Pursuing alpha

Despite remaining unchanged since classical times, it seems the first two letters of the Greek alphabet are being reversed these days. At least that's what some leading international dealers are saying.

They reckon that certain popular structures such as constant maturity swap steepeners and range accruals, which were previously sold as yield-enhancing structures, are now so common that they represent market convention. That means they are no longer the alpha-generators of choice.

Today, they represent the market benchmark, effectively beta, dealers say. That's a strange concept given that each structure is different in terms of maturity, benchmark curve, leverage and so on.

Nevertheless, large dealers believe the new source of alpha comes from proprietary trading models, which are rules-based, established as indexes and sold to clients as structured products. By offering this new breed of so-called alpha-generating fixed-income products, dealers have apparently put themselves on a collision course with their hedge funds clients from which they make significant sums of money as trading counterparts, and to a lesser extent by acting as their prime brokers.

The argument goes that if a major bank can roll out proprietary trading models to its clients in a transparent manner, why would a customer pay the typical 2% asset-linked, 20% performance fees required by a black box hedge fund that, after all, could well be deploying exactly the same trading strategy? Sure, top hedge fund managers will probably outperform an algorithmic trading strategy, but there are hundreds of hedge funds that won't.

There is a loose analogy here with the early development of constant proportion debt obligations (CPDOs), which automatically had to roll their positions despite the market conditions not necessarily being optimal to do so. Now, the same dealers that are touting managed CPDOs as a solution to that problem - they say a skilled manager can optimise the market timing of the roll - are nonetheless offering systematic index trades that may or may not suffer as they revolve into the next period of the contract.

- Christopher Jeffery.