Alpha or Beta? Skill or Luck? — Is everything just relative?

Christian Tobias Hille, January-2021

Figure-1

Introduction

2020 has been an unprecedented and extraordinary year from many perspectives. In financial markets, the huge bear market sell-off, followed by a capital market recovery, on the back of unprecedented global monetary and fiscal stimulus, has led to huge dispersion in performance amongst market participants. This articles aims to provide transparency and explanation for the immense discrepancies in investment results.

Whilst it is important to apply rigorous fundamental analysis and make tactical adjustments where needed in an ever faster changing world, I strongly believe an over-arching long-term strategy is paramount. It is important not to be distracted by short-term noise.

Figure-2

This article puts the 2020 financial performance into perspective. Over the past two decades, I have developed a simple framework along which performance, risk-adjusted performance, as well as skill in financial markets can be analysed and properly assessed. This is based on four core questions:

1. Alpha or Beta?
2. Skill or Luck?
3. Risk manage (accept lower upside) vs. stay invested (FOMO, i.e. fear-of-missing-out)?
4. Everything is (just) Relative?

Every portfolio manager needs to ask her/himself these four questions, every single working day, if they are self-reflective, humble and want to continuously improve.

The Financial Times (FT) published an article “Covid crisis opens chasm between hedge fund winners and losers” https://on.ft.com/3rriB9Z [1] by Laurence Fletcher in London, on 24-December-2020. Further read article [2], also published by the FT. Analysing the data presented in the first article and combining this data with market performance, will give us insights and takeaways, based on the presented framework.

2020 Performance data for hedge-funds, according to the FT [1]

The FT article lists the extreme dispersion of performance outcomes of major hedge funds across the globe in 2020.

Table-1: Major hedge-fund returns in 2020

Table-1

For comparison, let us look at an overview of 2020 index market performance across asset classes, sectors and sub-asset classes.

Table-2: Index market performance for 2020

Table-2

Now, we apply our framework and analyse active hedge fund performance, in the context of market opportunities over the course of 2020. We want to understand (i) what is alpha and what is beta (and that beta could be single factor or diversified)?, (ii) what is skill and what is luck?, (iii) evaluate the process of risk management versus missed opportunities, and (ii) putting investment results into a relative perspective versus global financial market indices.

Lessons learned — Alpha vs Beta, Skill vs Luck in relative perspective

We start by looking at market index returns first, to understand what has happened in financial markets over the course of 2020

First, 2020 delivered huge sector dispersions in equity returns

• S&P Global Clean Energy vs. S&P Energy Sector : 158% dispersion
• NASDAQ vs. S&P Energy Sector : >72% dispersion
• Note, that also significant ESG flows have been another major driver, pushing sectors like Technology and Healthcare to new highs and sectors like Energy to new lows. This implicit sector long-short trade, rather a pure ESG trade, has had major implications, as I will analyse in another paper.
• both sector dispersion above are larger than the top vs. bottom decile of hedge fund performance dispersion of 69%

and large performance discrepancies of equity assets between regions

• EM Asia +28.4 vs US S&P with +18.3% and vs Stoxx Europe 600 with only -1.4%
• At the same time Equities (MSCI world) and Sovereign Bonds (Barclays Global Aggregate) have shown almost identical returns
• which means that anyone betting on equities vs. bonds in one form or another didn’t have any material advantage vs. an investor who split his asset allocation very simply 50% into equities and 50% into bonds. Amazing, isn’t it? In particular, given that simple 50/50 strategy was substantially less volatile, with less draw-down (DD) compared to 100% equity investment.
• Global diversified Multi Asset portfolios, here simply combining just two ETF’s, i.e. representing the world-market-portfolio (WMP, [4]), have shown very good performance: between +4.3% for a 10/90 WMP to +6.7% for a 90/10 WMP, and the famous 60/40 portfolio at +5.8%.

Now, we compare these market index returns to specific hedge fund strategies in order to explain how the funds’ performance has been generated

Let’s start with Ackman’s Pershing Square, a concentrated Long / Short fund.

• While I regard Bill Ackman and his intellectual capability to analyse companies and situations to a level of detail, very few can do, he is a well-known substantial risk taker. In 2020 he has made +65%, which looks outstanding at first sight. He has bought credit protection, right before the Covid crisis and deserves much credit for that as the insurance paid off well. Further, he took off the credit-hedge and realized his mark-to-market gains at the right point in time. This was more than luck, and had to do with experience and skill, combined with an element of being bold and brave. Let’s estimate this made him a +20–30% profit for this trade only. On top, he likely made +20–30% from trading the selective growth stocks (tech and healthcare) in a concentrated way. Together with a few other trades this explains about +65% year-to-date performance.
• Alternatively, one could have achieved the same performance based on the same risk (equivalent), by simply going long a linear combination of NASDQ, Healthcare and Clean energy stocks. Do you think this is a justifiable comparison? Yes of course, as we compare like-for-like in risk terms, i.e. two strategies with a similar volatility and draw-down behaviour.
• We know that a one-year period is often less relevant, in the scope of a longer-term performance perspective (see figure-2) from an investor’s point of view. Simply looking at one-year returns, in particular in the ‘hard-hitting’ hedge fund industry, is almost irrelevant. We should always compare — in risk equivalent terms — two strategies over a minimum 3–5 year rolling risk and performance history. Has Pershing Square delivered based on this fair and transparent metric? I leave the judgement up to you, but remind you that stellar 1-year performance has been preceded by significant negative performance in years where Herbalife was the largest single stock bet of the fund.

Let us look at another extreme example. This time on the negative side. London-based hedge fund, CQS, a Credit fund.

• Michael Hintze’s flagship fund has performed -36% in 2020, according to the FT. Is this a poor result? Yes, it probably is, but at the same time it is explainable. CQS has taken significant credit risk in Q1–2020, and was likely stopped out at the peak of the Covid crisis. CQS investment managers wanted to risk manage their fund by taking risk off, but did not seem to have feared missing out (FOMO) on a potential recovery (see question 4 from our framework above). Their view at the time most likely was, that this crisis has much more profound impact on the real economy and financial markets would not recover as quickly as they eventually did. Would anyone of us have expected such an extreme recovery? Remember that credit markets where down more than -36% in the trough of the Covid crisis, and liquidity was virtually non-existent. Only when the Fed came in with unprecedented measures combined with a fiscal program, markets stabilized and recovered sharply.
• CQS also experienced a larger management shake-up (see Bloomberg and Financial Times), which is likely a reflection of issues around management and governance during the crisis.

We complete this analysis with a third example. Systematica’s Blue Trend, a Quant multi-strategy fund.

• BlueTrend has performed +7.6% in 2020. This performance is simply in line with any well managed public UCITS Multi Asset funds, and can be easily compared with the Multi Asset market reference portfolios, the so-called world-market-portfolios (WMP, [4]). Those two ETF (equity-bond) portfolios have performed between 4.3% and 6.7% year-to-date.
• These WMPs can be easily constructed by trading two ETFs, rebalanced on an annual basis. An amazing comparison to say the least. Hence, I invite you to compare Systematica’s Blue Trend’s longer-term performance to these WMP’s.
• In a separate forthcoming article I will shed further light on this ‘magic’ simple WMP strategy. How one can use it for transparent, risk-adjusted, performance comparison purposes or even as a base (diversified beta) investment strategy, which has proven to be superior, even compared with risk-parity type strategies, over the past decades.

The above examples illustrate key performance drivers of funds. One can easily support this more quantitatively by performing a principal component analysis (PCA) and multiple linear index regression. Typically for most strategies, you only need between 1–3 beta market indices, including factor (or style, smart) beta, to find a risk equivalent proxy benchmark. The residual part is then real alpha. You rarely find hedge funds or alternative strategies that produce sustainable, consistent alpha over longer time periods. Once you have found some, make sure you understand the underlying investment process, the investment team as well as the fund team’s long-term incentive structure. If all elements are sound, go ahead and invest, otherwise don’t.

It is very challenging to find ‘real’ alpha, rather than a strategy that simply generates diversified beta or beta plus aggressive random alpha, i.e. excess return, but market it as alpha. Real alpha is hard work, and requires a lot of experience, trial and error (‘fail fast’ but never twice for the same reason), and daily work with precision and long-term grit. It is by no means magic nor a star portfolio manager’s driven skill, as many like to make us believe. Most successful traders are humble, intelligent and human people that work in small teams with complementary know-how and skillset. They have gone through a tough learning process to develop and nurture their skills and typically exhibit the same characteristics as superforecasters. See “Superforecasting” by Phil Tedlock [3], on this very much related topic. A topic that has only recently found acceptance by and inroads into the investment world, but has the potential to disrupt and improve quality significantly over the coming years.

Everything is Relative — the risk equivalent proxy

We have learned from all this performance analysis, that everything in the investment world is relative. Before you make an investment you need to decide on a risk profile, based on your tolerance or appetite, besides choosing your investment horizon. The latter also having a profound relevance for your overall risk profile. A risk profile is a range of volatility (%) or a downside-deviation, or even simpler, the median of maximum annual draw-down (MMADD) that you can sustain from your own behavioural perspective.

This will then lead you to a choice of investment options, within our own risk profile set above. You then have the ability to assess the quality of the invested strategy, by a) comparing to a risk-equivalent index benchmark (single or 1–3 index linear diversified) and b) compare to other competitors in the market with very similar risk profiles. Hence the concept of a “risk-equivalent benchmark” is essential and the equivalent of a performance benchmark in the single asset class world. While in the single-asset class world you compare with the same benchmark index, for more complex, absolute or total return strategies you should compare with a risk-based benchmark, the appropriate risk-equivalent proxy.

Take a very simply example. Imagine you can sustain on average a ~<10% median of maximum annual draw-down (MMADD), i.e. on average every year you will be able to loose — on a mark-to market-basis — from peak to trough, ~-<10%. Note this is just the mark-to-market loss, and only realized if you stop yourself out or sell at the low point. This MMAD is approximately equivalent to a strategy with 6–9% volatility. Which again is equivalent to ~60/40% equities and fixed income portfolio. If you are lazy, simply buy the 60/40 world market portfolio (WMP, [4]) and rebalance annually. If you believe in Active management, like I do, then try to find the best long-term sustainable strategies in the fund universe and pick one with a solid and experienced team. And hopefully they will do sustainably better than the WMP in the long-run. You could also choose Systematica’s Blue Trend or any other hedge fund in the same risk bucket; or you could combine a few managers with complementary skills and approaches. Or, you chose the NASDAQ, but then don’t complain if over some years, you earn less, and over some years don’t be too proud to have generated much higher returns, as you are comparing apples with pears.

A final thought experiment

To complete the article and to demonstrate what I mean by skill vs. luck, let’s do a little thought experiment. One that it not far from being realistic.

Imagine we create and launch 30 funds, each one of the funds holding 1 single stock of the German DAX, the German stock market index. Disregard the fact that you would not be allowed to do it that simply, due to UCITS diversification rules. But you can easily create a very similar strategy in a way that is compliant with UCITS rules, as an aside.

Now imagine you let these funds run for approximately 3-years to gain track-record. After 3 years you close 27 out of the 30 funds, and leave the 3 best performing funds open, and start marketing those. Imagine further, you now manage all three of those funds more like a DAX ETF trackers plus a bit of active alpha. You market those strategies as the active, very successful funds with your three ‘star’ fund managers.

You will very likely raise significant net-new-assets (NNA). I could imagine, with the right distribution channels, up to ~€500mn+ in each in all of those three funds. This is true, because that is the way the industry works. It is still based on past performance, and performance as well as (Morning-)star momentum. Many investors don’t properly differentiate between skill and luck, nor alpha and beta, and are easily convinced and overwhelmed by extraordinary track records, without exactly knowing how this track record has been achieved.

So what can we learn from this thought experiment?

• Many investors buy past performance and stellar past track records
• Many investors don’t distinguish between skill and luck.
• And in the case explained above, alpha performance achieved was simply through an intelligent product strategy, based on diversified bets, i.e. luck.
• Many investors still don’t think in risk-equivalent terms.

What do I mean by that? Imagine two situations.

• A) Over this 3-year period we had a bull run, and hence Growth companies like Adidas or Infineon would have naturally outperformed. Hence it would have been those stocks that ‘survived’ the stock race and ended up building the stellar track record. But those stocks obviously also come with higher volatility and downside deviation. But only few investors perform due-diligence on the process and strategy in detail.
• B) We had experienced a recession or at least a sideways market over the past 3 years. In this case, most likely, more stable dividend stocks like Allianz and Henkel with lower volatility, compared to the DAX Index, would have performed best, and Growth companies underperformed. Hence it would have been those stocks that ‘survived’ the single stock race and ended up building the stellar track record.

Final remarks

I hope reading this article has shed some light into the often opaque world of hedge and investment funds. As you could see almost anything boils down to the four core questions raised at the beginning, which form the framework to properly asses performance in a relative context. And, as we have learned, everything is relative and almost everything can be explained, if analysed with the right tools and framework.

Alpha and skill still exists, despite the many people stating the opposite. It is just not so easy to find and even more difficult to generate as portfolio manager. And it is hard work, often performed by humble, experienced traders with immense grit. There are many analogies with high-competitive sports. I would add that it is even more challenging to become a good portfolio manager, especially as transparency on a daily basis is huge and industry compensation and incentive schemes (in particular at larger, non-independent asset and wealth managers) do not often nurture those skills or lead to quasi-passive risk-taking. Hence there are strong arguments to look for independent, properly incentivised teams with experience.

Stay positive, while asking yourself the four questions above, every single trading day. It will sharpen your thought process and skillset.

Christian Tobias Hille

This article is based on personal opinions and has not been written in any business capacity.
I thank Fürstlich Castell’sche Bank and Sempera Ltd, in particular, to give me the freedom to publish my open and transparent opinion in this format.
I further thank, Roger Douglas, Nikolaus Poehlmann, Nils Mallock, Rob Stanley, Andreas Feiner, Frank Haering and Walther Doernte (in no particular order or priority) for challenging me and cross-reading this article. They have spent precious private time to discuss my thoughts in the spirit of thoughtful disagreement.

Afterword

Over the course of 2021/2, I plan to write a few more articles, openly sharing my thoughts on relevant investment themes. Here are a few examples of relevant topics.

• Skill or Luck? Alpha or Beta? — Part II
• Risk Management — Outperformance or Insurance strategy?
• Efficient frontiers revisited, and long-term capital market assumptions (CMAs)
• Behavioural economics and the reality of Trading and Investing
• Sustainable ESG Investing — Between marketing trend and Investing with real impact

References

[1] “Covid crisis opens chasm between hedge fund winners and losers”, Financial Times (FT) by Laurence Fletcher, 24-December-2020

[2] “Picking hedge fund winners turns harder for investors”, Financial Times (FT) by Laurence Fletcher, 23-January-2021

[3] “Superforecasting: The Art and Science of Prediction”, 2016, by Philip E. Tedlock and Dan Gardner

[4] World market portfolio (WMP). Comprised of x% MSCI world (open currency, €-denominated) and (1-x%) Barcleys Global Aggregate (€ hedged and denominated). E.g. a 60/40% WMP is comprised of 60% global equites and 40% global fixed income. Why equities is open-currency invested and fixed income €-hedged, will be explained and rationalised in a forthcoming article.