Straight From The Source: Richard Kang

March 06, 2008 interviews Beta Brief blogger Richard Kang.

Richard C. Kang is the blogger behind The Beta Brief ( He has been active in both institutional and individual asset/risk management for over twelve years with extensive experience in multi-asset-class mandates as well as strategies applying the use of passive instruments. Recently, he spoke with assistant editor Heather Bell.

Index Universe (IU): What is The Beta Brief?

Richard Kang (Kang): The Beta Brief was meant to be sort of a transition for me in my career. I have no interest in being in the media or having a career in that space, but I exited a company in Canada focused on the use of ETFs more than anything else. Throughout my career in managing money, I've always been involved in the management of beta and beta instruments, whether it's derivatives or exchange-traded funds. I decided for basically all of 2007 to not manage money, but rather to comment on what I think is happening in the industry in terms of beta and the new products that are coming out. This, of course, comes from me as a practitioner and as such, I like to think about new ETFs from a portfolio construction point of view. What's the value of a water ETF, a nanotechnology ETF, or something even more esoteric-or even something that's very traditional and broad like the SPDRs or the QQQQs? What's its value now? Is its value just as much as when it first came out 10 years ago or not, especially when you see that there are so many competing instruments out there?

Now to be quite frank, at the beginning I really wanted to write a lot about derivatives, but when I wrote about derivatives I didn't get much action on the site. When I started to write about ETFs, suddenly The Wall Street Journal called me, so it's not that hard to understand why I put a lot of the emphasis there.

IU: Who do you consider your target audience?

Kang: I think it's whoever is interested in beta and derivatives and ETFs. The whole point of derivatives and especially ETFs is that they're tools that can be used by anyone for multiple purposes. The real advantage of an ETF is that it's the ultimate Swiss army knife. If I happen to like the corkscrew for opening up wine bottles, I'm sure I can find a dozen other people with the same pocket tool who find one particular feature that's most significant to them. So I'm not writing to any particular group. Sometimes I'll say well, this is now meant to be written for the financial advisors, like my post that was written as a follow-up to an event in Florida that was geared toward financial advisors [Inside ETFs conference]. If I write something about a new ETF for weather or something like that, I ask myself who will use it. If the answer is hedge funds, the post would really be aimed at hedge funds. So I might be specific, but I don't really care who's reading it because ETFs in general are meant for just about everybody.

IU: Is there a philosophy that underlies your approach to investment?

Kang: My background is not your traditional background in the industry. Maybe nine out of 10 people in the industry have a Bachelor of Commerce or MBA and probably studied for the CFA. They come at it from a point of view of, "It's not manager selection, it's stock selection," and an idea that, "I'm trying to beat the market because I have a great pedigree or I'm smarter than you." That's fine because that's the essence of active management, which clearly has its place in the world.

For me, I might think I'm smart, but I have to think about market efficiency. I'm not a 100% market efficiency guy and I'm not someone who believes in ETFs as the end-all, be-all for portfolios, or thinks that an individual should have a 100% ETF portfolio. What I do believe is that we're in the business of valuing risk, and thus we are basically allocating our money toward various kinds of risks.

When somebody says you should avoid hedge funds because they're more risky and you should get into bonds because they are less risky, I honestly think that's just plain wrong. If your retirement portfolio is all in your bank account or some kind of bond, somebody might say it's a low-risk portfolio. But the real risk is that you won't have enough money when you retire. Maybe you actually need emerging markets, because you're going to retire when you're 60 and you might die when you're 90. Well, one-third of your life, 30 years, that's a pretty long-term horizon. You might need some emerging markets because they're probably going to grow over the next 30 years, and somebody will say no, the emerging markets are high risk. To me the issue is not low risk versus high risk, but simply a transfer of risk. When you move from the emerging markets to your bank account, you're just transferring from the volatility of the equity market in the emerging space to some kind of credit risk, or inflation risk, or purchasing power risk, or the risk that you're just not going to have enough money during that retirement period. That's the essence of investing: understanding what the various risks are and reallocating or transferring from one kind of risk to another.

IU: Where does the line blur for you between alpha and beta? Because with ETFs, it seems like that line may be becoming more blurry.

Kang: I see a horizontal line, which I call the active-passive spectrum. At the extreme left, let's just call that beta, let's call that market risk, let's call that extremely cheap exposure to an investment, let's call it an ETF or a derivative. At the very other end, on the right side, let's call that alpha, let's call that absolute return, let's call that hedge funds, let's call that high fees, let's call that managed risk. So on the left is market risk, and on the right is manager risk.

Everyone has been talking in the past three or four or five years about the separation of alpha and beta, and you can see that on the left side in the growth of the ETF industry, and at the same time, on the right side in the growth of the hedge fund industry. Even though the mutual fund business is still very large, they're kind of losing their reason for being and their value, because people are saying I can build better portfolios with ETFs and hedge funds through this whole alpha-beta separation philosophy.

What interests me is that I think what's happening is actually alpha and beta convergence. If you look at the far left side, what's happening to the ETF space? They're not building any more SPYs at less than 10 basis points; they're now building niche-sector and thematic ETFs and exotic regional ETFs, with higher fees and less diversification. We're not talking 500 underlying stocks, we're talking about indices with maybe 60 underlying securities, and you're pushing inwards to the right-they're not just at the polar left anymore. ETFs are wanting to push in more toward the center and wanting to have higher fees. They're wanting to have higher margins and wanting to explore in the fringes of the capital markets.

At the other end on the right side, hedge funds in aggregate actually have a lot of beta in there. They don't like to advertise that because then they look like they're almost closet indexing like a mutual fund, but that's the reality. The hedge fund indices track very closely to equity indices. Hedge fund indices themselves are another example of the tendency to push inward. You're indexing something that's not supposed to be indexed.

And then you have hedge fund replication, which is basically legitimizing the fact that there is beta in hedge fund strategies and people are saying I can put together some combination of factors (alternative betas) and come pretty close to a hedge fund type of strategy-again, pushing inwards from the right side.

Wall Street is now attempting to plug in all the holes in between these two poles on that spectrum. That's what's happening right now.

So is it blurring the alpha-beta world? Yes, it is, but at least it's not outright insincerity. Maybe that's too harsh a word in terms of mutual funds, where they are saying, "We outperform the market and we do well. We pick good stocks, and we avoid bad stocks." They say stuff like that, but the reality is that they're not able to do it-not because they are deceptive but because the laws don't allow them to be fully diversified. Their constraints don't allow them to have more than a fixed percentage in a particular position. They don't allow them to short. There's a long list of restrictions imposed on mutual funds so at the end of the day there's no benefit for them to go too far beyond the index, and that's what closet indexing is. It's bad with mutual funds, but the fact that you see it in aggregated hedge funds-hedge fund indices and many fund of funds-is troubling.

IU: Are there any assets classes or areas that you think could use some more coverage by ETFs?

Kang: I think emerging markets have a long ways to go, and I think we're not as developed there in the ETF space because of the logistical constraints. ETFs require a certain amount of liquidity. ETFs are meant to be low-cost instruments, but once you get into emerging markets, costs are quite a bit different. In some cases, just the infrastructure in an emerging market doesn't allow for very fluid movement of capital, and it just makes it difficult.

Clearly active management is another area. And there are more strategy-based ideas that can come to fruition; for example, there's a lot of chatter about ProShares and their upcoming 130/30-related product.

So there are a lot of things on the fringes. I think that alternative energy and thematic funds will have a life all their own. You'd be surprised what people can think of when you have a wave like the ETF industry that is moving the way it is. I have a feeling that a lot of people are thinking this is one of those shots where, after a certain amount of time, it's too late and the party's over. Kind of like where the mutual fund industry was maybe 25 years ago. The amount of innovation that Wall Street has in its ability to think of something new to sell is actually quite amazing.

IU: Do you think actively managed ETFs will be a good thing for investors when they finally hit the market? Do you think they're going to successfully add value?

Kang: Here's the thing: If John Bogle is right and a lot of ETF investors are more and more involved in the active management of ETFs and really getting into high turnover and potentially tripping over themselves, then the problem of chasing returns in the mutual fund space, the sport of chasing active managers will transition over to the ETF space. It is sport; it's a competition where there will be winners or losers-there's no other way to characterize it.

If that happens, then I don't know who will be the winner-maybe the fund of funds who goes about selecting managers. In the U.S. you have something called a wrap, in which people package a bunch of mutual funds and they put them into models. That might be an area where somebody may be successful if they are actually good at picking managers. I'm not trying to have a negative stance on this, but once you do that, you add a new complexity to the ETF space and the concept of active risk management and everything that goes into the difficulties of actively managed products.

Once you get into active management and manager selection you add another significant potential for failure. Let me put it to you this way: If you're an investor and if your portfolio is completely dependent on picking ETFs, which are all index-based products, first you have to get the asset mix right. Then, for each component, you've got to pick the index.

For each one of those things, let's just say you have a 50/50 shot at outperformance. If the first one is a 0.5 chance and the second one is a 0.5 chance, and they're independent events, you already have just a 1 in 4 chance of success. Once you get into that asset class and then you add a manager selection, then you've got to figure that guy has a 50/50 chance of actually beating the index for whatever you determine to be success. That's 0.5 times 0.5 times 0.5, and now you're getting closer to 10% to 15% success.

Furthermore, the SPIVA [Standard & Poor's Versus Active] report cards that S&P used to provide often found that roughly 80% of managers underperformed their benchmark index. Sometimes it was 30%, sometimes it was 40%, but generally the number tends to be somewhere closer to 20% to 25% that can beat market. When you get down to numbers like that, it doesn't look good.

Certainly, I can understand the economics of actively managed ETFs, and I think that the concept of active management in an ETF structure makes sense under some conditions. I'll be interested to see how many new entrants, big and small, will enter the ETF space once actively managed ETFs become established.


IU: Do you think that hedge funds as a group deliver alpha?

Kang: I'd say that, in general, the answer is no, and if I had to give a one-word answer, it would probably be "no," but that is because your question asks about hedge funds "as a group." Despite this, I don't that is an absolute argument not to get into hedge funds. For those investors who don't have the adequate resources, I would probably say it's not wise for you to get into hedge funds, since it's not like picking ETFs or a mutual fund manager. For those with the appropriate resources, hedge funds are a worthy addition to an asset-class-based or beta-focused portfolio.

The problem is, taking a look at hedge fund indices, in general, during bull markets they track pretty closely to the index. During big down markets like 2000-2002, the performance is flat to slightly up, and thus it looks like a put option strategy was overlaid on there. So they do their job in major bear markets, but in general, like during the big climb from 2002-2007, during all those little blips, whether it was a subway bombing in London or even this past summer with mortgages, the hedge funds were going down in sync with the market.

I believe that the trick is to not invest too broadly into the hedge fund space, but really look for a set of unique and possibly small managers who have the ability to operate in certain capital markets that are very inefficient, like carbon trading or certain corners of the frontier markets or something of that nature. If you're looking at a hedge fund that's like a long-short U.S. equity fund, you'd have to wonder, with all the other CFAs, MBA, and Ph.D.s who are digging into the U.S. equity market, is it really possible to find that much inefficiency in it? It could be too difficult an environment to obtain alpha and justify the two-plus-20 fees. Or perhaps that's the point ... it is difficult to consistently find alpha in efficient markets, and that's why the fees are relatively high.

Anyway, when you start thinking about the fact that these smaller, more nimble managers have all kinds of risks because they're often less sustainable, being in an early stage of operation, it makes you wonder if these companies are more susceptible to failure. That's just the way business is in any industry. But those funds from large, well-established firms, like Goldman Sachs, that have successful track records, are closed to new investors. So either way, you're stuck. Interestingly, even for those large operations (whether they be open or closed to new investors), there's no guarantee of success as shown from Goldman Sach's Global Alpha program last year. Again, I'm not trying to be negative; I'm just saying it's a tough space and getting more competitive. A few investors, like Yale University, are successful at finding the right managers, but it requires a lot of unique resources.

IU: You talk about alternative energy on your site. Is it a sector that people should be looking at?

Kang: Yes, definitely. It's not a fad, obviously. There's real and justifiable concerns about what's happening to the planet.

The fact that there is a limited amount of oil out there is a concern. If you look at the Mideast countries, the oil producers, they're diversifying away from oil-many have recently invested in Wall Street investment banks. They're diversifying.

Some people call this commodity bull market a once-in-a-lifetime opportunity, and that's fine. But you have to think about the different scenarios-if oil goes up to $125, $150, or it goes down back to $50. If oil keeps going up, which it should, I believe, then there will be some reduction in demand, and consumers will try to wean themselves off of oil and get into alternative energy. But if the price of oil goes up, at the same time, alternative energy should also go up because its value increases as people realize that this is going to save their butt at the end of the day. And oil can't go up forever: At some point people are going to say, "Well I give up, that's it. I can't pay for that." And demand for oil is gone because it's just too expensive, driving prices down.

In that scenario, I think that alternative energy should keep going up because enough consumers have bought into it and enough people are putting solar panels on their roof and doing that kind of thing. To me, alternative energy is a participation in the ongoing energy bull market, but it should also be a hedge when oil goes down.

IU: Finally, is there anything that you think investors should take away from 2007?

Kang: Bull markets don't last forever. Risk is something that you didn't expect. You didn't expect that your money market holdings were going to do what it did-probably because someone called it a "risk-free asset." You can measure risk, but risk measurement and risk management are two totally different things. And perhaps the more that you measure your risk, the more you might actually have a false sense of security-and that in itself is one of the real risks that you have to manage. If you get that right, then you might actually might not just survive, but do well in the sideways or downwards market that we're in right now.

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