Sign up now to receive our free newsletter
The problem with Alpha (Absolute Returns): it lacks Beta
October 22, 2007
One of the allures of alternative investments lies in their ability to provide positive returns regardless of conditions such as a strong economy, low inflation, or a bullish stock market. Indeed, one of the key benefits of an investment in managed futures or trading systems is this ability to profit (or suffer losses) in virtually any economic environment.
These types of independent returns, which don't depend on the normal drivers of investment returns (strong stock market), are generally referred to as absolute returns, and refer to a style of investing that attempts to provide positive returns year in and year out, not returns which outpace the "market". There is no guarantee this style will be successful, of course, but the trillion or so dollars in hedge funds, managed futures, and private equity are betting that managers can provide absolute returns.
The investment industry has taken to calling these absolute returns "Alpha" in many cases, with newsletters and magazines named Alpha this, Alpha that focusing the hedge fund space and so on. What is Alpha? Alpha is the calculation of the excess return on an investment. And the idea behind it is that when the stock market is down, or bonds are weak - and a manager or investment is still able to make money - that manager has done something special through being smarter, faster, in a different sector, etc. to earn a return while the general market was not able to. That return is therefore in excess of what was expected in a normal investment, and that is Alpha - the calculation of the skill that manager showed in beating the market.
You're no doubt asking, excess return over what? And that's the right question. The simplest way to measure returns are to look at the simple return and see if you were up or down. Up is good, down is bad. But if you chose not to put money in a certain investment, that money wouldn't just sit there earning nothing (we hope), you would put it in a savings account, CD, or other interest bearing investment like a United States Treasury Bill which has virtually no risk of losing money. This is called the risk free rate of return, and at the least, investment returns should be measured against this level first and foremost. The theory is that you should be paid for the risk you are taking on, meaning that the return should be greater than it would be if you took on no risk.
Savvy investors have taken this logic even one step further when measuring investments by saying not only should the investment beat what could be gotten if risking nothing, but it should also beat the returns they could get if risking the same amount in a similar investment. This "similar investment" is represented by a representative benchmark in many cases. So, if looking at a mutual fund, most see what returns it has made over the S&P 500 or DJIA benchmark indices. If in a fixed income investment in bonds, most look at how much over a government bond index they made, and so on.
But what benchmarks can we use to measure the alpha of a trading system day trading e-mini Russell futures or a CTA selling options on commodities like Corn and Crude Oil? We can plainly see that the normal stock or bond indices surely don't seem to apply. We could compare to a commodity price index like the CRB or Goldman Sachs commodity index, but that surely doesn't seem like the choice if investing in a stock index option selling CTA or bond trading system, for example.
There are indices of Commodity Trading Advisor performance, which are probably the closest thing we can compare a single manager or system's returns to for checking alpha, but those usually aren't investable indices, meaning we couldn't re-create their returns even if we wanted to. And those indices still don't really apply when trying to evaluate the skill (Alpha) of an option selling CTA or other unique strategy type, which if it is represented at all in the index is usually a small percentage of it.
This leaves investors in absolute return/alternative investments "stuck" in a way, being unable to compare their investment in an absolute return vehicle with a benchmark of any meaning. Without this measuring stick, many investors find it difficult to know what to expect out of the investment's future (relying on past results only) and also find it difficult to stick with the investment during bad times.
Another problem with measuring Alpha, is that it ignores the risk of the investment. If two managers beat their benchmarks by 30% in a year, but one was leveraged 3 to 1 while the other had no leverage - they would both show the same Alpha, and per that measure be equally skilled in getting excess returns. But we know intuitively that the manager with 3 to 1 leverage is not as skilled, because she had to risk a lot more to earn her excess returns. Beta is the concept which tries to address that riskiness component of returns, and generally refers to how correlated with the "market's risk" an investment is.
If an investment has a Beta of 1.00, it is just as volatile as the market you're comparing it to. If it has a Beta of 3.00, its 3 times as volatile, meaning a market gain of 5% would equate to the investment gaining 15%, and so on. Betas can be negative, such as -2.0, which would mean the investment would lose 10% when the market made 5%.
While Beta may seem like an advanced statistical concept - most of us feel Beta whenever we look at our overall portfolio's performance. We may see that our portfolio of mutual funds was down in the third quarter, but not feel so bad because they were down less than the overall market. We may see that our high flying growth stock lost 3 times what the market as a whole did last Friday, but comfort ourselves by recalling that the stock had risen many times more than the overall market thus far this year.
We also feel Alpha - with thoughts such as I'm dropping this mutual fund because its underperforming the overall market, or I'm switching into another money market account because I'm doing no better than if I was holding T-Bills, and so on. So while not putting fancy calculations on paper with Greek symbols and figuring what your investments' Alphas and Betas are, most people can intuitively work out what the Alpha and Beta are for their STOCK and BOND portfolios. This is because they can feel the differences in return and volatility between any single investment and the overall stock or bond markets.
Alpha (Absolute Return) Investments Tough Mentally
The difference in an absolute return strategy is that it is much harder for an investor to feel those differences in returns and volatility, or at least to feel the CORRECT differences in returns and volatility. This is because there is often no meaningful index for the investor to measure her investment against daily as there is with stock and bond investments which have benchmark indices that are force fed to the investing public through the television, Internet, newspapers, and radio many times a day.
Many investors find it hard to live through a drawdown phase or even incur consecutive losing months due to this trouble feeling the Alpha and Beta of their CTA or trading system investment. Let's take the volatility spikes which have occurred a few times this year and made it a difficult year for stock index option selling CTAs. I'll venture to guess that more than half of those investors that pulled out of some of those CTAs program's in drawdown would not do so if they had been looking at their investments against an index of option selling CTAs.
If there was a reliable option selling CTA index, an investor could have seen that their program, while down, had actually outperformed the option selling CTA index by losing less than the average option selling CTA. Or conversely, that their program had done even worse than the index. Either way, that small piece of information gives the investor a mental edge, enabling them to know whether their investment choice is actually producing that ever-elusive alpha.
Another way to look at it, is that the decision on Alpha for many CTA and trading system investments lacks the knowledge of Beta needed to back it up. That is, we often times don't have a reliable benchmark which allows us to see whether the investment is doing more than just replicating the risk of a certain "market".
For example, the popular NDX programs which spread trade the Hog market have had an off year after stellar returns the past few years. Is this underperformance the result of the manager losing his "skill" - his ability to generate alpha, or is it merely because the types of spread trades which have worked in the past have not done as well this year (the underperformance a result of market risk defined by Beta). We know from looking into the trades, speaking with traders, and evaluating the performance of other spread trading CTAs that in fact it was a very bad spread trading "market" this summer.
But we don't have a spread trading index which we can calculate NDX's Beta on, to see that the smaller gains this year for NDX are indeed the result of the program having "market" risk. And this caused many people to quit that program this summer, as they didn't have any benchmark to fall back on and put the performance in perspective. They had no scape goat, so to speak, and instead looked at just the raw numbers and decided to cease trading the program.
Conclusion - Be Careful what you wish for...
So if the problem with investing in Alpha (or absolute returns), is that is lacks Beta (or a market benchmark), then the problem with lacking Beta is that it makes it tougher for investors to see their alternative investments through to a profitable conclusion.
The whole idea behind an alternative investment is to not be correlated or tied to really any market, so that they may perform regardless of what any market does. But the end result of this uncorrelated structure is having no benchmark to compare to, no scape goat for an investor to mentally fall back on.
An investor in a day trading system can't say, " I'm down this quarter, but not as much as the day trading market on CNBC" There is no market, and really, even if there were - the whole point of an alternative investment is that it is supposed to be making money regardless. It's a tough deal for the CTAs and systems, to be sure
This is part of the reason, in my opinion, why the stock market is so darn popular. Stock investors can pat themselves on the back when their picks are doing well in a rising market, and then turn around and blame the market when their picks aren't doing well. This built in scapegoat keeps investors mentally in the game.
Managed futures and trading systems have no built in scape goats. We invest in them specifically because they aren't tied to any benchmark. But we should be careful what we ask for, as not being tied to any benchmark makes it that much tougher to stick with them through thick and thin.
IMPORTANT RISK DISCLOSURE
Not on our mailing list? Sign up now to receive this weekly newsletter.
Political tensions in the Middle East, specifically the threat that Turkey will invade Northern Iraq, caused crude oil prices to soar to record highs last week. Crude Oil futures closed at 88.60 per barrel up +5.09% last week as the commodity seems destined to hit the $100 per barrel target so many analysts were predicting two years ago. The other energy markets followed suit with RBOB Gas +4.15%, Heating Oil +3.62%, and Natural Gas +0.58% all trading higher as well.
The record high energy prices along with very bearish earnings reports in the financial sector caused a big sell off on Wall St. last week. SP futures were down -4.37% as bank after bank continues to disappoint on the earnings front due to credit market exposure. Dow Jones futures fell an identical -4.37% while NASDAQ futures were down -2.25%. Smallcaps were hit hard as well with Russell 2000 futures -5.74% and SP Midcap futures -4.38% both trading lower.
Predictably, with investors scrambling for safety, bond futures headed in the opposite direction with US 30 year bond futures climbing +2.58% while US 10 year note futures were up +1.93%. Gold futures, another investor safe haven, traded higher as well gaining +1.94%. The other metals were mixed with Copper -2.77%, Silver -1.93% and Palladium -1.85% trading lower, while Platinum futures were up +2.43%.
Adding to the misery is that US Dollar is showing absolutely no signs of recovering soon. The Euro hit another intra-week high against the greenback and Eurocurrency futures were up +0.84% for the week. Japanese Yen futures +2.32%, Swiss Franc futures +1.40% and Canadian Dollar +0.89% futures remain strong against the dollar as well.
Finally, trading in the grains and softs was mixed with Corn futures +5.48%, Sugar futures +4.18%, and Cotton futures +2.40% climbing higher while Coffee futures where down -10.27%.
***Commodity Trading Advisors (CTAs)***
Based on the above market activity, last week’s trading was anything but quiet for most CTA’s.
With volatility jumping back into the stock market last week investors were reminded of the need for diversification as many Index Option sellers experienced a short term spike down in open trade equity. Short option sellers that were affected by the one day spike (markets rebounded today) included Ace Investment Strategist, Zenith, Zephyr, Rathiel, and BC Capital. On the opposite side of the picture was Ascendant Asset Advisors – Ascendant Strategic 1 and Strategic 2 programs have a short call bias across a wide range of index markets whereby they have traditionally benefited from quick market drops (i.e February 27th and July/August markets).
Outside of the option selling, Attain Portfolio Advisors Strategic Diversification program continued its winning ways and is ahead approx. 2% for the month. The strategies long term trend following and intraday components have been the highlight of the month to date.
Elsewhere,for those of you sitting on the sidelines waiting for the next Dighton Drawdown (click here to read about investing in Dighton's Drawdowns)- it appears to be looming as they are currently down approx. 15% from their recent equity high. Despite the recent drawdown, Dighton is still profitable for the month.
Finally, the popular PFG K3 Managed FX also capitalized on the week and is ahead approx. 1.5% for the month.
***Day & Swing Trading***
Stock index volatility shot up nearly 30 % last week as global stocks took a turn for the worse late in the week after reacting to credit market fears and record oil prices. The added volatility gave some of the flagship day and swing trading systems the opportunity to thrive but also hurt some of the programs that tried to buy the weakness in hopes for a bounce.
Compass SP hit new all time equity highs last week after profiting +$4,375 due largely to a winning short trade on Friday. The system is now up over 70 % for the year including all costs associated with trading the program. Quite impressive for a system released 7 years ago.
Keystone eRL had an impressive performance last week with profits of +$1,660 on four trades. OPXP welcomed the overnight sell-offs since it is a short-only system and made +$640 on four trades. Kappa Dax looks to take small chunks out of the market and did just that with gains of +$248.79. BetaCon 4/1 ESX had similar results with a gain of +$225.22 for the week. Waugh eRL profited +$120 on four trades for the week thanks for a winning short trade on Friday that wiped out losses from Mon, Wed and Thurs. RT Viper YM had a small gain of +$74.76 on four trades.
Moving on to the swing systems, Mesa Notes made +$2,028.12 for the week after closing out a winning long trade that it has been holding for several weeks. The sharp sell-off in stocks sent bond prices higher throughout the week with the biggest move occurring on Friday. Ultramini ES had some well-timed entries for a gain of +$1,952.50 for the week on two trades. Signum TY reversed long and made +$1,400 despite taking a loss on the closed out short trade (-$1,693.75). SeasonalST eRL and ES had profitable weeks up +$810 and +$640 respectively. Ultramini YM had one short trade that made +$310 for the week.
Elsewhere, Adaptive Euro lost -$167.77 for the week while Adaptive US lost -$9,810. These are the type of market conditions that can either make or break Adaptive as it will continue to buy day after day predicting some sort of bounce. Tzar took a hit in all markets as it was holding long and lost between -$990 and -$4,860 in the NQ, ES and eRL. Finally, Mosaic eRL lost -$3,437.50 for the week.
Strong gains were seen in rate futures last week as weaker than expected economic data and safe haven buying due to the stock market sell off sparked a firm tone in the entire sector, with most instruments hitting 5 week highs. This change in economic conditions has resurrected the idea a Fed rate cut in the future just may be in the offing especially if future data shows a slowing in the economy. The upcoming week’s economic releases are very light mainly focusing on the housing sector with a few manufacturing numbers mixed in. Long term trend followers are still slightly positive as Aberration is currently long TYZ with a current gain of +$1281.25 (open trade).
The U.S. Dollar again lost ground to most major foreign currencies last week as market activity seemed to again be influenced by the continued rally in inflation sensitive instruments like energies, metals and softs. Long term trend followers remain in a mostly negative stance toward the U.S. Dollar as both Aberration and Relativity are currently short DXZ currently making +$1880.00 (open trade) and +$2290.00 (open trade) respectively. Relativity is also Long ADZ making $1280.00 (open trade) and exited the CDZ last week banking $4520.00 (open trade).
Soft commodities mirrored the previous week with a mixed tone with the livestock sector posting losses, but most grains, oilseeds, and foods posted gains. The livestock and meat sector continues to find weakness from heavy supplies, although word of Russian dissatisfaction with some U.S. processing plants also added to recent selling pressure. Aberration is currently long KWZ making $12,279.00 (open trade), and long BOZ trade with a gain of $654.00 (open trade). Relativity is currently long SMZ making $2030.00 (open trade), Short LHZ making $3230.00 (open trade), and Long Jan Robusta coffee making $1640.00 (open trade).
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.