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| Say it sotto voce, the dirty secret of hedge funds is that they mix alpha and beta as well. A typical long/short equity strategy will have a lot of beta, a fixed income arbitrage fund rather less |
These days everyone loves alpha. The pursuit of alpha, we are told, is the proper preoccupation of the rational investor. Fund managers boast of their alpha credentials and pension fund officers declare that alpha will solve the deficit crisis. It is no longer enough for stockbrokers to offer clients share recommendations, they have to add alpha. Alpha is no longer a nice-to-have accessory, it is an existential requirement.
Simply defined, beta is the linear return from market exposure and alpha is the non-market-related component of the return of an individual security or portfolio. Alpha is the cream and beta the scone. What’s not to love? Alpha is fun. It is sexy. The head might say that there must be as many losers as winners in a closed investment universe and alpha is a zero-sum game, minus fees and transaction costs. The heart, all in a spin, says otherwise.
Friedrich Nietzche wrote: “Hope, in reality, is the worst of all evils, because it prolongs the torment of man.” Syphilitic mania obviously did little for his mood. But the search for alpha cannot simply be dismissed as a cursed infatuation, the forlorn pursuit of the natural victim. It makes sense, intuitively.
How can fund managers not do better than the market? They are mostly clever, well educated and well trained. Many are even good company. Fund managers also have fantastic incentives. If they do well they are among the best-paid people on the planet. Every standard economics textbook, everything we think we understand about human nature, says that fund managers have the odds stacked in their favour.
Further, the closed investment universe is not made up solely of Oxbridge graduates, alumni of Skull and Bones and CFAs. There are plenty of retired middle managers heeding the advice of stock market tipping columns written by mere journalists (horror), hyperactive day-traders, not to mention déclassé fund managers plying their trade in geographical or institutional backwaters. These mug punters are surely being turned over by the best and brightest of the City of London, downtown Boston and Fairfield County, Connecticut?
The good news is that “professional” investors do indeed outperform. One strand in the academic research says that it is frictional costs that steal alpha. If you can’t blame the fund manager, blame the poor old intermediary. It’s easy to hate Wall Street. Another research thread says that investment constraints (in particular the prohibition against shorting) stop fund managers who have skill demonstrating it.
In this latter case, hedge funds are touted as the answer. They, after all, are unconstrained alpha hunters of the investment world, roving the markets searching out the next profitable kill. Pension funds certainly believe the hedge fund hype. According to the sixth annual Goldman Sachs survey of hedge fund investment, pension funds now contribute 27% of all hedge fund capital, up from 16% in 2001.
We all know that traditional active fund managers mix alpha and beta. But faced with statistics that show that the average US equity mutual fund had a tracking error of just 365 basis points in 2004 it is hardly surprising that institutions are turning to hedge funds. With active risk dialled down to such meagre levels, any investor would ask why they are paying high fees when beta is available for basis points. That has driven the desire among institutional investors to separate alpha and beta.
Transparency is a good thing, although faced with the business challenge of becoming alpha providers many traditional money managers might not think so. But transparency is not necessarily a big win for hedge funds either. Say it sotto voce, the dirty secret of hedge funds is that they mix alpha and beta as well. A typical long/short equity strategy will have a lot of beta, a fixed income arbitrage fund rather less.
If you further extend the concept of beta to include all systematic returns available from markets, many hedge fund strategies deserve close scrutiny. Bridgewater Associates has done some excellent work on this. It shows, for example, that a naive merger arbitrage investment strategy – buying the top 10 targets and selling short the acquirers in the US in 2003 – would have generated a return of 10%. The average merger arb hedge fund tracked by the CSFB/Tremont returned 9% and the correlation between these funds and the naïve strategy was 56%.
Hedge funds might boast that they are alpha hunters, but many are beta grazers. Capturing the beta available by mimicking hedge fund strategies might prove a better business model than claiming an iffy alpha and trying to charge 2 and 20 for it.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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