With structured products, why even bother with alpha?

Hi everyone,

This may come across as a common sense question to some. But I'm a little stumped.

Few days ago, one of the top IBs came to my fund and advertised structure products in the form of tradable indices that meant to mimic a particular strategy. I took a broucher and saw a wealth of them.

FX carry, bond volatility, seasonal commodity trend. Some of them even advertised 5% annual returns.

Why doesn't a HF manager just diversify his assets among these indices. Why even bother hiring investment and research staff who could take a whole year conceiving a strategy that is essentially almost the same as one of these indicies, which was conceived by top IBs analysts and which he could invest right now.

Start a HF, diversify assets on ten indices, go for vacation, sound like a plan to me? Am I missing something?

Cheers,
Nijikon

Comments (9)

 
5/12/17

It's just another instrument to sell, it's all about sales base. Most men on wall st can't find Alpha so they all mostly push beta weighted instruments to collect a commission. It's the culture, even a low-cost index fund will outperform most hedgies because of the fee structures that don't promote getting alpha but rather repackaging beta and selling it. I will get attacked for this but a part of getting to alpha is finding what's true and what to do about it.

Learn More

814 questions across 165 hedge funds. 10+ Sample Pitches (Short and Long) with Template Files. The WSO Hedge Fund Interview Prep Course has everything you'll ever need to land the most coveted jobs on the buyside. Learn more.

 
5/12/17

Hi Franco,

I also kindda thought about it. As IB sales, is the real truth is that you wouldn't care for a product as much as a HF manager who has a real monetary stake in it. It's goes back to how good something is only goes so far as how willing you are to stake real money.

But then I was thinking in today's climate. You would say, a 5% returns is acceptable in today's HF world. It seems diversify among these assets, collect management fee, and kick back is a plan.

Then you have the other HF guys who REALLY think they can score a home run and screw these beta products and aim for that 20% returns.

Also, you mentioned such strats / tradable indices / structured products as weighted beta. I agree for FX carry. Something called commodity momentum sounds quite alpha to me, i.e., taking a direction view.

Cheers.

 
5/12/17

In a market crash, beta products will likely perform poorly. By definition, only alpha can provide a unique, completely uncorrelated source of returns. For example, carry trades (most commonly with yen) had big losses in 2008 and other similar periods of market stress. As such, diversification will be of limited value as it is highly likely that many if not all of these exotic beta strategies will face large drawdowns in a time of financial stress. Some of the stuff like commodity seasonality seems less like beta and more like a very simple systematic commodities strategy that is intended to produce alpha (now whether it will do that once it becomes well known is another matter, but it is intended to exploit a perceived anomaly not harvest a risk premium).

 
5/13/17

Well, I'd advise you to take a look at risk-premia investing. That's really a trending topic in Asset-management since 3/4 years now, and it consist in allocating your portfolio to low-cost tradable indices.

When comparing it to HF strategies, some reproach come to mind:

  • The alphas from such premium are likely to disappear once massive investment is flowing to these risk-premia strategies.
  • Is that real alpha or just some beta investing?
  • How are these strategies built? Is that a market anomaly risk-premium, is that a trading-desk structuring risk-premium?
  • Are you investing on sustainably long-term alpha or just some Sales bullshit based on an optimized backtest on the index?
  • Can you manage the risk of the underlying indices you are invested in, or are you totally blind?
 
5/13/17

You've answered your own question...

These "indices" are not really strategies or trades, but rather just a repackaging of the basic "building blocks" in a slightly different way. At some point, you could possibly argue that they offered some edge, even after costs. Today, such an argument would be difficult, because the devil is all in the details.

All that said, for a real money client they may offer value, since they provide a little more sophistication to a manager whose costs are low, relatively cheaply.

If you think that this sort of approach would allow you to collect your 2 and 20, however, you may want to think again.

 
5/13/17
 
5/15/17

Woah, thank you. You have given me a wealth of knowledge that I may not have learnt elsewhere. Just hope to wrap up this discussion with a few more prompts. Okay if not answered but just putting it out there.

<span itemprop=name>macrostudent</span>:

In a market crash, beta products will likely perform poorly. By definition, only alpha can provide a unique, completely uncorrelated source of returns. For example, carry trades (most commonly with yen) had big losses in 2008 and other similar periods of market stress.

I'm still not seeing why some of these strategies at not unequivocally alpha. There were FX carry and FX momentum. Sure, FX carry is beta. But at least 30% of the indices seemed to be clearly alpha, and a HF manager could just invest in those. Unless, I'm misinformed, momentum is taking a view and is alpha. Unless you're telling me that this FX momentum strategy is highly hedged in some why to make it low risk. Then again, they still carry 5% returns with decent Sharpe.

<span itemprop=name>RomaneeConti</span>:

Well, I'd advise you to take a look at risk-premia investing. That's really a trending topic in Asset-management since 3/4 years now, and it consist in allocating your portfolio to low-cost tradable indices.

When comparing it to HF strategies, some reproach come to mind:

  • The alphas from such premium are likely to disappear once massive investment is flowing to these risk-premia strategies.
  • Is that real alpha or just some beta investing?
  • How are these strategies built? Is that a market anomaly risk-premium, is that a trading-desk structuring risk-premium?
  • Are you investing on sustainably long-term alpha or just some Sales bullshit based on an optimized backtest on the index?
  • Can you manage the risk of the underlying indices you are invested in, or are you totally blind?

Yes, the word risk-premia was thrown around in the meeting and I'm still not entirely familiar on the term. All I know is risk-premia around index futures where a large drop, due to its asymmetric volatility nature, means investors need to be compensated more.

Totally agree with your points. 1. massive investments flow could erode the supposed alpha. 2. marketing could show a nice backtest, though they did well in arguing out-of-sample performance. 3. I immediately see the disadvantage if capital is locked up for 6 months. I didn't know definitively how liquid these indices are and took it for granted you can get in and out of the position at will, as you would a liquid product.

Oh yeah, good one with Jim Simmons.

<span itemprop=name>Martinghoul</span>:

You've answered your own question...

These "indices" are not really strategies or trades, but rather just a repackaging of the basic "building blocks" in a slightly different way. At some point, you could possibly argue that they offered some edge, even after costs.

I agree that the client wouldn't fully know the intricacies of the strategy. Indeed, HFs pay research staff to run the gamut of a more involved investment process and not use two technical indicators as signals. However, what stumped me was the performance they're advertising. Admittedly I didn't ask whether they were backtest or live. But coming from a large BB with PhDs on the cover, I guessed they HAD to be doing something right.

 
5/16/17

Even regarding performance, the devil is going to be in the details... Just pls believe me when I say that this ain't a free lunch. Heck, it ain't even a cheap lunch, unless you're an RM manager who doesn't have the will and the wherewithal to do such things properly.

 
5/16/17

1-Click to Unlock All Comments - 100% FREE

Why do I need to be signed in?
WSO is a knowledge-sharing community that depends on everyone being able to pitch in when they know something.
+ Bonus: 6 Free Financial Modeling Lessons with 1-Click Signup ($199 value)