all stocks which announce a takeover (the acquirers) are immediately sold and all targets immediately purchased. This simple strategy adds 1-2 per cent over the Dow even though it does not reflect any skill above the ability to make and implement the model.

Gordon says that investors should be cautious about some new forms of investments too, such as agribusiness funds and carbon trading funds, which may seem to make intuitive sense and could certainly be seen to ride a global fashion trend. “Agribusiness is not an investment, it’s speculation,” Gordon says. “It’s speculation because there’s no risk premium. There’s no risk premium because it’s just about prices moving from A to B. Carbon trading would be the same.”

He observes, however, that the early adopters of various new strategies have been well rewarded in the past. Those investors who are belatedly following the Yale model (investing in an array of lowly correlated alternatives) may be facing all sorts of risks.

But the biggest immediate issue facing investors around the world is the unwinding of leverage. “De-leveraging is not a six-month thing,” Gordon says. “If you look back to 1987 when the whole boom was built on leverage, it took several years for the market to recover. [In the recent run-up] banks became sales organisations, not credit organisations. That will change.”

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