One of the highlights of yesterday’s Bloomberg Markets 50 Summit (my notes here) was, without a doubt, the conversation between alternatives king Cliff Asness (AQR) and Lawrence M. Schloss, who is the Chief Investment Officer for the City of New York’s $145 billion pension portfolio.
Cliff Asness is a quantitative analyst and money manager, his firm AQR does everything from hedge fund-structure investing to ’40 Act mutual fund advisory. Not every strategy AQR employs will be the right one for a given environment and most are not expected to outperform a bull market in the S&P 500. Much of what quantitative firms seek to deliver are risk-adjusted returns, and, from that standpoint, the $70 billion AQR has clearly been successful.
When the conversation between Asness and Schloss turned to the cost of investing and whether or not alpha or risk-adjusted returns were really worth paying fees for, things got interesting.
Asness explained how, in this day and age, the classic hedge fund strategies that have always worked will continue to work – although with a more crowded field of practitioners they will probably be less profitable than they had been historically. He’s referring to styles like long/short equity, merger arb, convertible arb, etc. These types of strategies, he notes, probably are not deserving of the standard 2-and-20 anymore, given how easy they are to access and how common they’ve become.
But Asness believes that more sophisticated or proprietary strategies are still worth paying up for, noting that when you can find true, pure alpha (returns above a benchmark, uncorrelated with the market’s returns), it’s probably still a good bargain. That said, he believes that beta (raw market returns) has been creeping into the aggregate returns of the hedge fund complex for years now and actual alpha has become really scarce.
Lawrence Schloss weighed in on the cost of alpha with both a pro and con argument. His initial comment, was a rhetorical question: “If I can get beta for three bips [basis points], who cares about alpha? Why do I need it?”
This was followed up with a more conciliatory take, “Let’s be clear: Costs matter. But I only care about the net returns, only the net matters. if you give me seven [meaning 7 percent], why do I care if it was ten first before you paid yourself. You gave me seven!”
Cliff’s witty, devil’s advocate retort was “But what if it could’ve been eight?”
To which Lawrence deadpanned, “Then I negotiated a pretty bad deal for myself.”
I think the point is that the value of active management and alpha is still very much in the eye of the beholder. Schloss is running $145 billion and, with a portion of those funds, he’s thrilled to have non-correlated alpha being generated by managers like Cliff, so long as they are a part of a larger portfolio that is cost-conscious in the aggregate and even if they don’t keep up with the broader market in a rally.
It’s when you’re overpaying performance and incentive fees for disguised beta that the costs become harder to justify.