This thought leadership piece addresses the challenges that institutional investors face in achieving above-benchmark returns. The paper discusses risk-managed dynamic beta programs as a solution for an investment landscape where true alpha is limited.
In the hunt for yield, mega-allocators rely heavily on alternative investments such as private equity, infra- structure, real estate, and hedge funds. A 2017 study published by the International Forum for Sovereign wealth funds found that these investors have poured $168 billion into alternatives since 2009, reaching a high in 2015 — a year in which a whopping $27 billion was allocated.3 Similarly, the recent movement of global pensions into alternative assets is extensively covered by the financial media. A widely-circu- lated 2020 Willis Towers Watson report indicated that, in the 22 major pension markets (the P22), the average fund increased its allocation to alternatives by 15.2% over the 2019 calendar year.4
Since this trend is likely to continue, capacity constraints and alpha decay in the alternative space are increasingly a focus, especially for the largest allocators. The compelling returns that a skillful, yet capacity-constrained manager could generate on a $250 million investment are negligible in the context of a $500 billion portfolio. On the other hand, when managers begin to accept large sums of money (a tempting proposition from a management fee perspective), returns often decline. This phenomenon5, long anecdotally observed, was corroborated by a 2008 study of over 8,000 funds by researchers at Pennsylvania State University and Rutgers Business School. Their research confirmed a negative relationship between fund size and the upper quantiles of alpha. To put the concern around capacity into simple terms: there is just not enough alpha in the world for mega-allocators.