Forget Where's The Beef? Where Is The Alpha?!

What is "attribution analysis," and why do lawyers need to know about it?

Alpha return on investment Greek letterFor investors looking at any type of actively managed investment these days, only one thing really matters – alpha. Alpha is the return earned by an investor over and above what one would expect to earn taking on extra risk. Absolute returns rarely matter to smart investors – after all, returns are really just a function of risk, so if you increase risk enough, returns will be higher over a long period. Instead, the true measure of investment success is earning significant returns without taking on “too much” risk.

Determining the level of alpha for a manager requires assessing the risk that the manager is taking on, and then comparing that manager’s returns against a benchmark. This process is called attribution analysis, and it is a critical though underappreciated aspect of the investment business. For attorneys, attribution analysis is important for two reasons:

  • Attorneys need to be able to help clients with investment due diligence, which requires understanding attribution analysis
  • Attribution analysis in litigation finance is an area of the space that is still embryonic, which is one reason holding back litigation finance – if we can’t measure risk adjusted returns effectively, how do we know if we should allocate more funds to the asset class?

The gold standard in attribution analysis for equity funds and hedge funds is what’s called a four-factor model. This entails using regression analysis to isolate the risk exposures that drive returns for the fund. After isolating the returns that one would expect given the level of risk exposure in each factor category, the remaining return is the alpha for the fund. This model is so important that is was the basis for the 2013 Nobel Prize in Economics. In my capacity as a financial economist, I advise a number of reputable hedge funds and asset managers, and the best ones all rely heavily on four-factor models.

Attorneys helping clients in the investment arena should strongly advise using a four-factor model. Among other things, a historical four-factor model can be a significant help in assuaging SEC concerns about the appropriateness of back-tested portfolio results.

The four-factor model is applicable to equities, but applying it to litigation finance requires a deep understanding of the model. Unfortunately, even simple attribution analysis is often lacking in litigation finance. This brings up an important issue – how is an investor supposed to know if superior returns by Fund A in a given year are due to superior skill or simply greater risk than Fund B?

Litigation finance funds will often report basic statistics like the number of cases they are investing in, the mean investment in each case, the duration of cases, etc., but none of that truly isolates risk.

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Litigation finance funds need to start by identifying a relevant benchmark that has a similar level of risk to their fund. This helps investors to assess performance of the fund and demonstrate the value the fund managers are providing. There are many benchmarks that could be used – for example, an investor might face a choice between investing in publicly traded litigation finance company stock or investing in a private fund. A basket of such publicly traded litigation finance stocks presents an attractive benchmark.

Further, at a minimum, funds should be presenting correlation statistics showing how their returns are correlated against broader stock and bond markets. This is imperative for assessing portfolio diversification benefits. A still better approach would be for funds to decompose their returns into buckets related to the performance of the litigation fund market as whole and returns related to fund manager skill and selection ability.

I spend a lot of time talking to major institutional investors and thinking about the trajectory of various asset classes. I think litigation finance is one of the most exciting right now, but for the asset class to really grow into its potential, a lot more precision is needed in the reporting of risk-adjusted returns. Major investors will demand it. And the first billionaire litigation finance fund manager will probably be the one that cracks the code on attracting interest from major institutional investors.


Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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