Synthetic Hedge Funds?
Jul 11th, 2006 | Filed under: Alternative Beta & Hedge Fund ReplicationBy: Alpha Male
Chris Woods of State Street Global Advisors makes a common argument against hedge funds in an article published on May 3, 2006 - that their returns are driven more by “exotic” or “alternative” beta than they are by alpha. Ergo, an investor could acheive the same returns more cheaply by investing in a passive basket of various risk factors rather than with a hedge fund manager.
Excerpts:
“Much of the time it seems that hedge fund managers are not giving the investor pure undiluted alpha, but rather delivering what have become known as alternative betas.
“Alternative beta refers to the risk premium earned by isolating asset characteristics that are rewarded. Examples of alternative betas include the Fama-French equity risk factors small-cap minus large-cap, and high-value minus low-value.”
“We envisage that the delivery of low-cost hedge fund beta will be attractive to those clients who are wary of the intricacies of self-service manager selection and of the costs of investing through funds-of-funds.”
Steve Forester, winner of AIMA Canada’s 2006 Research Award makes a similar argument in a paper to be published in an upcoming edition of Canadian Investment Review (and re-published at www.aima-canada.org).
But I question the premise of the cottage industry that has developed around calling into question the hedge fund model. Let’s take a simple example: You hand over $100 to a professional money manager and give her a mandate to invest in US equities. You give her no direction beyond that since you are not an expert investor. She likes the potential of the technology industry and decides to invest all of your money in technology stocks….
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[…] While the notion of a custom benchmark seems appealing, it is only helpful if the investor actually seeks such a benchmark. Firstly, fitting a historical return stream to over a dozen factors is bound to produce a low alpha. After all, the mathematics of regression are designed to do so. I have referred to this type of analysis as “gotcha academics” elsewhere on this blog. […]