Swedroe: All Those Factors Shrink Alpha

June 28, 2017

Examples Of Wider Access

For example, investors now have access to low-cost, structured funds that not only provide exposure to small-cap stocks and value stocks, but to the momentum factor as well. And there are also low-cost, structured funds that provide investors access to securities and strategies that were once considered the sole realm of hedge funds, such as commodities, the carry trade, shifting maturity bond strategies, low-beta stocks, low liquidity stocks, and merger and convertible bond arbitrage.

As an example of how a “hedge fund strategy” like merger arbitrage can be implemented in a passive—and therefore a relatively low-cost—manner, consider that merger arbitrage involves both offering a form of insurance against the deal not closing, as well as providing liquidity to shareholders who want to sell immediately. Arbitrageurs who buy the target company and sell short the acquiring company capture a systematic risk premium.

Another example that was once the domain of hedge funds is managed futures. Managed futures are basically momentum strategies that can be accessed with passive strategies. Equity-market-neutral strategies are another example of a hedge fund strategy that can be replicated by going long value stocks and short growth stocks, or long positive momentum stocks and short negative momentum stocks, and done in a relatively low-cost, passive manner.

'Cancer On Institutional Fund World'

The preceding examples are all strategies that have provided positive long-term returns while also exhibiting low correlation with more traditional stock and bond investments. And you no longer need to employ a hedge fund and pay 2/20 to incorporate any of these strategies into an investment plan. What’s more, you certainly don’t need to hire what David Swensen (Yale’s chief investment officer) called a cancer on the institutional fund world: a fund of hedge funds (and pay an additional 1/10).

Finally, it’s interesting to note that among the leaders of bringing lower-cost structured strategies to individual investors is hedge fund manager AQR Capital Management. (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Before closing, I’ll offer the following words of caution. Investment strategies often appear appealing on paper, but once implementation costs are considered, the real-world returns don’t look as good. This is especially true of those that have high turnover (such as momentum strategies).

Thus, it’s important to be sure that the fund manager you employ to implement the strategy has strong skills in terms of fund construction rules and in terms of controlling trading costs and operational risks.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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