What do the Cable Television and Hedge Fund Industries Have in Common?

February 28, 2017  | by David Scarozza

Asset Allocation | Hedge Funds | Investment Strategy | Risk Management

These industries may seem an odd pairing, but both are in the midst of a disruption-led, industry-wide rationalization process. The two industries share in common a historically evolved “bundling” price structure, heavily favoring the sellers, that is breaking down due to the recent proliferation of distribution alternatives. This is giving consumers the option to be far more choosey about the prices they are willing to pay for varying levels of content.

Bundling

Bundling is a pricing technique that allows sellers to group together different combinations of products for customers who, often happily, purchase the pre-arranged package in exchange for the convenience of one-stop shopping. It can be a win-win situation for both producer and consumer.

Bundling works less well when the package in total, relative to the sum of its parts, is perceived to be too expensive or when consumers no longer believe they are getting a fair proportion of what might be perceived as the “good stuff”. Greater transparency into component costs and consumers' increasing options for a la carte purchases of both television entertainment and investment product is putting pressure on industry pricing standards, and particular pressure on providers whose value propositions are not so easily differentiated.

Cutting the Cord

It's not news that “cable cord cutters” are growing in number each year as other means for viewing programming cable companies used to distribute exclusively is now available through myriad alternative providers – Netflix, Hulu, HBO Go, etc. Why pay $200 a month for a premium cable package when you really only want to watch HBO, which you can now buy as a standalone for $15 a month? Every cable customer understands the implications of bundling, and, indeed, many have begun to de-bundle, as they isolate and pay for only the programming they really want.

Sketch

Somewhat less obvious, standard hedge fund pricing also resembles a “bundled” structure. In the case of hedge funds, it is various betas, or readily accessible risk factors, that are being sold in combination with varying amounts of “alpha”, or truly differentiated return streams. The betas, which are prevalent, on their own would be priced relatively inexpensively; the alphas, scarce and sought after, should command higher prices. An ever-growing array of ETF's and factor replication products, combined with increasing sophistication levels of hedge fund consumers, has resulted in many now refusing to pay hefty fees for beta and factor exposures they might access at far cheaper cost.

The difference between hedge fund providers who are producing mostly alphas versus betas is perhaps less transparent to the casual observer than the difference between really compelling television programming and mediocre production, but it is discernible with the right analysis. At Commonfund, we have the quantitative tools to decompose any managers' returns, hedge fund or otherwise, into their underlying risk factors and are thus keenly aware of whether a particular manager is truly delivering legitimate, uncorrelated alpha or simply repackaged beta. We are willing to pay up for the alpha; we are incredibly frugal when it comes to paying for beta.

Running the Numbers

To illustrate the point, we ran a quick diagnostic on the 1,489 Equity Hedge, Macro, Relative Value and Event Driven funds in the HFRI database that have more than $100 million in AUM and a track record of 5 years or more. On average, these funds are charging a 1.05% management fee and 16% incentive fees. The chart below shows the results of “fitting” these managers' returns to a single risk factor – namely, the equity market – and then to a group of off-the-shelf risk factors that any institutional investor might purchase more economically. For 200 managers in the sample, the equity market alone explains about 50% of the managers' returns. For 550 managers in the sample, a combination of readily accessible risk factors describes a similar 50%. As you move from left to right in this chart, the proportion of (desired) alpha to (commoditized) beta grows. Unsurprisingly, we focus our research on the right tail of these managers.

img-CH1-Cable-Hedge

Content is King

Hit shows and the companies that produce them will continue to be rewarded for the discernible value they produce. In fact, just last year, DreamWorks Animation, Miramax and Legendary Entertainment were all acquired at significant premiums in an industry consolidation rewarding content creators. Similarly, hedge funds who are able to generate compelling content, which we might call “alpha”, will be able to continue to demand premium pricing, and investors will be willing to pay up for this content. The future will be less rosy, however, for hedge funds, or traditional long only managers for that matter, who are unable to produce truly value-added return streams.

Implications for Hedge Fund Investing

When you view the hedge fund universe through our lens – one that demands true alpha production – and are disciplined about not overpaying for beta, much of the investable hedge fund universe falls away. Equally and opposite, our lens helps to shine bright lights on producers of highly compelling and differentiated return streams.

So back to the title question of this blog – what do the cable television and hedge fund industries have in common? Perhaps most importantly, there continues to be premium content creation coming out of both. However, the savvy consumer might be better economically served by demanding a bit of “de-bundling” as he/she seeks to isolate the premium content they desire.

Hedge funds in general have had a very tough run of it in the press and in investor perception for a number of years. Indeed, some of this criticism is justified. Equally important, however, in our quest to build the most diversified and potentially value-added portfolios, is the recognition that there are extremely valuable producers of alpha streams, or premium content, scattered about the hedge fund industry. We are working very hard to find them.

Authors

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David Scarozza is a member of the Investment team and is responsible for constructing portfolios that have the objective of outperforming passive equity alternatives. David is also primarily responsible for Commmonfund’s hedge fund portfolio which is used as a diversifying active risk and alpha source within equity portfolios and in the context of a total portfolio. Prior to this role, David was a Managing Director on the hedge fund team and prior to joining Commonfund, he served as a Vice President and the senior manager analyst on Citigroup′s fund of funds team. David received a B.A. in Economics from Swarthmore College, completed a one-year program of study at the London School of Economics and received an M.B.A. from Columbia University.
David Scarozza
Managing Director, Head of Equities

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Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.

Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.