Is Alpha All It’s Cracked Up to Be?

Supposedly, the reason that sophisticated investors like pension funds and endowments pay 2% management fees and 20% upside fees (and sometimes more) to hedge funds and private equity funds (and higher-than-index-fund fees for long equity managers) is that they are buying “alpha,” which is the manager’s ability to beat the relevant market. (To be more precise, it’s the risk-adjusted return over a benchmark, also referred to as “excess return.”)

As we have discussed, the problem is that a lot of fees are being paid, but not a lot of alpha exists. In fact, the gap between expectations of hedge fund performance and actual performance has grown so large that the salesmen have come up with a new rationale: “synthetic beta.” You are not paying for alpha, you are paying for a very particular combination of market exposures.

The problem with that is there is no reason to pay a 2/20 fee structure for that. A customized exposure, no matter how exotic, could be designed and implemented more cheaply.

An article in the current Economist, “What’s it all about, alpha?” covers some of the same territory, namely the seeming lack of real alpha, the claims made for the virtues of specialized profiles (the article doesn’t use the term “alternative beta”) and the rise of hedge fund clones based on the view that a lot of hedge funds are charging a lot of money for strategies that can be replicated more cheaply.

The piece is more than a bit distressing, because it serves up arguments that are bunk. The first is that even if hedge fund’s attractive (or seemingly attractive) is simply making the right mix and match of market returns (or betas) that’s worth paying for.

Uh,no. Any investor in a hedge fund has other investments (unless he is a fool). Institutional investors like pension funds hire fund consultants to help them determine asset allocation (as in what markets to be in, meaning what combination of betas to buy, as in how much in domestic stocks, foreign stocks, domestic bonds, etc.). So any “beta mix” decision by a hedge fund could run counter to other investments being made. Put it another way: the hedge fund isn’t being hired to choose which betas to invest in. That’s someone else’s job.

There is also a very strange discussion of style bias. Even hedge funds are expected to adhere to a style. There are hedge fund indices by style, and they are measured relative to the appropriate index. For example, hedge fund strategies include global macro, event arbitrage, emerging markets, distressed, convertible arbitrage, market neutral, etc. Not adhering to your style is very bad and fund consultants and investors punish you for it. If you are an emerging market fund, you can’t go and buy US biotech stocks, no matter how much money you’d make. Similarly, not fitting within a style box also gets you punished. I know of a US fund that has excellent performance that is neither precisely “long-short” nor “market neutral” and that has hurt them in fundraising. Another fund, despite being affiliated with the Basses, was positioned as “opportunistic” which meant they could do anything, and they too found it hard to raise money.

But the story makes it sound as if hedge funds have no style constraints, which simply isn’t true from a practical standpoint. And you can have style biases within your style, but so what? If it doesn’t produce measurable alpha, it’s just noise.

So not surprisingly, we find the piece gives more credit than is warranted to hedge fund manager skill (well, investment skill, they certainly are brilliant at fundraising):

Too many notes. That’s what Emperor Joseph II famously said to Mozart on seeing his opera “The Marriage of Figaro”. But surely to think of a musical work as just a series of notes is to miss the magic.

Could the same be said about fund management? It is the fashion these days to separate beta (the systematic return delivered by the market) from alpha (the manager’s skill). Investors are happy to pay high fees for the skill, but regard the market return as a commodity. Distinguishing the two is, however, difficult.

A fund manager might beat the market because of luck or recklessness, rather than skill, for example. Suppose he packed his portfolio with oil stocks. When the crude price rises that would pay off, but it would be a pretty risky portfolio. More generally, alpha sceptics often attribute eye-catching returns to “style bias”, such as favouring stocks with a high dividend yield.

But should they be biased against style bias? After all, the only portfolio utterly free of bias would be one that included the entire market. Were a Britain portfolio to exclude just one stock, such as BP, it would have a small-cap bias, a sector bias and a currency bias (most of BP’s revenue is in dollars). Hence any excess return must stem from some element of style.

Academics have entered this debate, trying to pin down the factors that drive a fund’s performance. These might include the difference in returns between small-cap and large-cap stocks (fund managers tend to favour the former) or the level of credit spreads and so on. Bill Fung and Narayan Naik of London Business School have come up with a seven-factor model which, they say, can explain the bulk of hedge-fund performance. After allowing for these factors, the average fund of hedge funds has not produced any alpha in the past decade, except during the dotcom bubble.

This approach suggests the whole idea of alpha might be an illusion. Academics can explain most of it, and the only reason they cannot explain all of it is because they are not clever enough to think of the missing factors.

However, it is also possible to take the opposite tack. This type of analysis gives managers no credit for choosing the systematic factors—the betas—that drive their portfolios. Yes, these betas could often have been bought for very low fees. But would an investor have been able to put them together in the right combination?

It is as if a diner in Gordon Ramsay’s restaurants were brave enough to tell the irascible chef: “This meal was delicious. But chemical analysis shows it is 65% chicken, 20% carrot, 10% flour and 5% milk. I could have bought those ingredients for £1.50. Why should I pay £20?” The chef’s reply, shorn of its expletives, might be: “The secret is in the mixing.”

This debate matters because people are now trying to replicate the performance of hedge funds with cloned portfolios. Indeed Messrs Fung and Naik have shown that their model would have produced an annual return over the past four years of 11.6%, well ahead of the average fund of hedge funds. Their performance was purely theoretical. But Goldman Sachs and Merrill Lynch have launched cloned hedge funds on the market.

There are two potential criticisms of the cloned approach. One is that it will simply reproduce all the systematic returns that hedge funds generate and none of their idiosyncratic magic. However, this “magic” is hard to pin down. Even if it does exist, Messrs Fung and Naik suggest it may be worth no more than the fees hedge funds charge, so the managers are the only ones to benefit from their skills.

The second criticism is that the clones will always be a step behind the smart money. You cannot clone a hedge fund until you know where it has been. But by then it may have moved on. As a result, the clones may pile into assets that the hedge funds are selling, making the classic mistake of buying at the top. This may not be a fatal flaw, however. It is possible to imagine some clones taking contrary bets, buying the betas that seem temporarily out of favour, in the hope that they will be purchasing what the hedge funds are about to buy.

There are some nice ironies at work here. Hedge-fund managers often rely on secretive “black box” models: the investor puts his money in at one end and sees the returns spat out at the other, but no more than that. Now, armed with just that information, academics are coming up with their own models, which almost match the hedge funds’ performance.

Mozart might have sympathised. His operas were more than the sum of his notes. But even if the great composer had no peers, he has had plenty of imitators.

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