Alpha is called a finite commodity

Mar 13, 2006 @ 12:01 am

By Christine Williamson

PHILADELPHIA - Everyone in the crowd assembled for the CFA Institute's hedge fund conference took notice when David S. Hsieh said that the amount of alpha available in the hedge fund industry each year is $30 billion.

Mr. Hsieh, a professor of finance at the Fuqua School of Business at Duke University in Durham, N.C., presented a synopsis of his ongoing research, which focuses on the style, risk and performance evaluation of hedge funds, at the Feb. 16 conference here. As part of his work, Mr. Hsieh questioned whether flows into hedge funds are causing a decline in hedge fund returns and what might happen if the high rate of inflow continues.

Because of difficulties in obtaining reliable hedge fund data, Mr. Hsieh used fund-of-hedge-funds data and broke down returns into alpha and beta sources. He said the research led him to "feel comfortable" determining that there is a finite amount of alpha - conservatively, $30 billion - managed by the approximately $1 trillion hedge fund industry. And even if capital invested in hedge funds were to rise, the amount of alpha would remain the same.

Provocative speakers

Mr. Hsieh was one of 12 provocative speakers at the Charlottesville, Va.-based CFA Institute's annual hedge fund event.

Heavy hitters from the institutional investment side of the hedge fund industry gave presentations that sparked interest and questions from the audience. M. Barton Waring, managing director and head of the client advisory group at Barclays Global Investors in San Francisco, set out to prove that there is no such thing as absolute-return investing. "There is a clear intent to contrast the term 'absolute return' against the term 'relative return,'" he said, with the understanding that traditional investment managers chafe against returns being compared with a relative benchmark while hedge fund managers are not subject to the same constraint.

Mr. Waring broke down investment returns into three components - cash, alpha and beta - and supported Mr. Hsieh's contention that alpha is a finite commodity. He reminded the audience that to gain alpha, a manager has to "take money away from people who are trying to take it away from you … More and more people and dollars [are] pursuing [the] same opportunities." And just as no one wants to consult a below-average doctor, "there's nothing worse in the investment industry than an average active manager," Mr. Waring said.

He showed that alpha is conditional, dependent on the presence of market inefficiencies and on managers having the skill to exploit them. And because alpha is conditional, or relative, and absolute return is dependent on alpha generation, Mr. Waring concluded "there is no such thing" as absolute return. "No wonder we couldn't get comfortable with absolute-return investing!" he said.

A walk on the dark side

In another session, Clifford S. Asness, managing and founding principal of AQR Capital Management LLC in Greenwich, Conn., explored the future of hedge fund investing. "Hedge funds represent the future of active management in general. In the perhaps distant future, the investing world might look like hedge funds plus index funds," he said.

Mr. Asness noted many "dark sides" of hedge funds - hedge fund betas/correlations, lags in mark-to-market valuations, hot money and survivorship bias, to name just a few - need to be exorcised before this vision becomes reality.

For example, said Mr. Asness, the industry has to adopt a "needed professionalism" to make hedge funds fit into a modern portfolio. The industry also must develop enough capacity to "make it matter."

Mr. Asness predicted that part of this impending hedge fund evolution will involve moderating return expectations, arriving at rational fees, better benchmarking, an understanding and tolerance of headline risk as inevitable but manageable, and resolution of the "transparency wars" in which third parties take over portfolio holdings reporting.


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