Where is the ‘Hedge’ in Hedge Funds?

An industry paradigm shift in the making

Originally published in the September 2008 issue

Since the credit crisis began last summer, global capital markets have been hit with a tsunami of historical volatility and asset deleveraging. The role of hedge funds in this crisis has become a leading topic of discussion among government regulators, the financial media and hedge fund investors. Overall, the performance of the industry throughout this crisis has left a lot to be desired. Since the beginning of the year, large losses and fund liquidations have been reported on a constant basis and through July the hedge fund industry has reported its worst year-to-date performance in decades.

Recent articles in the financial press have questioned whether most hedge funds are truly generating alpha, in other words returns that are primarily a function of manager skill, and if the performance of the funds justifies their fees. In truth, many funds are not producing real alpha and the excess fees are not justified. At the same time, a small percentage of hedge funds are worth every penny we pay them and perhaps more.

Actual performance vs pitch book promises

Hedge fund investors are constantly inundated with pitch books that promise low correlation and volatility, absolute returns in all market environments and buckets full of magical alpha. Since the equity market peaked in October 2007, the HFRI Equity Hedge Index has dropped 10.93%. The fixed income markets peaked in June 2007 and the HFRI Fixed Income Index has dropped 9.05%.

This performance can lead to only two conclusions, neither of which bodes well for the future of the industry. In some cases, after years of trending markets, managers have slowly inched up their net exposures. In effect, they have become mutual funds on steroids. Other managers who have stuck to a more market neutral approach have still not escaped their correlation to the market. Why then are we paying them 20% or more of full profits while a good portion of the profits are beta, or market, dependant?

Alpha risk vs beta risk

It is important to separate what is beta in some form and the strategies that have the potential to generate alpha. The majority of the returns generated by significantly net long equity and credit strategies are beta returns. The manager may produce some alpha on the margin but the returns will be highly dependant on their market exposures. The only thing that makes these funds into hedge funds is their private partnership designation and a 220 fee structure. In fact, many relative value strategies are also disguised beta. In these strategies managers are in effect selling liquidity options. When liquidity is abundant they will make stable returns and when liquidity dries up they tend to have disastrous results. The liquidity crises of 1998 and 2008 have had the same effect on many relative value funds. These strategies have proven to have the profile you would expect from an option seller, low netreturns over time with periods of extraordinary volatility.
We have now reduced the true hedge fund industry or potential real alpha generators to low leverage, low net exposure and liquid strategies. It is important to recognise that we have not eliminated all of our risks we have simply shifted them from primarily beta driven to idiosyncratic exposures. We pay our managers to take and manage idiosyncratic risks. If they do that well then they are probably producing significant alpha and have earned their fees.

Portfolio construction: the real alpha

As hedge fund investors we should not expect each of our managers to be producing alpha all of the time nor should we expect the vast majority of their returns to be true alpha. Creating a stable alpha stream is a function of intelligent portfolio construction. Identifying which strategies and managers are capable of significant alpha generation over a full market cycle is only part of the task. Balancing cyclical relationships between strategies and adjusting for the market environment is even more critical.

Even a well structured alpha generating portfolio still has an Achilles heel though; systemic risk.

Systemic risk

Since systemic risk re-entered the financial lexicon in the summer of last year, we have had three anomalous months(August 2007, March 2008, July 2008, August 2008) in which the equity markets and beta managers have been nearly flat while many true alpha managers have performed poorly (see Fig 1). All three months were marked by significant deleveraging of market participants. In that type of environment good assets that alpha managers own are sold and bad assets they are short are bought back. Alpha managers are not paid for nor are they expected to be experts in hedging systemic risks. We should not expect them to perform well in those periods. We can however expect them to take advantage of the opportunities created by wholesale deleveraging to reposition their portfolios into the better opportunities created. In the end, their future returns will be higher and should compensate for the temporarily higher volatility.

A hybrid future

We believe a paradigm shift is upon us. Institutional hedge fund investors will focus on the difference between true alpha and disguised beta and recognise the need for systemic hedges on their hedge fund portfolios. There will be significant pressure on fees for firms that don't stand up to the true alpha test. There will also be increased demand for firms that have an expertise in managing and hedging systemic risks.

The alternative investment model of tomorrow will be a hybrid model, combining expertise in alpha identification, portfolio construction and systemic hedging. The resulting hybrid strategy will be worth every penny.

Ari Bergmann is Managing Principal and Steve Gross is Principal of Penso Capital Markets