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Investing, Philadelphia Style
Land ownership once was the only practical form of savings, until banking matured in the mid-19th century. Philadelphia took an early lead in what is now called investment and still defines a certain style of it.
Nothing is more irritating than jargon among professionals, because outsiders often suspect it is a method of insiders talking in code to exclude outsiders. Nevertheless, "alpha" a letter in the Greek alphabet, is used by investment geeks to refer to an investment return which is greater than the return offered by an index fund, usually S&P 500. By implication, it reflects the skill of a particular investment manager, who is thus in a position to make larger profits for his clients than the client could derive from buying the index fund and forgetting about it. Alpha is the fund manager's answer to the threat of index funds, which produce more profit than most non-professional investors do on their own, and even more than most fund managers actually net when you consider their fees. A good investment manager is thus someone who can demonstrate lots of alpha.
A hedge fund manager is just an ordinary fund manager with three exceptions, often reduced to a jargon of 2-20-5. The client agrees to pay 2% of the investment as a fee, which is pretty high and often used in part as a referral fee. Four-tenths of a percent is the more customary annual fee for hand-holding, while 2% is twenty times as much as some index funds charge annually. That's the 2 of 2-20-5. The second number of 2-20-5 refers to 20% of alpha, the premium produced by active management. You may feel reassured that if there is no alpha generated, there is no 20% fee. And the final 5 of 2-20-5 is a five-year lockup, which means you can't get out of the contract for five years, apparently compensating the high-alpha manager while he undertakes long-term illiquid investments on your behalf. Little or no information is usually provided as to the fund contents, thus preventing other managers from profiting from his research by simply imitating his portfolio.
It is now time to examine alpha. One ingredient of it is available in the daily newspapers, or Internet, everywhere. It is the daily report of the Standard and Poor's Index of the prices of five hundred biggest and best stocks. The "S&P 500". As it turns out, anyone could beat the daily S&P by comparing it with the same data, reported quarterly. Quarterly averages are always higher than daily running averages, as the result of a statistical fluke. You can get the general idea from observing that if a stock goes from 10 to 5, it is going down 50%. On the other hand, if it goes from 5 back to 10, it is going up 50%. Therefore, if it goes from 10 to 5 and then back to 10 it hasn't changed at all, but its average fluctuation in the example has gone down 50%. As a result of this optical illusion, it is possible to generate "alpha" differences in favor of quarterly data, compared with the average daily changes of exactly the same list of stocks. And therefore it is tempting to charge 20% of that illusory alpha as a fee for being so smart. Comparing the S&P with the value of illiquid investments like Canadian forest land introduces other complexities, but the same upward bias of infrequent alpha reporting can be present in any down market.
Originally published: Tuesday, August 28, 2012; most-recently modified: Thursday, May 23, 2019