By: Alpha Male

Thanks go out to Abnormal Returns for giving Alpha Male a heads-up about a recent Economist article of particular relevance to this blog. (link to article)

The article begins by suggesting that the growth in the ETF Industry and the hedge fund industry are inter-related.

“From January 1st through to August 31st, the average hedge fund returned just 4.2%, according to Merrill Lynch, less than the S&P 500 index’s 5.8% total return.

“So why are people paying up? In part, because investors have learned to distinguish between the market return, dubbed beta, and managers’ outperformance, known as alpha. ‘Why wouldn’t you buy beta and alpha separately?’ asks Arno Kitts of Henderson Global Investors, a fund-management firm. ‘Beta is a commodity and alpha is about skill.’”

So, full points for positioning hedge funds in the appropriate context.  However, the magazine goes on to reinforce some of the “urban myths” surrounding hedge funds.  Firstly, it is unfair to say that investors seek out hedge funds for “higher returns”:

“And yet investors may be willing to gamble, despite the higher fees, because they desperately need high returns.”

Historical market (beta) volatility is in the 15% range.  Generally speaking, alpha (particularly if diversified in the form of a fund of funds) is less volatile than beta.  If investors ”desperately need high returns”, then why not a levered ETF?  If the answer is that the investor is bearish on the overall market, then why not a levered short ETF?  And if the investor has no idea which way the market will go, then why would they bet that hedge funds would beat it?

The truth is that institutional investors don’t invest in hedge funds because they “desperately need high returns”.  They invest because they are tired of riding a roller coaster each year.   

The Economist also raises the scepter of capacity-constraints limiting future hedge fund returns. 

“…top-performing managers, especially in hedge funds, may well close their doors to new investors to prevent returns being diluted.”

This urban myth has been circulating for a number of years.  While it is true that hedge fund returns have been less dramatic over the past 2 years of massive asset inflows, the causal relationship remains dubious.  Returns have been muted for a variety of reasons (more likely related to self-selection or “launch bias” in the hedge fund indices).  Research at the Edhec Business School, a leading academic researcher of alternative assets, shows that hedge funds themselves don’t really believe this (EDHEC survey shows that industry professionals do not feel overly threatened by the capacity effect).  Indeed, their research shows that it may not even be true:

“The capacity problem that is supposedly linked to the disappearance of arbitrage opportunities has not been demonstrated and cannot, in our opinion, be demonstrated.”

(Capacity Effect or Incapacity Effect? , Prof. Noel Amenc, Edhec Business School, June 17, 2005)

Alpha Male believes that the capacity-limitation yarn is more often spun by shrewd hedge fund marketing executives to get investors “off the fence” and into their funds.  But it seems to have backfired since it is commonly cited (as it is by the Economist) as a reason to have second thoughts about hedge funds in general.

To conclude, the Economist seems to contradict its own suggestion that there is a relationship between the growth of ETFs and the growth of hedge funds by positioning them as alternatives to each other, not complements:

“Nevertheless investors will probably keep pursuing alpha, even though the cheaper alternatives of ETFs and tracker funds are available.”

Read Full Article (free) 

- Alpha Male