Send in the clones

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

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3 Comments

  1. rckang
    October 30, 2006 at 2:02 am

    AM

    I obviously agree with Hsieh’s comments on the amount of alpha per player. But now that this is in the Economist, a place where hedge funds are discussed in roughly just about every other issue, it really makes me wonder. I’ve been following the concept of “beta management” in the hedge fund space for a while and am beginning to wonder about how the industry is really viewing this development. Where’s the value of this focus on beta and a move away from manager selection? Lower costs to attract more institutional investors? Less need for active managers and thus the ability to provide greater transparency (process/positions/whatever) to these same institutional investors?

    For example, Asian hedge funds and FOFs with an Asian bent are quite popular now. Perhaps due to the higher perceived potential for alpha in this area, especially with regard to China … I personally wonder just how much shorting can be relied upon in this space. Anyway, suppose I’m an Asian focused HF/FOF based in Hong Kong. I’m trying to get into the typical names (Yale, San Diego, Ontario Teachers, etc.) and I’m going up against others in this space (Asian HF). Clearly, I need to differentiate myself based on the above criteria (cost, transparency requirements, etc.) among others.

    So I’ve got to wonder if putting a certain amount of my overall program, (X% whatever that is?!), into something that is a hedge fund return replication strategy would be a key “selling point”. What would San Diego think about this line of thinking considering how much press they’ve received regarding Amaranth?

    I would guess that having someone like Hsieh, Kat, Jaeger (I know, he’s a practitioner not an academic) or similar individual would be nice to have as an advisor to back the mandate’s proposal when pitching to the fund sponsor. However, wouldn’t one just be transfering the manager risk? Although you’d be moving from something that smells like true alpha to something that smells more like beta, you’re still relying on someone’s recipe to deliver the goods. Somehow, I don’t see this as a reduction of manager risk … and certainly not the elimination of it.

    There has been quite a bit of discussion lately about the demise of the FOF space. Some say multistrategy will continue to capture “market share” (not the proper term in this case) from FOFs as investors question the value of the added cost layer. With continued research, I believe we’ll soon know much more about just which of the underlying hedge fund strategies actually have the best shot of being replicated using a “beta oriented” strategy. If this happens, I fear less for the specific strategy and single strategy HF managers in that space than I would for the FOFs.

    The parallel to this is for the typical long only vanilla investor. Divide your world by asset classes. Within each asset class, determine how much you believe that space to be “efficient versus inefficient” and implement accordingly … in other words, determine how much to invest using ETFs/derivatives versus active strategies/managers.

    Imagine yourself running a FOFs right now, and seriously consider all the underlying strategies currently invested in or are looking to invest in. Knowing what you know from just this website, would it be reasonble to quickly try to determine if a replication mandate is in the cards for any of the underlying hedge fund strategies. I think the answer right now is a definite no, but they’ve got to be paying attention to new developments.

    It may just be that in time, and with research conducted over a significant period of time, hedge fund strategies will become “betaed” and new strategies will be put into the FOF portfolio that may or may not likewise become “betaed” in time.

    I suppose one of the skills needed will be to determine when to make the switch to beta (use of replication strategy). Knowing what I know of higher moment analysis and other statistical factors, I don’t think it will be the same as determining when to switch out of my Indian or Eastern European manager for an ETF.

    Lastly, AM, you say from your recent polling on upcoming topics that “ETFs” looks like a dark horse. Based on your recent focus on beta and replication strategies, this one looks strong comin’ round the bend.


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