How Can Investors Source Alpha In An Evolving Alternative Investment Environment?

Research confirms alpha exists in hedge funds and particularly among small managers. However, sourcing quality opportunities among thousands of alternative strategies remains a time-consuming challenge, especially if done the traditional way. Using the latest academic research and technology, investors can quickly and efficiently narrow any number of funds to a manageable size, finding best-in-class solutions.

Sourcing alpha in alternatives is a traditionally tricky business. Most investors find managers by attending industry conferences, through a referral, or from a financial professional at some of the largest banks –  most likely an inefficient and dated process.

By sourcing opportunities from such a limited pool investors often pile money into the same funds, the largest funds. The herd mentality causes managers to quickly exceed initial strategy capacity and start reaching for returns, creating a negative impact on the fund’s alpha delivering capability. Despite waning performance, managers still charge premium fees, traditionally ‘2 and 20 percent,’ reinforcing investor dissatisfaction. The following chart highlights dissipating alternative investment performance as fund size increases using a quantitatively curated group of funds based on the average annual return of the most recent three years.

graph1Source: Fundbase.com “Fundbase Free” index

With 65 percent of funds being unable to meet expected rates of return and managers still charging high fees, it’s no wonder investors are increasingly frustrated with this asset class. Some of the largest endowments and pension funds, like the New York City Employees’ Retirement System, are announcing intentions to scale back or exit hedge fund holdings. According to a Preqin survey report, 47 percent of investors issued a redemption request in 2016, citing underperformance as the leading reason. Investors are frantically trying to reallocate resources to optimal locations, but are doing so by stumbling in the dark.

The statistics prove the alternative investment industry is facing an alpha crisis.

Investors face the challenge of finding alpha while digging through the opaque and mysterious alternative landscape. Available fund data highlights consistent outperformance amongst smaller managers. Small managers benefit from less competition and more capacity to exploit market inefficiencies. In a 2014 study by City University London, research proved investors were better off with small managers in 17 out of the 20 years examined.

The City University London team also found that young and small are different. Just because a fund is small in terms of assets under management, doesn’t mean it’s positioned for success. Small managers with a long track record experienced marginalized performance over time compared to younger peers of similar size.

Fund managers around the globe are using technology to quickly source more opportunities. As the pace at which competitive edges are realized and exploited increase, its critical investors have rapid access to quality data to source and invest in quality managers at the right time.

By applying machine learning algorithms to a centralized data pool, it’s possible to quickly assess thousands of alternative funds including factors like French and Fama, return, correlations, regressions, and compare the results to various indices or a peer group of funds. With a sophisticated and intelligent process, it’s possible to find consistent alpha producing funds very few know about, aren’t in the news, and maybe keep a low profile on purpose. The following chart compares how technology can source the best funds among a universe of many. Fundbase Premium and Fundbase Free are proprietary indices maintained by Fundbase.com for investor use.

graph2Source: Fundbase.com

Technology makes it fast to create a focused list of funds to review based on given input, reducing time wasted chasing funds that don’t meet the most basic criteria. This isn’t replacing normal qualitative checks and due diligence, but helps speed up the preliminary process and get to that point.

Mainstream media outlets might be selling the story that hedge funds are experiencing an alpha crisis and the industry is dying, but that’s only a small sample size. With technology, there is now access to a larger and more diverse world of hedge funds and liquid alternatives. Investors will see, once again, the potential of active management and outperform the market with the power of technology.

Learn more about how the alternative investment landscape is evolving at fundbase.com.

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