Hedge fund managers are increasingly distinguishing hedge fund alpha and betas.
Scores of hedge funds have lived up to perceptions in recent years, outperforming stocks in bull markets and reaping profits for investors even when equities are being hit hard. Still, not all hedge funds are meeting bold expectations. As a result, suspicion has grown that a large number of funds — even those insulating investors from market direction and keeping pace with the applicable strategy index — do not perform in a way that can be explained by the alpha-beta divide.
In this evolving view, buttressed by a number of academic studies, the non-beta returns a hedge fund delivers cannot be solely attributed to a manager’s skill, or alpha. Rather, these returns are a function of managing exposures to various risk categories, some of which are known to be associated with traditional money management. While some hedge fund returns arise from risk management and capturing various risk premia, what traditionally is described as alpha can’t be explained by known risk factors. In other words, hedge funds can produce returns that might not be alpha or beta.
“It becomes apparent that not all hedge funds deliver pure alpha, but rather returns from earning various risk premia. That is hedge fund beta, and it should be distinguished from alpha.”
— Victoria Vodolazschi
Director of Hedge Fund Investments, Northern Trust
This newly defined component of hedge fund returns is referred to as “exotic beta” or “hedge fund beta” and it’s changing the way people look at hedge funds and their fee structures. “The common belief is that you should pay for alpha. In the past, you got true alpha from superior security selection or identifying inefficiencies in the market,” says Victoria Vodolazschi, director of hedge fund investments at Northern Trust. “But it’s hard to believe that all hedge fund managers are that much smarter than traditional money managers, or that there are enough inefficiencies in the market to provide consistent alpha for the $1 trillion-plus hedge fund industry. So it becomes apparent that not all hedge funds deliver pure alpha, but rather returns from earning various risk premia. That is hedge fund beta, and it should be distinguished from alpha.”
The notion that much of what hedge funds return is not actually alpha has given rise to a considerable amount of research. This research has focused on whether hedge fund performance minus the alpha, can be mechanically replicated — thus delivering the non-alpha upside of hedge funds without the high fees.
Hedge fund replication portfolios introduced during the past year and a half — arising from research conducted by academics such as Andrew Lo of the Massachusetts Institute of Technology, David Hsieh of Duke University and Harry Kat of London’s Cass Business School — are seen as more sophisticated successors to investable indices, which carried the promise of liquidity and low fees. However, because of drawbacks such as survivorship and selection biases, the investable indices generally have underperformed the universe of actual funds in operation. For example, one new breed of clone uses a technique commonly described as “hedge fund factor replication.” This is said to better capture the actual return profile of a given strategy and therefore, rival the beta. Factor replication strives to provide exposure to hedge fund betas obtained from a properly assembled portfolio of non-correlated return sources, without the layer of fees carried by a fund-of-funds.
This newly defined component of hedge fund returns is referred to as “exotic beta” or “hedge fund beta” and it’s changing the way people look at hedge funds and their fee structures.
This type of replication portfolio sifts through hedge fund data and uses standard regression analysis to break out the risk factors (interest rate, volatility, credit, etc.) and the alpha from the expected returns of the sample. The passive portfolio assembled from this process is designed to mimic the full beta performance, including hedge fund beta, of the actual hedge funds. Replication portfolios claim better liquidity, full transparency, customization ease and scalability when compared with hedge funds-of-funds.
On the other hand, Lo and others have acknowledged ways in which replication portfolios do not truly replicate the returns attainable by funds-of-funds. Aside from the alpha of the manager’s skill, the clones simply cannot replicate certain strategies. For example, a replicator that uses futures, with their high liquidity, to replicate risk exposure will not work with illiquid strategies. These strategies include convertible arbitrage, emerging markets securities and distressed debt, which has been one of the best-performing categories from January 2001 through the first half of 2007.
Furthermore, critics of hedge fund replication portfolios have said that research to date shows that performance in the categories the replicators mimic has been closely correlated to the S&P 500 Index. Cass Business School’s Kat has argued hedge fund replicators expose investors to a high degree of traditional risk, and thus do not provide the same diversification as hedge funds-of-funds.
“The products that are out there aim to replicate highly diversified indices,” Kat says. “The problem with adding hedge funds together in a basket, however, is that by doing so you diversify away what makes hedge funds special. Highly diversified indices typically have few true hedge fund features and are just traditional portfolios primarily driven by equity and credit risk. Viewed from this perspective, investing in these products doesn’t make sense, as investors would just be trading in real equity and credit exposure to pick it up in a replication product. From the perspective of the supply side, it is a great deal, of course.”
“If you’re trying to replicate hedge fund performance based on principal component analysis, you run into issues using historical hedge fund data.”
— Anthony Zanolla
Senior Director of Hedge Fund Investments, Northern Trust
Anthony Zanolla, senior director of hedge fund investments at Northern Trust, addresses the possible pitfalls of the index issue. “If you’re trying to replicate hedge fund performance based on principal component analysis, you run into issues using historical hedge fund data,” he says. “You don’t know how the composition of the index has changed. Managers may have gone out of business or changed strategies — you are looking in the rear-view mirror. Compare that with the S&P, which is replicable, transparent and has detailed, timely information that is publicly disclosed.”
One study, conducted by Liability Solutions, a hedge fund placement and investment consulting firm with offices in New York and London, found both positives and negatives in hedge fund replicators. The study looked at returns for two replicators against the HFR Fund of Hedge Funds Index and the S&P 500. From the start of 2003 through February 2007, the S&P produced the highest returns, while one of the replicators outperformed the fund-of-funds index.
However, the fund-of-funds index showed much less volatility than either of the replicators, and on a risk-adjusted basis performed much better than they did. The report concluded that statistics do not yet prove whether replicators can duplicate “access to much of the average hedge fund return in a safe, transparent, regulatory-friendly manner.” The report also stated the limited statistics available suggest that hedge funds-of-funds provide better capital protection attributes.
Vodolazschi acknowledges the significance of replicator innovations, especially for their scalability and potential to exert downward pressure on hedge fund fees. However, for investors seeking to reap the full potential of hedge funds as part of a diversified portfolio, she sees a continued central role for a managed fund-of-funds.
“An optimal fund-of-funds should consist of a true alpha component combined with a portfolio of different hedge fund betas,” Vodolazschi says. “Aside from looking for pure alpha, it is a fund-of-funds manager’s job to identify and extract hedge fund betas.
This requires a solid understanding of hedge fund strategies and cannot be substituted by an index or a replicator.” In constructing an optimal portfolio, she says, portfolio managers and risk analysts work with a risk budget and allocate across strategies to try to map different risk factors to specific strategies.
The goal is a mix of funds that will capture returns from categories of risk where premia tend to be predictable in various market conditions. “If you can tell me what the market is doing, I’ll have a good idea of how each manager should perform,” Zanolla says. “Changing market conditions have a different impact for each individual manager.”
For the most part, hedge funds have performed as investors expected they would — capturing much of the upside appreciation during periods of strong stock market performance while also doing a better job than pure equities of perserving capital during times of stock market weakness.
Vodolazschi stresses the importance of dynamic allocation, where a fund-of-funds team actively seeks out managers who can find profits in changing market conditions. Such a mandate often points to managers in emerging strategies, as opposedto categories where the potential for profit has dried up or become stagnant.
“The goal is to find new and unique sources of returns — often not what you would find in an index,” Vodolazschi says. The reinsurance market and asset-backed lending can be cited as examples of where these opportunities may exist.
The emergence of hedge fund replication tools probably has helped illuminate the actual return components of a multimanager hedge fund portfolio. Understanding the nature of hedge fund betas and identifying sources of hedge fund beta that may not be easily replicated is helpful as institutional investors think about the sources of hedge fund returns and the potential role of hedge funds in an institution’s total investment portfolio. From the perspective of a hedge fund-of-funds manager, hedge fund beta is a conceptual tool. Portfolio managers can work with well-defined and measurable risk factors for the beta component of the portfolio while employing market knowledge, manager selection skill and an eye for innovation in scouting true alpha.