Will Horlick's hedge fund for the masses work?

published 23 October 2006

The Sunday Telegraph reported last weekend that City "Superwoman" Nicola Horlick is about to turn her hand to hedge fund management. Fund Manager Bramdean Asset Management, which Horlick helped to set up, is reportedly to list its Alternative Investment Fund on the stock market from next year. What makes La Horlick's plan any different to existing hedge funds is that this product, a fund of hedge funds, will be aimed not at very wealthy individuals but at the "mass affluent" with "just a couple of thousand pounds" to invest. Expect buses and advertising hoardings to be plastered with Bramdean-related marketing in much the same way that we have come to learn more about the universe, while idling in many a traffic jam, through vague scrutiny of the offerings from New Star and Jupiter. But will it work?

Setting aside the regulator's obvious concerns regarding subjecting relatively unsophisticated investors to the vagaries of hedge funds in an environment of considerable over-capacity and falling returns we should remind those looking for scraps from a rich woman's table how hard it is to generate pure alpha in an overpopulated market place.

On 21st January 2005 we wrote that "We generally tend to view investor enthusiasm for hedge funds in a positive light". We argued then, as now, that the investment world should, and will, evolve towards a world of separating passive investment decisions (beta investing) from active decisions (alpha investing). Most institutional investors continue to merge their alpha a beta decisions(i.e. an institution typically decides how much money it wishes to invest in equities and then goes out and hires a fund manager to manage it). This is, in our opinion, inefficient as the two decisions are not linked. Investors should, instead, decide which asset classes they want to be in and then overlay on top of those asset classes the best alpha managers they can find. This alpha overlay is a better way to run a portfolio and many institutions at the cutting edge of industry thinking are moving towards managing money in this way.

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To the extent that investors use hedge funds to achieve some alpha spice to overlay their portfolio, the dive into hedge funds may be worth taking. But, evidence suggests that hedge funds themselves are increasingly mixing alpha and beta together, blurring the picture. To repeat ourselves, there are only two ways to make money in the equity market and it is important to distinguish between the two.

One way to make money in financial markets is to take on systematic risk, for which the market compensates you. This type of risk is called beta. For instance, asset classes like equities have a higher expected return than cash over time for the simple reason that they represent a more risky investment than cash. The same is true for long duration sovereign bonds over cash, corporate bonds over sovereign bonds, mortgages over sovereign bonds, emerging market debt over developed market debt etc. At any given point in time, risky financial assets may be expensive or cheap, but over time they should deliver higher returns than less risky investments. Beta investing is relatively easy (nave investment strategies can capture beta). Over longer periods of time, beta strategies have positive returns, however, they tend to have relatively low volatility and for the most part are closely correlated with one another (in part because risk is inherent within each of them).

The other way to make money in the financial markets is to take it away from other participants. This is known as alpha. Alpha investing is a zero sum game. For every buyer there is a seller and so for every alpha trade there is both a winner and a loser. Examples of alpha trading include market timing and active security selection. Only investors who are genuinely brighter than the market will be able, reliably, to produce alpha on an ongoing basis.

Finding managers who can, consistently, beat other financial market participants is certainly a daunting task. It is, however, necessary and unavoidable even in the fund of hedge funds market place. The skill is both rare and hard to achieve through varying market conditions. Thus the price of alpha is relatively high. This being the case, a relatively switched on investor should be unwilling to pay significant fees to an asset manager who is simply taking in risk premiums for them. Taking in risk premiums over the longer run is simple to replicate and it produces a very poor longterm ratio of risk / return (although it can produce strong returns in the short-term!). Since hedge funds typically mix the two strategies and charge for both the waters quickly become murky.

Given the continuing respect accorded to the hedge fund industry, the general perception must be that hedge funds are indeed producing alpha performance. In truth many hedge funds are simply packaging up beta and charging alpha-type management fees for it! Judging by recent industry performance statistics it is quite clear that even if the emperors aren't quite naked, the wardrobe is looking distinctly limited.

Our point is that, despite claims of individuality, most hedge funds carry a lot of beta embedded in their strategies and returns. Those investors already investing in, or considering an investment in, hedge funds need to consider the implications of these systematic risks and the costs associated with an investment that may not be all that it seems. For those readers sceptical of this conclusion and still eager to grip Mrs

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