For several months, investors and their advisors have been worrying about the profitability prospects for hedge funds. Modestly entitled the "capacity effect", the analysis of the reasons behind the fairly disappointing performance in 2004 constitutes, if we believe those who are putting the argument forward, a serious calling into question of the alternative investment industry's value proposition.

Alphas would be tending to become rarer, for two main reasons: The significance of the sums drained into the alternative investment industry are making the implementation of "niche arbitrage" strategies more and more difficult (for example, convertible bonds or arbitrage on small stocks); more globally, the increase in operational volumes is reducing market inefficiency and market anomalies, which are allegedly the main source of performance for hedge funds.

The windfall represented by the remuneration model and the very strong growth in assets under management is attracting more and more managers, which is leading to a dilution of the talent available in the industry. The "democratisation" of hedge funds is making them increasingly dull, the pessimists argue.

According to research by French business school Edhec's Risk and Asset Management Research Centre, this pessimism doesn't hold up when we examine the facts. A recent paper by research associates Walter Géhin and Mathieu Viassié, has argued that the issue is related more to the incapacity on the part of both investors and managers to understand or explain the true benefits of investment in hedge funds than to the capacity effect. "The capacity problem that is supposedly linked to the disappearance of arbitrage opportunities has not been demonstrated and cannot, in our opinion, be demonstrated," the paper's authors argue.

On the one hand, they say, the alternative industry, even taking the leverage effects into account, represents less than 2% of worldwide stock market capitalisation and, on the other, even when considering specific market segments (the raw material derivatives market, stock loan /borrowing market, etc.), it is true that one can reach very significant proportions of activity relating to the intervention of hedge funds, representing up to 30% of operations on certain stocks or up to 50% of some open positions, but these volumes rarely correspond to arbitrage operations. They generally involve bets that are directional (CTA, Global Macro) or related to the unfolding of events on securities that by definition are intended to move between market segments in accordance with speculative opportunities.

In certain situations, hedge fund profits can be limited by the depth of the market, but it is not strictly speaking a reduction in inefficiency, simply a concern on the part of managers not to be the only providers of liquidity.

It has not been demonstrated either that the new entrants into the industry have less talent than the initial entrants. Academic research and empirical work on the "age" effect on hedge fund performance gives conflicting results. Besides, estimating a hypothetical increase in the number of fund failures is not possible either, given the reporting biases and the insufficiencies of data -bases in this area. In fact, the essential part of hedge fund performance comes from their betas.

Their talent resides in the management of those betas, namely, correctly taking risks for which the premiums, i.e. the "normal" returns, are less easy to capture in the equity and bond markets.

Allowing investors, for example, to access the credit and volatility markets in good timing and price conditions undeniably constitutes added value, which justifies turning to specialists. Even the performances of so-called "Relative Value" strategies such as Long/Short Equity and Equity Market Neutral are conditioned by bets on particular risks like, for example, the evolution of the Large Cap – Small Cap spread.

By constantly highlighting arbitrage alphas that are difficult to measure, hedge funds have themselves fallen into the trap of the capacity effect, with the risk of forgetting their true virtue – that of offering new betas to investors who are always looking for effective diversification.

Two studies, by Watson Wyatt and UBS (both from March 2005), give a pessimistic view of the hedge fund industry's capacity to generate long-term returns, due to its increasing size.

"Unfortunately, these studies focus almost exclusively on alpha," Edhec's Géhin argues. "In our recent paper (summarized here), we show the importance of considering not only the exposure to the market (the traditional beta), but also the other exposures (the alternative betas) to cover all the sources of hedge fund returns. To do so, we examine the real extent to which the variability and level of hedge fund returns are affected by (static) betas, dynamic betas (i.e. factor timing), and pure alpha (i.e. security selection)."

Traditional beta, alternative betas and alpha

Like a mutual fund, a hedge fund can be exposed to the traditional beta, in other words to the market risk consisting of unforeseeable variations in the prices of basic assets, stocks and bonds. However, a hedge fund is also exposed to risk factors which are different from those of long-only managers (so-called alternative betas), i.e. volatility risk, default risk and liquidity risk.

Hedge fund returns are the addition of the traditional beta (normal returns generated from exposure to rewarded market risk), alternative betas (normal returns generated from exposure to other systematic risks), and finally alpha (abnormal returns due to the manager's skill). "Hedge funds cannot be presented as absolute return vehicles that always deliver positive returns without risk exposure," the paper's authors argue. "Hedge funds can be viewed as an asset class whose beta-benefits (from the broad perspective of alternative betas added to the traditional beta) lead to them being included in the strategic asset allocation decision. They broaden the sources of performance offered by traditional investments, such as mutual funds. Consequently, hedge funds are attractive in terms of dynamic portfolio diversification."

Revisiting market capacity and manager capacity

In order to examine the extent to which the performance of hedge fund strategies actually relies on alpha, Edhec assessed the relative importance of (static) betas, dynamic betas (i.e. factor timing), and pure alpha (i.e. security selection) on both the variability of hedge fund returns and the performance of hedge fund strategies. "We concluded, firstly, that only 25% of the variability in the returns of hedge fund strategies is due to pure alpha (i.e.security selection)," Géhin says. "Secondly, pure alpha accounts for less than 4% of the return of hedge fund strategies!

"Clearly, the importance given to alpha as regards the variability and level of hedge fund performance is strongly overstated. Conversely, the importance of beta appears to be strongly understated as it turns out to be the main determinant of the variability and level of hedge fund performance.

"Furthermore, there is no clear evidence, on the basis of our analysis, of a declining trend for alpha. The only strategy to show a steady, slightly decreasing trend over the whole sample period is Equity Market Neutral. In some cases, alpha has first increased and then declined. In other cases, alpha has first declined and then increased. Except for Equity Market Neutral, none of the strategies is currently producing an historically low level of alpha."

These results suggest that the disappointing returns obtained by hedge fund strategies in the recent past cannot be attributed to alpha components. In most cases, the trend of value added through dynamic betas is much more pronounced than that of pure alpha, suggesting that the evolution of total alpha is mainly driven by the ongoing value added through dynamic betas.

"This result is particularly interesting as it suggests that hedge fund strategies' alpha, contrary to what has recently been said, is more limited by manager capacity than by market capacity," says paper co-author Viassié. "This comes from the fact that the level of pure alpha primarily depends on the quantity of market opportunities that are available to hedge fund managers, while the level of value added through dynamic betas depends above all on the ability of hedge fund managers to time factors with success."

"In other words, our results suggest that the level of alpha is not bound to diminish significantly as the number of market player increases, provided that the average quality of hedge fund managers remains the same."

Conclusion

The debate on alpha, beta, and the capacity of the hedge fund industry to generate high yields in the future is an important one for investors. Hedge fund returns are drawn from exposures to a variety of risk factors, but Edhec's analysis shows that only 4% of the level of hedge fund performance is explained by pure alpha (security selection). This result naturally calls into question the real role of alpha as a source of constant returns. According to the paper's authors, the consequence of this is that the beta-benefits of hedge fund investing are more convincing and attractive than the alpha-benefits, even though alpha does not appear to be seriously threatened by the increase in market participants: "We are more prone to promoting the long-term diversification power presented by hedge funds than the difficult and random search for alpha."