So much for “double alpha”

4 June 2007

When explaining what they do for a living, long/short hedge fund managers will often use the term “double alpha”.  These managers attempt to generate alpha by outright stock picks in both their long and short books.  “Double alpha” is also sometimes invoked when describing the removal of the long-only constraint to benefit from the Fundamental Law of Active Management. 

Portable alpha - in its most basic form as a long position in an active manager and a short position in that manager’s benchmark - is not technically a “double alpha” strategy.  By shorting the benchmark to isolate manager alpha, a portable alpha manager relinquishes any potential alpha from the short book.  In other words, the short book is for hedging only. 

But in an ominous development, reported by Marketwatch on Friday , long/short managers are loading up their short books with ETFs instead of individual securities.  Apparently many managers now believe shorting individual stocks is too risky.  Having once had a ringside seat to takeover-rumour inspired short squeezes on terrible stocks, I am sympathetic to this concern.

But where does that leave the much heralded “double alpha”?  Well, I guess if the short book is full of a basket of ETFs whose weightings differ from those of the broad indices, then the short book can still be said to produce alpha.  But if long/short managers drift toward a passive short position in their benchmark, they can no longer lay claim to the double alpha argument.

Instead, they essentially become portable alpha funds.  This would be no big deal if such strategies were complicated and difficult to replicate.  Unfortunately for long/short managers however, going long an active manager and short their benchmark is not rocket science.  Such a world would put downward pressure on the fees paid by fiduciaries as they begin to view long/short managers as mere long-only managers with a (minor) twist.  As a result, they may be reading from this song sheet when it comes to fees, not the usual “2 and 20″ melody.

Curiously, using ETFs in the place of individual securities in a short book actually works against 1X0/X0 strategies (and against their theoretical rationale, the Fundamental Law of Active Management).  As the Marketwatch article cited above points out, shorting an ETF is a blunt instrument since it amounts to a short position in many names that the manager may not otherwise have wanted to short.  In other words, the primary benefit of 1X0/X0 - increasing a manager’s ability to express a negative view on a stock - is erased in favor of short positions across the board (assuming for a moment that the manager shorts only her benchmark). 

Sure, ETF-adopting long/short managers aren’t likely to create totally passive short books.  But the transition from an all-stock short book to an all ETF short book necessarily reduces the very “degree of freedom” so vaunted by 1X0/X0 advocates.  Good short ideas may be hard to find these days.  But giving up on the ability to express a significant negative view on a specific security comes with its own risks.

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2 Responses to “So much for “double alpha””

1. The Aleph Blog » Ten Important, but not Urgent Articles to Ponder Says:
   July 17th, 2007 at 3:32 am

   […] I work for a hedge fund, but I am dubious of the concept of double alpha.  It sounds nice in theory: make money off of your shorts and longs without taking overall market risk.  As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade.  Typically, hedge fund investors are only good at generating alpha on the long side.  The short side, particularly with the crowding that is going on there is much tougher to make money at.  If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare). […]

2. allaboutalpha.com: AllAboutAlpha.com Says:
   April 7th, 2008 at 7:51 pm

   […] This was a concern raised last June in this MarketWatch article (see related posting, “So Much for Double Alpha”): “Some equity hedge funds have quit short selling stocks because the strategy is riskier in a rising market and has become too crowded to be profitable. Instead, more managers are shorting exchange-traded funds. That’s a problem, according to some experts, who argue that using ETFs to hedge equity portfolios is a poor substitute for the real thing.” “ETFs are also indexes, and so, by definition, they provide so-called beta — that is, the return generated by the market. Hedge-fund managers are in the business of creating alpha and outpacing the market benchmarks. So if they build short positions with ETFs, that part of their strategy will track whatever portion of the market they’re betting against. That could end up looking more like beta than alpha.” […]