New approach gets hedge fund returns with traditional risk

CAPM / Alpha Theory 11 Oct 2006

By: Barry Burr, Pensions & Investments
Published: June 12, 2006

“What’s in a name? that which we call a rose
By any other name would smell as sweet;”

Quick: which Shakespearian soliloquy contained this famous line?  Time’s up.  It was Juliet in Romeo & Juliet.  She had just learned that Romeo was a Montague – the enemies of Juliet’s family.  Here’s what she said next:

“…Romeo, doff thy name;
And for that name, which is no part of thee,
Take all myself.”

Hedge funds are sometimes viewed by skeptical pension funds as potential enemies.  If only hedge funds could “doff thy name”, then pensions might actually want them to “take” them too.

Thanks to sophisticated marketing efforts, the money management industry has managed to do just that.  This article is about the “120/20” and “130/30” investing strategies pursued by pension funds that apparently don’t feel comfortable investing in (evil?) “hedge funds”.  A “120/20” portfolio is simply long 120% and short 20% (leading to a net market exposure of 100%). The approach is being touted as “new”, “offering hedge fund-like returns”, and with “the risk level of a traditional portfolio”.

But these strategies look a lot like long-bias long/short equity hedge funds to us.  Sure, net exposure remains at 100%, but gross exposure rises from 100% to 140% or 160%.  Does 100% net exposure mean the funds have “the risk level of a traditional portfolio”?  The same (dollar-weighted) market exposure perhaps.  But cranking up gross exposure to 160% and introducing short-selling, a whole new set of risk management issues arises.

When explaining these products to P&I, their proponents seem simply to espouse the virtues of good old fashioned long/short hedge funds without actually using that term:

“Short selling ‘can enhance performance by permitting meaningful underweight positions that are simply not achievable in long-only portfolios,’ the Jacobs Levy paper (a research report) notes.”

Hmmmm.  Sounds familiar.

Proponents of “1X0/X0” strategies point to the fact they are not pure alpha, but a package- deal including alpha and beta:

“The 120/20 strategy is more optimal than long-short, Mr. (Bruce) Jacobs (of Jacobs Levy Investment Counsel) said. The 120/20 ‘bundles beta and alpha together by providing beta exposure and enhancing returns with underweighting…'”

We have gone to great lengths on this blog to illustrate why we believe a “bundled” alpha/beta solution is sub-optimal.  Sophisticated institutions ought to buy their beta on the cheap and worry about alpha separately.

But don’t call us a hedge fund!

Scott Bondurant, Executive Director of UBS Asset Management’s long/short products tells P&I:

We don’t view ourselves as a hedge fund but an equity substitute…

Little wonder nearly all new converts to this approach are formerly long-only investors.  It seems they get spooked by hedge fund stories like Amaranth, but secretly realize that focusing on alpha-generation makes a ton of sense.

At the end of the day, we are pleased that high-alpha-content strategies are being adopted, even if we have to make up new names for them.  Let’s just hope this story ends better than Shakespeare’s masterpiece.

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