Fees prevent alternative investment strategies from outperforming

The business literature on the performance of active management and its ability to outperform benchmark indices is particularly rich. Research typically shows that money managers struggle to outperform when the analysis takes investment costs into account. A study entitled Asset Management and Alternative Risk Premiums: Are Fees Justified?led by Francesc Naya, Jahja Rrustemi and Nils S. Tuchschmid, researchers from the Haute Ecole de Fribourg, enriches it by focusing on a new category of products, the so-called “Alternative Risk Premia” (ARP) strategies.

These new investment strategies, mostly reserved for professional investors, are similar to hedge funds. Some speak of hedge funds 2.0. The similarity is strong in that these ARPs choose to replicate strategies that can compete with hedge funds. Liquidity, “transparency” and relatively low costs can be cited in favor of these new products. The size of this market reaches about 15 billion dollars. For comparison, the hedge fund market cap will be $4 trillion at the end of 2021.

Also read: Hedge Funds: Really Risky Investments?

ARPs therefore use long/short strategies – the combination of long and short positions – and the use of leverage and derivatives. However, they are more sophisticated and different from traditional mutual funds that do not use debt and bet on losses. They can be implemented in two ways: either the manager develops a strategy himself in-house and offers it to his clients, or he usually sources it from investment banks, which give him access to these strategies.

The search for alpha

“Our work focuses on alpha, meaning outperformance or excess return relative to the market,” he says time Nils Tuchschmid, finance professor at the Friborg University of Economics. The question for a manager is whether he can buy at the right time and buy or sell at the right price. In fact, the manager can only “do alpha” if he has forecasting skills.

Also read: From research to alpha transfer

This study first simulates a manager’s sorting ability by selecting ARP indices that have outperformed their peers. To do this, it uses around 200 ARP indices provided by investment banks and covering the period from 2007 to 2021.

The researchers then calculate the performance of these indices each quarter and classify them into two quantiles, the top 50% and the bottom 50%. They then modulate a selection capacity by assuming that the portfolio manager is able to preselect a predefined number of indices in the first quantile. In other words, the manager has the ability to make predictions even when they are imperfect. Every quarter this process is renewed and repeated 1000 times. Finally, these 1000 returns are compared to those of a benchmark index. These early results show that there is alpha (about 1.6% on average).

In a second step, the researchers no longer look at indices, but strategies (e.g. of the Momentum or Value type). The advantage of looking at the strategies directly is to avoid the risk of choosing the wrong bank provider. Again, the researchers show that it is possible to release alpha.

Lack of outperformance for funds of funds

Based on these observations, Nils Tuchschmid and his colleagues then turned their attention to the ARP fund of funds market and no longer to indices or strategies.

These funds allow a wider audience to invest in this market through a simple and proven solution. For every fund available to them, they calculate alpha… but find none. Although some funds perform well, the results are mostly disappointing.

On average, the alpha of these funds is negative, ranging from -1.29% to -0.35% depending on the benchmark chosen. This means managers are either unable to forecast, or the alpha they were able to generate has been eroded by management fees.

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