By: The Economist
Published: October 28, 2006
Maybe Alpha Male wasn’t the only one paying particularly close attention to David Hsieh’s recent opining about “hedge fund beta”. This week’s Economist cited his research in a story about the rising interest in “cloning” hedge funds using cheap, liquid instruments.
“The result could be a cheap competitor for the hedge-fund titans, akin to the index-tracking funds that have eaten into the market shares of active fund managers.”
Several studies have recently concluded that a portion of hedge fund returns, taken together, can be explained by a series other “risk factors” (e.g. equity markets, spreads etc.). But we believe this dialogue is missing a key point: hedge funds are not an asset class.
These studies treat hedge funds as if they were a distinct asset class such as equities, real estate or precious metals. But hedge funds are simply a way of investing in an asset class, not an asset class themselves. For example, if your mutual fund manager invested in 50 large cap US stocks, you would say she was investing in “equities”. But if she then shorted the S&P500 against this portfolio to neutralize the effect of the market on her portfolio, would you say she had switched asset classes from equities to (long/short) hedge funds?
These studies seek to identify whether the “asset class” called hedge funds (i.e. all hedge funds put together) produces returns that are consistently better than the market on a risk adjusted basis. If the studies were to suggest that there was indeed “alpha” in the hedge fund asset class, then one could correctly conclude that a monkey throwing darts at a hedge fund database would produce consistently superior results. Of course, that would be wonderful. (especially for the monkey).
And this may in fact be the case right now. Most of these studies conclude that a large portion of returns – but still only a portion – can be explained by easy-to-replicate risk factors. Hedge funds taken in aggregate seem to produce more than their fair share of returns.
But before you rush out and buy a monkey, consider this: David Hsieh’s research suggests the amount of alpha across all hedge funds has been shrinking for years. Hsieh recently told All About Alpha that he believes new market inefficiencies will emerge to temporarily “pump-up” alphas. But he warns that there is only a finite amount of alpha potential to go around, and that more players equals less alpha per player (our good friend Richard Kang of Seeking Alpha would likely agree).
So your monkey better wear glasses and have good aim.
But, as William Sharpe famously observed, net aggregate alpha is zero across the entire market. So if you were to perform the same analysis on long-only funds, then you’d probably conclude that there is no alpha in the equity market. Yet investors continue to spend billions trying to find it. Why? Because those who invest in active managers truly believe they have a skill in picking the winning managers.
In theory, over the long run there can’t be any “winning managers”. But over the short and medium term institutional investors would surely argue their success is a result of prudent manager selection and due diligence, not pure luck.
The bottom line is that even if these academic studies explained 100% of hedge fund returns using other risk factors, investors would continue to seek out the “best” hedge fund managers in the same way they continue to seek out the best long-only managers. In this sense, investors are themselves active managers whose track record is their historical ability to pick winning managers.
In other words, a broad equity market ETF can theoretically explain 100% of the performance of all long-only managers put together. Yet still, ETFs remain a tiny proportion of all equity investments. Every long-only investor who has ever picked an active manager must therefore believe they are smarter than the monkey throwing darts at a league table. Why should hedge fund be held to a higher standard?
– Alpha Male