2 and 20 – Alpha Capture Systems

Over the last month there have been a few articles on the 2 and 20 rule – I&PE and HFMWeek. Deutsche Bank’s comments in the I&PE article refer to the “right source of alpha”. So what is alpha? Well, Wikipedia offers:

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers’ performances. Often, the return of a benchmark is subtracted in order to consider relative performance, which yields Jensen’s alpha

Information Ratio (IR) is often found in the same context as alpha:

The information ratio is often used to gauge the skill of managers of mutual funds, hedge funds, etc. In this case, it measures the active return of the manager’s portfolio divided by the amount of risk that the manager takes relative to the benchmark.

Which leads to an interesting paper via JOIM, “Where do alphas come from?”, which then raises the question as to what you’d need to start a hedge fund. This luckily is partially answered by an article over on LifeontheBuySide: How to Start a Hedge Fund … and Buy that House with the Pool and the Pond. Key to a hedge fund, other than the strategy 🙂 , is the back office, and the need for a Prime Broker. JPMorgan and Goldman Sachs are two such player, but there are more – the usual suspects 🙂 This raises another question; should a hedge fund have more than one prime broker? Again a google offer some views, one of which dates from 2008, but is possibly still relevant, and concludes that a second broker will benefit:

  • Mitigation of risk: counterparty, financing, liquidity and operational
  • An additional source of alpha-generating trade ideas, capital introductions, etc.
  • Ensure optimal financing through competitive pricing of margin lending and stock loan
  • Gain access to competitive or innovative cross-margining policies of the competing prime broker
  • Leverage across the relative strengths of service providers in synthetic financing, swap trading or market access
  • Catalyst for reduced dependency on outside service providers, giving greater direct operational control

Interesting, the Merrill Lynch and RBS’s prime services literature (RBS dated June 2010 and hence newer) both talk about trade ideas – a topic that has been around for some considerable amount of time. RBS and ML specifically calls out the fact that smaller funds are interested in trade ideas:

A significant strategic benefit of using a prime broker is the ability the prime broker has to make available alpha-generating ideas and strategies

Which nicely brings us back to alpha, and leads us to TIM Ideas, which provides interesting reading, specifically:

Unlike traditional sell-side research recommendations, these actionable ideas are developed with the investment or trading strategies of specific clients in mind. They are supported by a commentary and additional parameters from the contributor, including direction (long or short; no ‘holds’), style (e.g. growth or pportunistic), conviction and time horizon, in order to facilitate analysis by buy-side recipients. All ideas are priced and time-stamped

More details are available here. What struck me most was the following sentence:

trade ideas have become a premier alpha generating tool for traditional long only investors, long-short equity hedge funds and quant funds

The nice thing about the “Six ways trade ideas are changing investor strategies” article is the bit of history around Marshall Wace:

The modern use of trade ideas started earlier this decade when the London-based Marshall Wace hedge fund complex began to track the performance of brokers’ ideas systematically. MW found that their ideas regularly outperformed the market, prompting the firm to develop a proprietary website for brokers to submit ideas. MW went on to establish a variety of trade idea-driven hedge funds, an investment approach that enabled it to become one of the best performing, largest commission-payers in Europe.

Nowadays, ideas are developed by more than 600 institutional brokerage firms and used by more than 200 asset managers. This includes most of the world’s largest buy and sell side firms around the world. Industry commissions from trade ideas exceed $500 million. The buy side is driving this growth as investors seek to capture the alpha that is being generated externally to their own research departments, to benchmark their internal analysts and benchmark their brokers, and to regain visibility on market sentiment that has become obscured by the fragmentation of market venues.

In closing, AdvancedTrading offer “Slicing the Alpha-Generation Pie


~ by mdavey on March 1, 2012.

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