The Death of Alpha and its Impact on Wall Street

May 2013

Confidential

Market Environment/Trends

What happened to Alpha?

I.
The Internet provided the low-cost communications tool for companies to disseminate information to investors simultaneously. The traditional role of intermediary for the investment banks was greatly diminished if not moved to obsolescence companies to disclose material information to all investors at the same time. IBs and their analysts no longer could receive and disseminate selective information

II. Regulation Fair Disclosure enacted in August 2000, required all publicly traded
Why should institutions pay wall street if they cant make money?

III. Electronic Trading less obvious but equally onerous. Most trading is now done
electronically and when combined with the increased fragmentation of execution destinations and the lack of natural order flow (because there is no research call), has put the pricing pressure in the hands of the buy-side.

IV. IPOs: their number and their upside potential are virtually non-existent. The IPO
calendar, long a material alpha generator, has fallen to just 14% of the number between 1995-2000, and still only 26% of the more normal 1980-1994 period. Even when there are deals, the private equity firms are now the customer not the institutions. As a result, the IPO discount of 15%, has been largely eliminated and is being absorbed by the selling shareholders

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Market Environment/Trends

The State of Industry

Equity ADV down 20% in last 2 years you dont need to see another chart on this Equity Brokerage Revenues are down 40% Y/Y, in Q4 2012 40% fewer public companies than 10 years ago 60% fewer companies with analyst coverage 75% fewer IPOs than the period between 19801994 and 85% fewer than 1995-2000 Active investors, both institutional and retail, are not participating as they have in past as evidenced by the lack of mutual fund inflows save a recent inflow rally Major institutional and most hedge funds are consistently underperforming even HFT returns have fallen dramatically although still providing adequate ROIs 9 out of the last 10 years, hedge funds have underperformed the S&P 500 PE returns have not been much better On average 75% of all equity manager underperform the market
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Passive investing, anyone?

Market Environment/Trends

IPOs are gone and so is the commensurate Alpha

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CONFIDENTIAL

2012

Professional Managers Underperform

Fama and French: Luck versus Skill in the Cross Section of Mutual Fund Returns

For the period 1984 to 2006, when the CRSP database is relatively free of biases, mutual fund investors in aggregate get net returns that underperform CAPM, three-factor, and four-factor benchmarks by about the costs in expense ratios.

Nobel award studies support lack of alpha

Why stronger results for 1975 to 2002 versus 1984 to 2006? One story is that in olden times there were fewer funds and a larger percentage of managers with skill sufficient skill to cover costs. Over time the skilled managers lost their edge or went on to more lucrative pursuits (for example, hedgefunds). Journal of Economics, 2009

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Professional Managers Underperform

Subsequent Performance of Top 25% of US Equity Funds

- As of December 31, 2010
20012005 20062010

Top Quartile
284 Funds
81% of top 25% underperformed the market in the subsequent 5 year period

53 Funds (19%) 40 Funds (14%) 34 Funds (12%) 47 Funds (17%)

Top Quartile

Quartile 2

Quartile 2

Quartile 3

Quartile 3

Bottom Quartile
(1,135 total funds)
Funds Sorted by Performance Relative to Their Respective Benchmarks

Bottom Quartile
(1,219 total funds)

110 Funds (39%)

Did Not Survive

Source: Dimensional Funds and CRSP Survivor-Bias-Free US Mutual Fund Database.

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The Failure of Active Management:

Percentage of active public equity funds that failed to beat the index - Five Years as of December 2012

100% 90% 90%

83%
75% 74% 62% 76%

% of Active Funds That Failed to Outperform Benchmark

80% 70% 60% 50% 40% 30%

21% 20% 10% 0% US Large Cap US Mid Cap US Small Cap Global International International Small Emerging Markets

Equity Fund Category

Source: Standard & Poors Indices Versus Active Funds Scorecard, year -end 2012. Index used for comparison: US Large CapS&P 500 Index; US Mid CapS&P MidCap 400 Index; US Small CapS&P SmallCap 600 Index; Global FundsS&P Global 1200 Index; InternationalS&P 700 Index; International SmallS&P World ex. US SmallCap Index; Emerging MarketsS&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-BiasFree US Mutual Fund Database.

The Failure of Active Management:

income - Five Years as of December 2012

Percentage of active public fixed

100% 90%

94%

95% 90%

% of Active Funds That Failed to Outperform Benchmark

80% 70% 60% 50% 50% 59% 60%

76%

40%
40% 30% 20% 10% 0% Government Long Government Intermediate Government Short InvestmentGrade Long InvestmentGrade Intermediate InvestmentGrade Short National Muni CA Muni

Fixed Income Category

Source: Standard & Poors Indices Versus Active Funds Scorecard, year -end 2012. Index used for comparison: Government LongBarclays Capital US Long Government Index; Government Intermediate Barclays Capital US Intermediate Government Index; Government Short Barclays Capital US 1-3 Year Government Index; Investment Grade LongBarclays Capital US Long Government/Credit; Investment Grade IntermediateBarclays Capital US Intermediate Government/Credit; Investment Grade Short Barclays Capital US 1-3 Year Government/Credit; National MuniS&P National AMT-Free Municipal Bond Index; CA MuniS&P California AMT-Free Municipal Bond Index. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database. Barclays Capital data, formerly Lehman Brothers, provided by Barclays Bank PLC. 8

CP1810.2

Hedge Funds: Only thing Consistent is Under-performance

9 out of the last 10 years, hedge funds have underperformed the S&P 500 only meet/beat was 2008

No one can consistently be smarter than everyone else combined its illogical

True Professional investors knew Madoff was cheating

Paulson Advantage Plus Fund down 47% in 2011, and 19% in 2012 SAC no comment Galleon initially benefitted from rising tech markets he was fortunate then the only way to achieve alpha was through information no one else had

Getko, Tradebot and Renaissance use technology to find valuation correlations among markets to extract microstructure alpha

Firms who consistently post above average returns without technology are receiving information no one else has this is hard to do in the full disclosure world

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While Equity Mutual Funds Stagnate Despite Rise in Market

Equity Mutual Fund Market in $B: 2.2% CAGR

7,000

Without alpha, returns have lagged as has asset growth

6,000 5,000 4,000 3,000 2,000 1,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Nov-12 ETF Market in $Billions Equity Funds

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Market Environment/Trends

ETF Exhibit Consistent Asset Growth: The Passive Vehicle

ETF Market in $B: 22% CAGR
1,400 1,200 1,000 800 600 400

Regulation will soon accelerate this growth!

200 0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Nov-12

ETFs just received major Regulatory Catalyst - 408(b)(2) and 404(a)(5), went into effect late last year - will require all plan sponsors, fiduciaries, and trustees (normally all the same people) to gather and present all fee information and to accept fiduciary liability
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Conclusions

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Market Conclusions

Alpha is Dead Conclusions: Active is going Passive

Prior to 2002, many large mutual fund complexes and hedge funds exhibited market beating returns as investment banks and other data companies provided alpha Information advantage going to scale payers IPOs and their 15%-25% discounts to market padded returns

Now after a decade of underperformance, Mutual and Hedge Fund managers will continue to suffer Will experience significant asset erosion

Major traditional asset managers (wire houses) without alpha and with high fee models are also losing assets to
Passive Investing Models major beneficiaries including: ETFs Independent advisors, technology and service providers to this channel And Custodians like TD Ameritrade, Schwab and Fidelity will have a decade of market share gains

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Market Conclusions

Alpha is Dead: Is Wall Street Next?

Investment Banks must find ways to remain relevant/valuable Will lead them to an outsourced technology solution inhouse build is too risky and costly Even further employment attrition and consolidationthis is beginning to help those left standing Institutions continue to look for ways to bypass IBs for execution, research and even IPOs

The economy will eventually improve leading to rising markets Traditional brokerage models to greatly benefit from increased trading and higher interest rates but this will be a false positive

Investment banks and institutional asset managers face severe expense constraint and cut their internal technology build/spend in favor of outsourcing and Managed Services takes hold as optimal solution for cost and technology

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Market Environment/Trends

Alpha is Dead: Technology and New Models to Fill Void

Technology differentiates in new world order HFT, where alpha still exists lives on only real threat is regulatory

Dark Pools also have regulatory threat in equities fixed income will soon benefit from this model (though this will not be good for employment)
New Models likely to take large share of AUM in retail channel Can lead to consistent outsized gains

Major focus on planning, optimizing and lowering expense burden

Cloud Computing/Big Data will drive innovation and some alpha A form of Crowdsourcing or other evolving market models can displace PE and Wall Street complexes

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