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Now It’s Official: Hedge Funds Deliver No Alpha

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Ha. We were suspicious in back in 2005 when Edhec-Risk, an asset management research company, issued a report, “Hedge fund industry: is there a capacity effect?” which examined whether various hedge fund strategies were becoming too crowded for the managers for the managers to earn excess returns. And excess return (meaning earning more than the relevant market returns), or alpha, represents manager skill. That in theory is why investors pay the huge fees that hedge funds demand (a 2% annual fee + 20% of profits is typical, and some funds get even more than that). Excessive competition was recognized as an issue well before the Edhec report (it led to a collapse of performance in convertible bond arbitrage), but the fact that it was deemed worthy of a formal inquiry suggested widespread interest, meaning widespread concern. And more recent stories have made it clear the problem of lack of alpha is becoming more pronounced.

Even back then, there were efforts to finesse the alpha problem. Oh no, hedge funds’ value wasn’t simply alpha. No, it was that they could generate unique exposures (that theory is “synthetic” or “alternative” beta). While that may be true, first, hedge funds are sufficiently closemouthed about the particulars of their investment approach that it is well nigh impossible to know exactly what sort of synthetic beta you are getting, and hence to know how it will fit with the rest of your portfolio. Second, there is no reason to pay 2% up 20, as the fee structure is described, for mere alternative beta. You can construct that on your own much more cheaply (and some investment banks are offering services that do precisely that).

So even though Merrill has announced that hedge funds are no longer generating alpha, don’t expect a rush for the exits. People want to believe, despite all the evidence, that some investors have a magic touch. And if they don’t get that, they will console themselves with alternative beta.

From MarketWatch, “Hedge funds have lost ‘alpha,’ Merrill director says:”

Merrill Lynch & Co. managing director Heiko Ebens had an awkward message for hedge fund managers and investors attending the 2007 MARHedge conference in San Francisco on Tuesday.

“Alpha has essentially disappeared” from the hedge fund industry, said Ebens, who heads equity derivatives strategy for Merrill in the U.S.

Alpha is industry parlance for the extra return, above what’s offered by the market, that’s generated by the skill of the hedge fund manager.

Ebens argued on Tuesday, in front of a stonily silent audience, that most hedge fund returns come from the broader markets and can be replicated by indexes constructed, coincidentally, by Merrill.

One of those so-called synthetic hedge fund products – the Merrill Lynch Factor Index – outperformed widely followed investable hedge fund indexes run by Hedge Fund Research, Morgan Stanley Capital International, Credit Suisse and Tremont, over the past three years, he noted.

Ebens touched on a sensitive subject for the hedge fund industry. As assets have ballooned and more managers have entered the business, some argue that increased competition for a finite number of trading opportunities has dented returns. If that’s true, the high fees levied by hedge fund managers may no longer be worth paying.

“Costs need to be justified and with active managers, there’s large overhead,” Ebens said. “We don’t have a superstar manager who we have to pay millions of dollars a year to keep.”

Investors using Merrill’s Factor Index are charged roughly 50 to 100 basis points a year. Another index, which replicates a hedge fund strategy called volatility arbitrage, charges similar fees, he noted. In contrast, hedge funds usually charge a 2% annual management fee (200 basis points) and take 20% of any profit each year.

Rather than being hostile to this synthetic, low-fee approach, Ebens said a lot of hedge funds have shown interest in using the Merrill products themselves.

By letting Merrill to take care of the returns that are generated by the market, hedge fund managers can in theory focus on trying to generate gains above and beyond that – the apparently elusive ‘alpha,’ he explained.

Hedge fund managers have been particularly interested in Merrill synthetic products that replicate short selling – a technique used in the industry to bet against stocks and other securities, Ebens said.

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