If Beta Flags, Try Alpha - 06/12/01

Are the markets uncomfortably high? A lot of institutional investors fear so. After an excited start to the year the main US indices have slipped back to more or less where they started. The same applies to London's FTSE 100.

The conditions could be right, therefore, for long-short strategies to make progress. They have already made a moderate impact in the US - if more on endowments than pension plans - and now there is news of the award of a mandate in the UK. Caparo, the Midlands metals group, has appointed State Street Global Advisors to run a market-neutral strategy.

This is a modest contract in scale, a 10 per cent allocation from a fund worth under 200m ($330m). But the much bigger Zeneca fund is said to be considering an allocation to a comparable non-traditional strategy.

Quite a few UK pension plans are on the lookout for something different. This is partly because many of them have become disillusioned with the performances of the dominant traditional managers. And they are not persuaded that simply switching to another balanced manager will solve the problem of disappointed expectations.

More fundamentally though, there are doubts about future market returns. True, it has been tremendously profitable to be "long only" when over the past 10 years average annual returns have ranged from 19 percent on US equities and 15 percent on UK equities to about 12 percent on UK bonds.

Pension funds have had no difficulty in achieving their target return of about 6 percent real.

From this point in time, however, future returns look more problematical. Real returns on long gilts are only about 2 per cent.

On the formula of dividend yield plus trend economic growth, the prospective real return on UK equities is 4 ½ -5 per cent against the achieved 8 percent over the past 80 years.

Conceivably, the good times could roll on for another year or two. But more funds are ready to look at alternative strategies for the long run.

Long-short strategies are not always completely symmetrical, because they are often net long, but a market-neutral formula has been chosen by Caparo.

In the jargon, the approach accumulates alpha, or stock specific returns, and excludes beta, the market return, which arguably can be more economically captured by index-tracking funds.

Moreover, by running short as well as long positions, the manager can double up the alpha for the same money. This is wonderful - so long, of course, as the alpha is positive. If it is negative the losses will mount.

State Street is running the strategy in the US stock market (though it is working on a UK version). The aim is to beat the US Treasury bill return by 5-7 percent a year. Comparable US hedge fund managers have achieved an average return of 14 percent during recent years.

Plainly many other approaches - including index-tracking - have achieved much more, but this is an absolute return strategy designed for hard times.

Will such strategies catch on? Leading UK investment consultants like Watson Wyatt recommend that pension schemes should diversify part of their funds into alternative investment styles, including specialist niche products.

Whether UK trustees can take on board the full mumbo-jumbo of "portable alpha" and "absolute return" is another matter.

Using familiar relative performance measures, trustees have been able to gain the comfort of the herd. Absolute returns are designed to be steady; however, they will be very volatile in relative terms, both against the market indices and the peer group.

Very sophisticated monitoring will be required and not just the simple top quartile-type approach.

If only the stock market would continue to return 15-20 percent a year indefinitely. That would make life a lot simpler.          _x000D_