By: Tristram Lett, Integra Capital
Published: Winter 2006, Canadian Investment Review

The term “zero sum game” generally describes a somewhat negative predicament.  For example, the field of psychology calls zero-sum games ”social traps” (MAD – mutually assured destruction, being one such trap).  Generally speaking a zero-sum game (such as chess) has one winner and one loser – no ties.

As William Sharpe famously declared, alpha is also a zero sum game.  If one group of investors manages to beat the average, then all other investors must lag the average by a commensurate amount in aggregate.  Hedge fund protagonists and “peak alpha theorists” have latched onto this logic to support the argument that hedge funds do not provide value because they do not, in aggregate, produce alpha.

Tris Lett, author of this insightful commentary on our favorite topic, is a bona fide alpha hunter.  But at the same time, he embraces the seemingly contradictory notion that alpha must be zero-sum in order for it to be valuable at all:

“…what makes (alpha) so special?  If alpha were positive in aggregate, then you could invest passively in it. And, if you could invest passively in it, it would not be that special—and fees would be beta-like. In other words, alpha needs to be zero-sum or it’s not special.”

In fact, Lett takes direct aim at the peak alpha community for suggesting that asset inflows into hedge funds “dilute” alpha:

“A general theme in the financial media today is that the large influx of investments flowing to hedge funds and the number of new firms servicing these investments is diluting alpha and, therefore, returns are falling and will continue to fall. I find that this theme tests credibility.”

Even after acknowledging that aggregate alpha is negative after management fees, Lett sees bright prospects for those who believe the future of asset management is all about alpha.  In fact, he believes a new generation of institutional alpha-generator will soon dominate the financial landscape (see related post).

“We are now witnessing the arrival of process driven, long-only, institutional managers offering absolute return strategies with a high degree of success. Barclays Global Investors, for example, went from a dead start in 2000 to $17 billion under management (unleveraged) in less than five years. These managers offer strategies with significant differences from mainstream hedge fund managers. Five characteristics distinguish them—lower fees, lower transaction costs, purer alpha, full transparency (risk or position) and monthly liquidity. The first two characteristics help increase the net alpha production for their clients. Purer alpha is a major bonus when combined with lower fees and also in portfolio construction. The final two characteristics give fiduciaries a great deal of comfort.”

We agree with Lett and would add that the hedge fund industry’s asset growth means that its aggregate alpha may simply be coming into line with that of the broader asset management universe: zero.  (Still, as long as hedge fund managers – as a subset of all asset managers – continue to eat some of the alpha lunch of the “non-hedge fund” universe, then hedge funds will continue to out-perform (see related post)).

But in any event, zero aggregate alpha hasn’t deterred investors from seeking active long-only returns in the past.  So why should low (or zero) aggregate alpha in hedge funds be any different?

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