Synthetic Hedge Funds?

By: Alpha Male

Chris Woods of State Street Global Advisors makes a common argument against hedge funds in an article published on May 3, 2006 – that their returns are driven more by “exotic” or “alternative” beta than they are by alpha.  Ergo, an investor could acheive the same returns more cheaply by investing in a passive basket of various risk factors rather than with a hedge fund manager.


“Much of the time it seems that hedge fund managers are not giving the investor pure undiluted alpha, but rather delivering what have become known as alternative betas.

“Alternative beta refers to the risk premium earned by isolating asset characteristics that are rewarded. Examples of alternative betas include the Fama-French equity risk factors small-cap minus large-cap, and high-value minus low-value.”

“We envisage that the delivery of low-cost hedge fund beta will be attractive to those clients who are wary of the intricacies of self-service manager selection and of the costs of investing through funds-of-funds.”

Steve Forester, winner of AIMA Canada’s 2006 Research Award makes a similar argument in a paper to be published in an upcoming edition of Canadian Investment Review (and re-published at

But I question the premise of the cottage industry that has developed around calling into question the hedge fund model.  Let’s take a simple example:  You hand over $100 to a professional money manager and give her a mandate to invest in US equities.  You give her no direction beyond that since you are not an expert investor.  She likes the potential of the technology industry and decides to invest all of your money in technology stocks….

Turns out that technology hits the lights out over the next 3 years and your $100 has doubled.  During this time, the S&P500 has appreciated by 40%.  Is the 100% of return of your portfolio alpha or is it beta?  One might argue that your manager simply rode the Nasdaq up to great heights over that period and that the return is just “tech beta”.  They might say it could easily have been replicated – far more cheaply – by simply buying QQQQ’s.

But I beleive the answer isn’t so simple.  To answer it, you need to go back to your original mandate and define an appropriate benchmark.  You told your manager to invest in US equities and gave her no further directions.  So the appropriate benchmark would be the S&P500.  Without being directed by you, your manager then decided to invest in technology stocks.  Thus, the additional returns (or, as it might have been, underperfomance) are alpha, not beta – even though it could have been easily replicated with an ETF.

On the other hand, if you have specifically directed your manager to invest in technology stocks, the same return would have been beta.  So alpha , like beauty, is in the eyes of the beholder.  All alpha is relative and there is no such thing as “absolute alpha”.  Even the last bit of return that cannot be explained away by factor regressions may just be undiscovered exotic beta just waiting to be replicated by some systematic strategy.

To the manager who identified an esoteric trading strategy such as long Indian corporates and short nickel futures, I say “Kudos to you for finding this anomaly!”  After all, isn’t this what the hedge fund industry is all about: finding and exploiting structural anomalies in capital markets?  There is no way your investors directed you to invest this way.  Therefore, your returns are alpha.  Saying that these returns could have been replicated using some passive strategy or ETF ex post facto, doesn’t cut the mustard.

Besides, this esoteric strategy might only work this year.  It may never work again.  Therefore the manager’s timing ability is the source of returns (again: alpha, not beta).

What makes riding the equity market (as many equity mutual funds do) a worse offense than riding an exotic beta is that the market has been academically proven to go up in the long run.  Exotic betas, like alpha, are either a) a zero-sum game or b) rely on non-economic players to support the other side of consistently profitable trades.

An extreme example of this “gotcha” academics might unfold as follows:  Imagine if your US equity manager had invested in only one stock, Microsoft, and Microsoft appreciated 50% last year.  Would someone accuse your manager of simply riding the “exotic beta” of Microsoft’s own return?  Would they charge that your peformance could easily have been achieve – far more cheaply – by simply buying Microsoft yourself?  Where do we draw the line?

Drawing this line is really about attributing your profits to two parties: you, and your manager.  Your manager’s value-added is defined by the alpha while your value-added is the beta (in this case, US equity beta).  Most mutual fund managers will shune such calculus for obvious reasons.

– Alpha Male

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