So much for “double alpha”
Jun 4th, 2007 | Filed under: 130/30, CAPM / Alpha TheoryWhen 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.
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[…] 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). […]
[…] 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.” […]