Do individual hedge funds really contain so much beta?
Nov 22nd, 2007 | Filed under: Alternative Beta & Hedge Fund ReplicationOne of our all-time favorite alpha-centric companies, Bridgewater Associates, released an interesting edition of its “Daily Observations” Newsletter earlier this week that caught our eye when a loyal reader passed it along to us. First, here’s why we’re fans. Says the latest edition of Daily Observations:
“As you know, we generally view the move into hedge funds as part of the evolution of money management. As we have described for many years now, the investment world should—and will—evolve towards a world of separating passive investment decisions (we call them beta) from active investment decisions (alpha). Most institutional investors continue to tie together their alpha and beta decisions (i.e. an institution typically decides how much money they want in equities and then goes out and hires equity managers to manage it). This is clearly inefficient, as the two decisions need not be linked. Instead, investors should decide which asset classes they want to be in and then overlay on top of these asset classes the best alpha managers they can find, no matter which asset class they get their alpha from. This is alpha overlay and it is a better way to run a portfolio. Cutting-edge institutions have begun to manage their assets this way, and the rest of the world will eventually adopt this superior strategy.”
Later in this issue, the firm reiterates its January 2007 observations about alternative beta. While we are fans, we felt that Bridgewater didn’t address a few key issues in its analysis. Knowing first hand, however, how the like to keep to itself, we opted to bite our tongues (Ed: to clarify, each opting to bite their own tongues).
But since our friends at HedgeWorld chose to run with the story, we felt that now might be a good time to chime in.
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I agree with the above assessment. The broad hedge fund indices bear little resemblence to individual hedge funds. However, they do represent the value of something else- the performance improvement that comes from relaxing investment constraints.
Traditional investments are highly constrained because they can only go long, they’re forced to overdiversify and they’re confined to narrow strategy catagories (e.g. large cap value). In contrast, the broad hedge fund indices represent the value of being able to go long and short, concentrate positions, and employ a variety of styles. In a similar fashion, 130/30 relaxes the long-only constraint, and diversified beta funds like Bridgewater’s All-Weather or AQR’s Diversified Beta relax the narrow-strategy constraint.
It may be that the true contribution of alternative beta isn’t the ability to track these indices, its the performance pickup that comes from relaxing investment contraints. Discuss.
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