Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investment in Hedge Fund Strategies Deliver?

By: Lars Jaeger & Christian Wagner, Partners Group
Published: November 7, 2005 

This article aims to give reference to this academic effort and provide a coherent discussion on the current status of ‘beta versus alpha’ controversy in the hedge fund industry. 

– Jaeger & Wagner 

We admit that we’ve been a little obsessed about the definition of alpha recently. It’s a phase. We’ll grow out of it. But we couldn’t resist the sheer number of Jaeger-isms in this article (i.e. colourful metaphors for alpha).  We even threw in a few of our own.

We have discussed the notion that alpha is simply beta that has not yet been commoditized, that hedge fund alpha is often exotic beta, and that systematic active/passive funds can fill the gap between true alpha and true beta.  This article sheds additional light on these issues. 

A Family Feud 

This extensive white paper was co-written by Lars Jaeger, a leading figure in the alternative investment research field (as many of you are aware). It’s a little long, but remarkably easy to follow. Jaeger and Wagner cover a number of key elements in the alpha/beta hedge fund debate. 

They essentially divide the world into two feuding families [our term, not Jaeger’s]: those that say hedge fund alpha is just a difficult-to-execute beta and those that they call alpha protagonists (Americans, read: the Hatfields and the McCoys). They say the source of this dichotomy is a lack of general agreement on the definition of alpha in the long-only world, let alone in the hedge fund space. 

In attempting to mediate this feud, Jaeger and Wagner propose a sort of continuum from real alpha to alternative beta to traditional beta: 

If the specific return is available only to a handful investors and the scheme of extracting it cannot be simply specified by a systematic process, then it is most likely real alpha. If it can be specified in a systematic way, but it involves non-conventional techniques such as short selling, leverage and the use of derivatives (techniques which are often used to specifically characterize hedge funds), then it is possibly beta, however in an alternative form, which we will refer to as ‘alternative beta’. In the hedge fund industry ‘Alternative beta’ is often sold as alpha, but is not real alpha as we define it. If finally extracting the returns does not require any of these special hedge fund techniques but rather long only investing, then it is ‘traditional beta’. 

Alpha: “Dark Matter” or Left-overs from Dinner?

Building on Fung & Hsieh’s seminal hedge fund factor modeling work, Jaeger & Wagner describe alpha as: 

the dark matter of the hedge fund universe. It can only be measured by separating everything else out and seeing what is left. In other words, alpha is never directly observable, but is measured jointly with beta. It can only be indirectly quantified by separating the beta components out. 

As a result, say the authors, alpha amounts to a garbage bag of inexplicable returns. This bag might contain real alpha or simply just risk factors that have not yet been discovered. (We would submit that two might actually be one in the same). 

 

Beta in Alpha’s Clothing 

Like many before them, Jaeger and Wagner suggest that beta is actually dressing in alpha’s clothing (Transvestite beta?  Eeeuww!). 

We estimate that up to 80% of the returns from hedge funds originate as the result of beta exposure (i.e. exposure to systematic risk factors) with the balance accounting for manager skill based alpha (or not yet identified risk factors). 

We at AllAboutAlpha.com might remove the or in the parentheses above since we believe that skill-based alpha is the exploitation of not yet identified risk factors. 

Hedge Fund Indices: Alpha or Beta? 

The authors review the commonly cited problems with hedge fund indices (survivorship bias, backfilling etc.). But they depart from the usual griping to define a true test for a hedge fund index: 

The true test of whether a hedge fund index is a valid investment vehicle is whether there is a secondary market for hedge funds, whether one can construct derivatives from it and whether it can be sold short. The possibility of short selling and constructing synthetic positions based on derivatives (in a cost efficient way) creates the prospect of arbitrage opportunities using the hedge fund indices. Ironically such arbitrage opportunities would most likely be exercised by hedge funds, in a sort of Klein bottle of investments that contain themselves. 

Alpha’s Future Career Prospects

The authors run through each major hedge fund sub-index and describe the explanatory power of their model – including the amount of alpha inherent in each strategy. But then they rain on the hedge fund parade: 

There is good reason to believe that generally the average alpha extracted by hedge fund managers is destined to decline. As a matter of fact, we can already today observe that alpha has grown smaller in size over time. 

They go on, like many others, to hypothesize that increasing hedge fund asset flows are ironing out market inefficiencies. Although they do throw the hedge fund industry a bone: 

However, there is no good reason to believe that the global capacity for alpha which is ultimately a function of how many inefficiencies the average global investorwill tolerate actually decreased over time that dramatically. 

An Alternative Explanation 

They propose a second hypothesis to explain low hedge fund returns: that the average quality of manager is decreasing. We like this hypothesis (although many of our best friends are hedge fund managers). Even if net global alpha is zero (which it is), then a sub-set of managers identified as hedge fund managers could, technically, come out on top if they showed some persistence in their positive returns. 

As Jaeger and Wagner suggest, alpha-generating hedge fund managers may, in fact, be taking less obvious cues from the market to make a trade: 

Alpha might depend on market related variables other than prices which are not so easily captured in our risk based models, such as trading volume, open short interest on stocks, insider activity, leverage financing policies of prime brokers, etc. 

And here is where the debate heats up. Are returns generated by the careful analysis of leverage financing policies alpha or beta? Perhaps they used to be alpha. But watch out! As soon as Jaeger and Wagner (and hoards of academics) catch up with you – it morphs into beta.

Alpha, Shmalpha! 

In conclusion, the authors say that our obsession with alpha (returns that can’t be traces to any conceivable risk factor) is misplaced. Rather, orthogonal hedge fund betas (a.k.a. exotic betas, alternative betas) are the primary benefit to be derived from hedge funds. 

the future growth prospects of the hedge fund industry become quite compelling considering that we are far from any limit with respect to beta capacity in the hedge fund industry. While the search of alpha surely remains compelling, we believe it is investment in alternative betas which will be more and more the key to successful hedge fund investing in the future.  

Whither Peak Alpha? 

And this leads us to the most important conclusion in this paper. The authors say that the global tolerance for market inefficiencies is 0.25% of global equity values (US$88 trillion). That’s only about $200 billion of true alpha. They figure that hedge fund managers, as a sub-set of all investment managers, can take about 25% of this alpha pie, or approximately $50 billion. Assuming those returns of $50 billion represented about 15% ROR across all funds, the capacity based on pure alpha alone is about $350 billion – much smaller than the current size of the industry. 

BUT, since the authors have shown us that only 20% of hedge fund returns are true alpha (the rest is made up of various forms of beta), overall hedge fund capacity is 5x larger than this.  They essentially conclude that “peak alpha” will be reached when the hedge fund industry reaches approximately $1.8 trillion. 

At $1 trillion, we’re only about 55% of the way there.  So the only thing Jaeger and Wagner left unsaid was “keep on truckin'”.

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