Remonopolising Alpha

Hedge funds must stay ahead of the game to achieve alpha

Originally published in the September 2008 issue

One-stop alpha beta shopping has given way to a more discriminating approach to portfolio construction. Against this background, the shifts in the hedge fund industry are nothing short of paradigmatic.

The dominant paradigm of traditional money managers is characterised by long only, benchmarkrelative management and ‘constrained’ investing, that has little use of alternative strategies such as shorting or derivatives. This paradigm has come under pressure, as long only active funds have demonstrated a historical underperformance. A 2007 study by the IBM Institute for Business Value shows that only 29% of traditional fund managers in the US outperformed the market over a 10-year historic period. Consequently, many investors have begun to re-engineer their portfolios to employ alpha/beta separation.

Why the need for portable alpha?

Alpha/beta separation or ‘portable alpha’ is a method that seeks to add low correlation sources of return (alpha) to a portfolio while at the same time maintaining the total portfolio’s desired systematic (beta) exposures. While there are various concepts of portable alpha, hedge funds have become a preferred source of excess returns in these strategies. Notably among retirement plans, demand for hedge funds has accelerated. In addition to reduced capital markets’ returns, these players are burdened with growing demographic pressures. The National Association of State Retirement Administrators (NASRA) found that state pension plans have deteriorated from a US$20 billion surplus in 2001 to a US$381 billion deficit last year. With overall required returns of 8 to 9%, pension plans are forced to adjust their investment policies in order to bridge the gap between return requirements to meet their future obligations and the returns that traditional money managers have difficulty delivering. Hence, in the past few years, these players have embraced portable alpha with a ferocity that has become a critical growth driver.

Yet portable alpha comes with a price for the hedge fund industry. As the costs of active management have grown exorbitantly, hedge fund selection has become more discriminating. A recent report published by Watson Wyatt found that average investment management fees paid by pension funds globally grew from 65 basis points in 2002 to 110 basis points in 2007. Unsurprisingly, external active managers accounted for the majority of this increase. As a consequence, institutional investors are more diligently assessing whether hedge funds returns are veritable alpha or only attributable to a different form of beta. Here, Markowitz’s modern portfolio theory had prepared the grounds for the realisation that hedge fund returns do not necessarily stem from alpha, but may come from ‘alternative beta’; the return derived from exposure to alternative risk sources such as credit risk, liquidity risk, FX risk, commodity risk, etc.

The alternative beta theorem brought about another realisation of paramount importance: the possibility of replicating the alternative beta exposures of hedge funds. With alternative beta and replication strategies on the rise, this ‘new’ concept of beta has become nearly as notorious as its alpha counterpart.

“Hedge funds have become increasingly active participants in the leading business”

Alpha, beta and hedge fund replication

From the industry’s perspective, the replication trend represents a Damocles’ sword bound to lead investors increasingly to avoid the purchase of regular hedge funds. In fact, alternative beta providers promise the benefits of hedge fund returns without hedge fund fees, while at the same time offering high liquidity and transparency of the investments. Yet, with these markets relatively new and underdeveloped, it is still in question how large a threat is really emanating from products of this sort. One consequence of the proliferation of the alternative beta concept, however, is beyond doubt: hedge funds are pressed to differentiate themselves from the pack and deliver on the alpha promise. ‘Lucky’ alpha will no longer do for sophisticated institutions.

In response, hedge funds are leaving no stone unturned to source new and innovative investments that will generate that elusive alpha.

Staying ahead of the game

On the lookout for superior returns, hedge funds are tapping into ever more sophisticated algorithms. Algorithmic trading enables hedge funds to initiate orders based on information that is received electronically, before traders are aware of the information. Thus it synthesises the activity of a skilled and tireless human trader. While once a niche phenomenon and confined to equity instruments, algorithmic trading, today, accounts for an estimated 11% of hedge funds’ overall trading volume and is fanning out across foreign exchange, options, futures and FX markets. In parallel, the practice of Direct Market Access (DMA) has spread more widely.

DMA offers low-touch, high-speed trading and market venue aggregation for hedge funds, allowing managers to define best execution, destination and order routing functionality for themselves. Particularly for quantitative hedge funds, it has become fairly common to have direct access to market exchanges and trading platforms. This, in turn, comes with important implications for the DMA provider market. With the growing adoption of multi-asset class algorithms, providers that were once focused on the equity realm are now heading in all directions.

Moreover, hedge funds have become increasingly active participants in the lending business. While hedge funds have been offering loans to companies for a number of years already, the credit squeeze has created more opportunities for those engaged in providing liquidity. A greater number of cash-strapped companies, shunned by banks and commercial lenders, are hitching themselves to hedge funds. Yet, while the current surge in hedge fund lending is a somewhat opportunistic phenomenon and as such cyclical, lending strategies will, no doubt, remain a permanent feature of the hedge fund style box. Hedge funds have taken to filling part of the void created by consolidation in the banking industry. As banking giants avoid smaller and riskier deals, hedge funds make up for an increasing share of this market.

The latest trend: hybrid investing

The current market environment also serves as a catalyst for a trend that has been under way for a number of years already: hybrid investing. This is the practice of carving out a discrete amount of capital to be invested in illiquid private investments only. Hybrid investing gives hedge fund managers a broader base from which to generate returns and enables them to alter their investment strategy depending on market cycles. Investors, in turn, have the opportunity to invest in both worlds, without the costs of dealing with a hedge fund and a private equity firm separately. By going hybrid now, funds can capitalise on a wealth of distressed opportunities in both the hedgefund and the private equity way.

By pressing hedge funds to deliver on the alpha promise, alpha/beta separation drives multiple convergences. As a consequence, the coherence and the ability to distinguish the hedge fund industry appears to be once more in question. The concept of ‘hedge fund’ has become more elusive again, encompassing pools of liquidity engaged in a vast array of different activities, some of which had hitherto been the preserve of private equity firms and banks. At a closer look, however, alpha/beta separation acts as a distiller to help identify those that are truly all about alpha and unmask those that have long benefited from the hedge fund packaging without creating alpha value.