The answer is that in both cases some of their returns are systematic. We have known since Halley in the late 17th century that comet returns can be predicted; indeed the pattern of their returns is well understood, i.e. it is systematic. Before then, each appearance of a comet was thought to be a unique event. In the same vein, we have understood since Sharpe over forty years ago that much of what an equity manager produces is not unique, but systematic. And now we are beginning to see that a part of many hedge funds’ returns is not unique.
Sharpe’s one-factor model was a revolution in our understanding of investment management that led (albeit with a two-decade delay) to index funds. In other words the easily replicable returns to the market factor became available to investors for a very low fee. Then Gene Fama and Ken French introduced in the early 1990s, a three-factor model that included not only the market excess returns but also a fund’s exposure to the small company risk factor, and the value-growth factor. With a delay, but predictably, it has now become much cheaper even for retail investors to harvest the small cap and value risk premia. Low-cost ETFs with low spreads are now quoted daily in the FT. In the institutional market for traditional long-only investment management, only truly active managers can charge high fees. Closet indexers are being flushed out. Let’s now look at hedge funds. Could the pattern we have seen in traditional asset management be repeated? If hedge funds are typically idiosyncratic, which is a widely-held view, then high fees are safe. But if there is evidence that there are common factors at work that determine a significant proportion of hedge funds’ returns, then the industry could be on the cusp of a sea change. It behoves both buy-side and the sell-side to keep watch on developments.
A November 2006 article in the Economist1 and a report by Merrill Lynch2 in October 2006 suggest that change could well be on the way. Both reports referred to a piece of research by Fung, Hsieh, Naik and Ramadorai. The paper “Hedge Funds: Performance, Risk, and Capital Formation” is available for download on the BNP Paribas Hedge Fund Centre’s website www.london.edu/hedgefunds.html.
The paper focuses firstly on whether the stereotype of hedge fund returns as uncorrelated with market-related returns is correct. Consultants for example recommend hedge funds as part of a defined benefit pension fund portfolio because of their supposedly low correlation with existing investments in equity and bond markets. Hedge funds also provide access, according to consultants, to active management strategies that are difficult to identify within the traditional, long-only investment management community.
Secondly, the authors wanted to know whether the market could identify high alpha funds and whether capital tended to flow to these, or whether the distinction between pure alpha returns and market-related or ‘beta’ returns had no effect on subsequent capital flows.
Thirdly they wanted to know whether those flows into successful funds impacted their future capacity to generate high returns.
Lastly, the ten years covered by the dataset – from lanuary 1995 to December 2004 was a turbulent period, punctuated by the collapse of LTCM in September 1998, a bull market in technology stocks that burst in March 2000, and a subsequent bear market. It also saw the enormous growth in the popularity of hedge funds and a change in clientele, from almost exclusively high net worth individuals towards institutions such as endowment and pension funds. The paper investigates therefore how the mix of returns had changed over that period, and whether in absolute terms the alphas had grown or diminished.
This is an ambitious programme. The dataset used was fund-of-hedge-funds (FOFHs) returns, for the simple reason that these reflect far more faithfully the true investment experience of end-investors. Hedge fund indices exist, but apparent performance is often biased upwards by various reporting (and non-reporting) influences.
The key issue is the separation of ‘true’ alpha from systematic risk premia or beta. The authors constructed a factor model measuring the sensitivities of FOHFs not only to the equity and bond markets, but also to the small cap effect and to default risk, as measured by the corporate bond spread over treasuries. Three momentum factors were added that measured a trend-following exposure in the currency, commodity and bond markets. Beta returns therefore captured the cumulative effect of exposure to these seven factors, each of them relatively easily replicable in a mechanical way, and therefore unlikely to command a premium fee for managers – at least not in the long run.
Over the whole period, the proportion of FOHF returns explained by the factor model averaged 74%. Clearly this average masks variation among funds, through time, and across our different factors, but it is nevertheless a high proportion of returns. It confirms results found by others.
To have or not to have alpha
In the study, if a FOHFyielded a two-year record of significant alpha, it was labelled a have-alpha fund; otherwise it was part of the beta-only groups. The composition of each group was then revised annually on a rolling basis. Did the have-alpha funds attract more new money than the beta-only group?
This was indeed the case. The market for investment management services clearly functions, in that buyers compete to identify successful managers and reward them with more business.
Unfortunately, however, it appears from the data that there are diminishing returns to scale. Have-alpha funds which expanded at an above average rate tended to do less well in subsequent periods than those that expanded at a below average rate, albeit better in alpha terms than the beta-only group. There is limited capacity therefore for successful funds to expand and continue doing well. Of course the whole industry has expanded, and the data shows that inthe sub-period before the LTCM crash, the average have-alpha fund added 5.6% per annum. In contrast, the same group in the post 2000 period added only 2.2% per annum.
Funds of hedge funds, it could be argued, suffer a double hit to their alpha. Firstly, they suffer two levels of fees, both of which will reduce the alpha banked by the final investor. Secondly, there is a diversification effect. As different strategies and funds are aggregated, alphas are diversified away and beta returns begin to dominate. The question therefore arises whether individual funds have experienced declining alpha in recent years as FOHF have, and whether they too suffer from capacity constraints on their ability to generate alpha. This is the focus of a second working paper from the BNP Paribas Hedge Fund Centre at London Business School. Naik, Ramadorai, and Stromqvist show in their working paper “Capacity Constraints and Hedge Fund Strategy Returns” that both alpha attenuation and capacity constraints have characterised the individual hedge fund industry in recent years. Figures 1 and 2, taken from that article, support the idea that as the industry has grown in terms of number of separate funds as well as of total assets under management, non-systematic returns have become more difficult to achieve.
These results are already having an impact on the shape of the industry. February sees a major conference in London on ‘Alternative Betas’. If substantial parts of hedge funds returns are not unique to the manager but represent scalable market factors, where there are no or few capacity constraints, then there is no reason why these return patterns should not be available to investors as passive or quasi-passive funds – passive that is in the sense that they are created mechanically. This does not mean traditional equity and bond index funds, but relatively simple long-short strategies that exploit market-wide systematic risk factors. These products are to be distinguished from the un-hedgeable and idiosyncratic alpha returns of the have-alpha group described above. Passive vehicles would have the advantage of being more transparent, though they are unlikely to command the fee levels we see in the industry today. Indeed a number of major investment banks, including Merrill Lynch and Goldman Sachs, are developing investment products along these lines. The capacity constrained, high fee sector is likely to co-exist alongside these innovations. Such differentiation along investment-character and fee-level lines has been a feature of the investment management industry for many years. The hedge fund industry is no exception.
Mark Tapley is Executive Director of BNP Paribas Hedge Fund Centre, London Business School.