Here’s an interesting example of a genetically modified hedge fund that aims to deliver pure alpha. Armajaro Asset Management, a UK-based firm with significant business in Africa, recently launched a synthetic market neutral equity fund that the firm calls the purest representation of the portable alpha concept.

As we have illustrated on this blog, a dynamically adjusted market-hedge can neutralize the beta exposure in a typical long-only fund. Interestingly, Armajaro starts with a long/short fund that presumably would have a lower beta component already. In fact, if the underlying fund were variable bias (sometimes long and sometimes short) then the market hedge would also have to be long or short to neutralize the exposure.

Alpha Male once cooked up a synthetic hedge fund that comprised of a position in an underlying long-only fund, a position in an underlying short-biased fund, and a position in an ETF (long or short). The ETF was dynamically adjusted to provide clients with a static pre-defined beta exposure.  Armajaro seems to have taken a similar tack. According to the firm:

To create the product, (the) Fund invests in equity long/short hedge fund managers on a managed account platform. Each manager trades the managed account as his strategy dictates – typically with some equity market exposure. Armajaro calculates and hedges the net aggregate equity market exposure (positive or negative) of each hedge fund manager’s portfolio with an appropriate number of equity index futures contracts on a daily basis.

Of course, the trick with the dynamic hedge is to know how many futures contracts to sell (or buy). Armajaro adds up the total dollar exposure of each underlying manager and shorts out that exposure en masse using index futures. But what about the beta-weighted exposure of each underlying manager? A relatively dollar-neutral manager with a high volatility short book might actually require a long futures position to neutralize her performance.  After all, the goal is to create a fund whose performance has no beta, not necessarily one whose positions themselves contain no aggregate beta.

Even if the fund was beta-neutralized today, its returns could easily display a non-zero market correlation going forward. Stripping beta out of future returns by adjusting the current market exposure is like driving the proverbial car looking out the rear-view mirror (not that any of us have actually tried this – so I’m guessing here). The divergence between the static market exposure of the fund and the beta of the fund’s future returns can be chalked up to the quality of the betas. It seems to me that a static market neutral fund will only lead to a pure alpha track record if the individual positions perform in exact accordance with their beta (i.e. the betas all have a 1.0 r-squared).

While some academics might have field day raining on Armajaro’s parade, this is an initiative worthy of praise and Alpha Male agrees with the Armajaro marketing guy.  Says the press release:

Commenting on the announcement, Neil Heywood, Sales & Marketing Director of Armajaro Asset Management, said: ‘A Fund such as (this) that offers pure alpha is always the perfect addition to all portfolios as it offers a return stream that will behave independently of markets and other investments’.

Footnote: As the above excerpt from the Armajaro press release illustrates, it’s always fun to quote yourself in a press release that you yourself wrote (Alpha Male is guilty on several counts). Referring to one’s self in the third person like this reminds Alpha Male of the Jimmy character from Seinfeld: As in, Jimmy likes pure alpha funds.

- Alpha Male