It is no secret that we invest in hedge funds. At the same time it should be apparent to both readers of the Absolute Return Letter and clients of Absolute Return Partners that we are indeed among the most critical of the hedge fund industry. The point we make consistently is that investors should stay away from highly directional and leveraged equity funds dressed up as hedge funds.
In the July issue of this letter we wrote about the reasons why we find it difficult to get excited about emerging market hedge funds. We concluded that these types of hedge funds tend to outperform broad equity indices when markets are rising, and they underperform when markets are falling.
Last month we demonstrated that the correlation between the stock market and long/short equity hedge funds has risen to almost 0.9 from levels around 0.4-0.5 a decade ago.
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Recently we came across an interesting article from Bridgewater Associates named "Hedge Funds Selling Beta as Alpha". The author argues that many hedge funds package up beta and sell it as alpha, thereby implying that the funds in question charge high fees without delivering any form of hedge.
In very simple terms beta is the return that can be explained by market movements and alpha is the return over and above the market return which the manager is capable of generating. If the market is up 7% (beta = 7%) and the manager generates a return of 10%, we say that he generated alpha of 3%. In the hedge fund industry managers are paid to produce alpha. Bridgewater Associates constructed a number of "naive" (long only) funds, replicating to the best of their ability the return pattern of the corresponding hedge fund indices over the past 10 years. As you can see from table 1 below, it makes for some interesting reading.
Correlation of Hedge Fund Strategies
Convertible Arbitrage 50% (70% last 3 years)
Fixed Income Arbitrage 78%
Emerging Markets 80%
Distressed Securities 78%
Risk Arbitrage 52%
Managed Futures 70%
Source: Bridgewater Associates
The inevitable conclusion is that hedge fund investors buy a significant amount of beta when indiscriminately investing in hedge funds. Some of the numbers above are surprisingly, and frankly disappointingly, high. Investors are entitled to expect more from the industry. Certainly we do.
Increasingly the hedge fund industry subjects itself to very risky and speculative strategies wrapped as hedge funds. Ideally an equity long/short fund or an arbitrage fund should take two speculative tools, short sales and leverage, and apply them in a conservative manner, as Alfred Winslow Jones did when he established the first hedge fund back in 1949. His goal was to lift the burden of performance from market timing to stock picking. It was simple and it worked, which is more than a lot of today's hedge funds manager can say about their models. Of course, we recognise that we are making broad generalisations here, but our point is that investors should look very carefully at the strategies they invest in. We spend a huge amount of time on this process because we believe it is an essential ingredient in generating absolute returns.
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