By: Casey, Quirk & Associates, The Bank of New York
Published: October 2006
This report is chalked full of interesting tidbits for the “hard to buy for” money manager on your holiday list. It’s an update of an equally interesting report published in 2004 by Casey, Quirk & Associates. While we would love to get into many of the findings regarding the institutional adoption of hedge funds (the chart to the right, for example), we will focus here on the elements of report that pertain to alpha per se.
The Alpha-Beta “Squeeze”
The authors suggest that institutional investors will begin to consolidate their alpha holdings and delineate them from their beta positions:
“Today’s active allocations and hedge fund allocations are blurred. The active/absolute return components of institutional investors’ portfolios converge into a single more absolute return-oriented portion of the portfolio while the beta portion of portfolios is comprised primarily of index-like mandates.”
However, they still foresee a role for alpha/beta combinations in the form of 1X0/X0 funds:
“Long-oriented hedge fund products are a prominent part of the hedge fund landscape. Despite the squeeze discussed above, long-oriented products (for example, 120/20- type products or products with systematic net long exposures) will become more important. Partly a result of hedge funds applying their investing techniques to less capacity constrained products and partly due to investors’ continued, but changing, interest in long-oriented exposures, these products are a major part of many institutional investors’ portfolios. Many of today’s traditional managers will use these products to transform themselves into viable ‘hedge fund’ managers.”
Note the last line in the excerpt about traditional long-only managers morphing into de facto hedge fund managers. They call this the “Alpha-Beta Squeeze” (see diagram).
Fee for Alpha
The report also says that institutional investors will wise up to overpriced beta and learn to better match fees to alpha-generation:
“Institutional investors have a more sophisticated view on fees and their relationship to value/net returns. Through experience and a deeper understanding, institutional investors are better able to discern value and understand the ability of hedge funds to deliver on their net return requirements.”
“Performance fees are explicitly tied to alpha. Hedge fund performance fees are increasingly levied not on the total return (anything greater than 0), but on alpha. Hedge funds that can demonstrate they are delivering alpha and exceeding institutions’ cost of capital will command the greatest performance fees, even well in excess of 20%…”
In excess of 20% performance fees?! Woo Hoo! No, wait…
“…In addition, performance fees may be subject to a clawback when and if future performance falters.”
Ouch. No more asymmetric return profiles for the manager? Lucky Amaranth didn’t have this clause…
The report goes on to recognize the growth in synthetic hedge fund exposures (like the ones discussed in the recent report from Merrill Lynch).
“The alpha-beta separation framework has impacted the hedge fund industry and, while not all hedge fund strategies lend themselves to it, innovative managers have found ways of creating synthetic exposures to certain strategies.”
The authors conclude with a warning to the industry about taking on too much beta exposure in response to their own underperformance:
“What could cause this underperformance? The sudden and dramatic inflow of assets into hedge funds (which we are in the middle of seeing) could lead hedge fund managers to drift from their absolute return roots and take ever-greater beta exposure. Might hedge fund strategies too closely resemble the traditional long-only strategies investors they are seeking to replace?”
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