It is often argued that aggregate hedge fund performance data suffers from a near-fatal flaw: since it is voluntarily reported by the manager, hedge fund indices only include funds that the managers have deemed marketable.  In 2002, David Hsieh of Duke University and William Fung of London Business School wrote a seminal article on this issue called “Benchmarks of Hedge Fund Performance: Information Content and Measurement Biases.”

In contrast, regulations often require mutual funds to register with securities authorities before they can begin to assemble a track record.  As a result, mutual fund data is assumed to be free of such bias.

But as Alan Palmiter and Ahmed Taha, law professors at Wake Forest University write in a forthcoming article for the Vanderbilt Law Review called “Star Creation: The Manipulation of Mutual Fund Performance Through Incubation“, the requirement for a mutual fund to register does not eliminate the problems arising from so-called “mutual fund incubation.”

Observe the professors:

More…

Those new to the hedge fund industry often find the concept of “buying volatility” and “selling volatility” to be somewhat confusing.  Volatility, after all, is not a tangible thing that can be bought and sold (save for the VIX), but is rather a description of tangible assets (a “volatile stock” or a “low-volatility fund”).

Yet hedge funds are often accused of simply “selling” volatility to generate returns, resulting in them being “short volatility”.  A short position in a stock implies that you would gain if the stock went down and lose if the stock went up.  Similarly, a short position in volatility implies you would gain if volatility went down and lose if it went up.

So how could you construct a position that would gain when volatility goes down and lose when volatility goes up?  Sell (i.e. write) options contracts.

Not unlike writing an insurance contract, writing options generates a steady stream of premiums with no apparent cost – until the judgment day comes.  In other words, if volatility unexpectedly jumps (as it does in severe market downturns), then you’d have to pay the piper.  Obviously, this could erase all of the apparently risk-free returns you seemed to be receiving by writing options over the the years.

Some say that’s how hedge fund managers really make their money.  Last year, we told you about a paper by Wharton’s Dean Foster and Peyton Young of Oxford University that claimed, among other things, that hedge fund managers routinely “fake” their alpha by simply writing puts and collecting the premiums (see post).  Wrote Foster and Young:

More…

Regardless of their underlying investment strategy, it’s reasonable to expect that all funds should be comparable at some common level.  The proof is in the pudding.  Or, as we like to say, it’s not about “hedge funds” or “mutual funds”, it’s all about alpha.

While the calculus for comparing hedge funds and mutual funds on an “apples to apples” basis seems to be slow in coming, a gaggle of academic studies over the past 2 decades have proposed performance measures that compare the value-added by mutual fund managers regardless of the underlying style.

One such metric – called “Active Share” – was proposed in 2008 by Martijn Cremers and Antti Petajisto of Yale (see previous post).  This metric is based on the divergence of the fund’s holdings to those of a passive index.  Cremers and Petajisto found that funds with a higher Active Share tended to perform better than those with a low Active Share.

The notion of Active Share is intuitive, but as you can imagine its calculation is data-intensive (you need to know the holdings of thousands of mutual funds in order to make any conclusions).

More…

By design, hedge funds have a much lower correlation to equity market indices than mutual funds.  Regular readers may remember this chart from a presentation given by Bill Fung and David Hsieh to the Atlanta Fed back in 2006.  The chart shows the proportion of both hedge funds and mutual funds that fall into each of ten buckets based on their correlation to equity markets. 

Now a new paper by researchers at the University of California takes the same general idea and applies it to hedge fund strategies themselves.  The authors Lu Zheng and Ashley Wang aim to determine if manager and strategy “distinctiveness” is a predictor of positive alpha in the long run.  To do this, they use a measure they call the strategy distinctiveness index.  The “SDI” is simply one minus the r-squared of the manager’s return vs. those of her peer group. 

Once the SDIs for over 2000 hedge funds in the Lipper Tass database were calculated, Zheng and Wang grouped them into deciles.  As you might have guessed, certain hedge fund strategies tended to be the home of highly idiosyncratic managers with a low average correlation to their sub-index (e.g. market neutral), and certain strategies tended to be the home of a large number of managers with a high correlation to their sub-index (e.g. CTAs). 

More…

David Hsieh

Bank of America Professor of Finance, Fuqua School of Business, Duke University. 

Homepage (Duke)
Research (SSRN), Research (Duke)
Recent Course Syllabus (Duke)
Relevant Postings (AllAboutAlpha.com)
   

“We essentially have 10,000 Ph.D.s looking at the same data.”

That’s how Vadim Zlotnikov, CIO for growth equities at AllianceBernstein described the world of quant funds to the Annual Meeting of the CFA Institute last week in Vancouver.  Zlotnikov was talking about the findings of a new paper by the Research Foundation of the CFA Institute based on a survey of asset managers, consultants and investors.   

A press release announcing the study confirms what is now commonly believed, that August’s mayhem was mainly the result of quant hedge funds yelling “Fire!” and running for the exits (see related posting).

Larry Siegel, the Director of the Research Foundation of the CFA Institute (see previous guest posting), points out the supreme irony of this development:

More…

In the late 1990’s a couple of academics David Hsieh (Duke University) and Bill Fung (London Business School) wondered if traditional statistical analysis was appropriate for a new type of investment fund – the hedge fund. Although they had collaborated since early that decade, their 1997 paper “Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds” put the two on a collision course with history.  Several years later they teamed up with the equally prolific Narayan Naik, who worked with Fung at LBS and met Hsieh at Duke while doing his PhD.  Last week the trio landed another in a long string of commercial successes advising some of the world’s most powerful financial institutions.

On Friday, State Street Global Advisors announced they had landed a US$200 million “hedge fund replication” mandate from the Universities Superannuation Scheme, a British pension plan serving the country’s academic community.  This is newsworthy since its one of the first major pensions to pursue such a strategy (although there has been lots of talk).

A State Street official sounded a refrain that will be familiar to regular readers of AllAboutAlpha.com:

More…

Here is a sample of the news stories we didn’t get a chance to explore in detail this week.  As usual, all of them can be found on the Alpha-ticker above or in the news items section of AllAboutAlpha.com (free registration may be required for a few of these).

Morgan Stanley says Alpha/Beta Separation “the way of the future”. The AllAboutAlpha site partner lays out its alpha-centric philosophy telling IPE that the pension industry is about to experience a “second wave” of LDI strategies based on the separation of alpha and beta.

Dutch Insurer Aegon splits portfolio into alpha and beta segments are farms each one out to a different manager. According to the firm’s press release, “By managing the parts separately from one another, better risk-return ratios are possible. This way, more sources of value added will be available and a greater focus can be created in the portfolio. Separating the US share portfolio has created an increase of a yearly average of the total return of 2.5% without any risk increase.”

More…

Earlier today, a conference wrapped up in London featuring some of the big names in the hedge fund replication industry (Bill Fung & David Hsieh – see related news item from today, Lars Jaeger – see related posting, and William Shadwick – see related posting, and others).  In case you couldn’t make it to this powwow, you’re in luck.  We trained an uncommonly intelligent house fly (he prefers the name “Musca Domestica”) to take notes over the past two days and send them to us by a miniature fly-sized Blackberry.  What follows are the Blackberry ruminations of our ‘fly on the wall’ at the world’s leading alternative beta gabfest.

9:00 AM Monday, March 10: “Got in yesterday despite the bad weather back home and a 300 mph jet stream (which also cramped up my wings a little – had to get a wing massage – but don’t worry, I won’t expense that).  Nice Sunday afternoon in London though.  Saw a Goose and a Black Swan cavorting yesterday in the park across from Buckingham Palace.  Bad omen?  Daffodils are blooming here, but storm coming in to London today.  Miserable this morning.  Hopefully send something more interesting about replication shortly.”

10:23 AM: “Peter Norman from AP7 discussed their separation of alpha and beta (see related posting). They get beta for free given its low-cost. Then they pursue alpha through risk budgeting to managers and not through capital allocations.  Long positions are funded by short positions.  AP7 covers any temporary losses and allows managers to use their credit.  Risk allocation is done using a tracking error methodology carried over from their old long-only active management approach.  Going forward, contemplating moving to a VaR approach.”

More…

We are pleased to bring you a guest posting today from Dr. Lars Jaeger of Partners Group.  Regular readers and students of hedge fund replication will recall that Dr. Jaeger edited one of the first books covering the topic back in 2003.   Since then, he has written a number of papers on hedge fund replication (see related posting) and has spoken at many conferences.  He’s also one of the speakers on the programme for Terrapinn’s second Alternative Beta & Hedge Fund Replication conference in London (March 10-12).

Hedge Fund Replication and Alternative Beta: Two different ways of looking at replicating hedge funds

Special to AllAboutAlpha.com by: Lars Jaeger, Ph.D., CFA, FRM, Partner, Partners Group

The discussion on alpha versus beta in the breakdown of investment returns is as old as the capital asset pricing model which defined these terms some 40 years ago.  Today, it has finally reached the hedge fund industry – an area of investing traditionally associated with pure alpha or absolute return.

Investors and researchers alike realize that hedge fund returns are largely composed of betas. However, hedge fund beta is different from traditional beta.  While both are the result of exposures to systematic risks in the global capital markets, beta in hedge fund investing can be significantly more complex than traditional beta (and can be often be “hidden in the alpha smokescreen”).

We therefore refer to this beta as “alternative beta”, a term that now part of the hedge fund lexicon.  In fact, the increased academic and non-academic effort to model and understand hedge fund return sources has also reached Wall Street.  The new buzzword: “hedge fund replication”.

Most providers of “hedge fund replication” use a trading model application of a linear factor decomposition of hedge fund returns (as represented by particular return time series).  However, these models yield satisfactory results for only a few hedge fund strategies, namely directional ones such as Long/Short Equity or Event Driven (see Table 1 for the R-squared values for various strategy sectors).

When linear factor models work, traditional beta (i.e., equity market factors) are all that is required.  In other words, hedge fund replication of this kind works when investors need it least to work – in the directional equity space.

On the other hand, linear factor models are not satisfactorily successful when applied to most other hedge fund strategy sectors, specifically non-directional and Relative Value hedge funds or indices.  In order to cope with these strategies we have to employ more complex market factors and/or dynamically adjust factors to include non-linear profiles.  These factors are likely to represent dynamic trading strategies that capture alternative risk premia with their contingent and non-linear payout profiles.

In addition, linear models are backward looking only.  In contrast to hedge fund managers who base their decisions on current data, these models adjust exposures with a significant time lag.  This can be problematic in a fast changing environment!

Many hedge fund “replicators” use these backward looking regression models as the basis to estimate current and future hedge fund exposures.  They essentially ask “Why not give up on alternative beta and model hedge funds with traditional beta only?”

Actually, this approach would have proven reasonably successful in the last four years (which is exactly the period most providers choose to display when they show their back-tested performance to attract investors).   However, even in this benign environment for equity directional strategies, alternative betas can add value to investors’ portfolios.  Figure 1 shows a simple risk weighted average of the following generic alternative beta factors:

• Deutsche Bank Carry Index,
• CDX High Yield Index,
• CRB Commodity Index,
• value versus growth spread,
• small cap versus large cap spread,
• BXM covered call writing (BXM Index – 0.5*SPX Index),
• the Merger Arbitrage Fund (MERFX  Index), and,
• the spread between emerging market equity returns and developed equity markets (MSCI Emerging Markets – MSCI World).

The second chart represents the Merrill Lynch factor model which we believe is a very good proxy for the equity component in hedge fund returns.

Source: Bloomberg, PG calculation*

We see that alternative beta can yield similarly attractive results as equity beta in hedge funds during periods of equity bull markets. The result looks very different, however, when we include the bear market from March 2000 to March 2003, a period when hedge funds, in aggregate, made money despite heavy losses in the equity markets.  This is shown in the figure below, which is based on the same data - just extended further into the past.  Here we see the real attractiveness of alternative betas.

Source: Bloomberg, PG calculation

However, the large majority of alternative beta can only be extracted by conditional trading rules directly aimed at benefiting from particular risk premia in the global capital markets.  Instead of naively replicating past properties of doubtful (i.e., biased) time series with inappropriate (i.e., linear) models, it seems more appropriate to tackle the hedge fund risk premia/alternative betas one by one.  We believe that the hedge fund investor is well advised to stay with the alternative beta returns rather than chase the pseudo hedge fund returns of traditional beta.  Hedge funds may be simpler than what many investors have believed so far, but they are not that simple.

How recent market developments have impacted the field of “hedge fund replication”

In Roman mythology, Janus is the god of gates and doors as well as of beginnings and endings.  He is usually depicted with two faces looking in opposite directions.  The year 2007 will be remembered by investors as a Janus year.  The first half was sparked with euphoria and buoyant equity markets, only shortly interrupted by the turbulences in late February/early March.

Retrospectively, many consider this period now as the end of the four year period of low volatility and low investor risk aversion that began in 2003.  In contrast, the second half of 2007 proved one of the most difficult periods for investors in the last decade - comparable perhaps only to the summer of 1998.  The second half of 2007 have represented the beginning of a new phase in the global markets characterized by higher volatility, more uncertainty and hence higher risk premiums across asset classes.

A closer look reveals that the crisis triggered by the US sub-prime market, which sent shock waves around the world is mostly a non-equity crisis.  While the credit and the inter-bank lending market was sent into paralysis, the FX markets turned the carry trade sour, small cap and value underperformed large cap and growth, volatility soared, and merger deal spreads widened dramatically.  But the global equity markets themselves experienced limited losses (albeit showing much higher volatility).  The MSCI World index closed 2007 only about 5% below its all time high.

This caused hedge fund replication programs that focus on alternative (hedge fund) beta to underperform those based on traditional equity beta.  The first 20 days of trading in 2008 shows that this is about to change.

Note: The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

It was only a couple of years ago that David Hsieh made an off-the-cuff remark that many took as a questioning of the long-term viability of the hedge fund industry (see related posting).  He estimated that around $30 billion of alpha was available to hedge fund managers.  This immediately started a round of navel-gazing in the industry the led to a number of competing estimates of the total supply of alpha in the world (such as this one by Lars Jaeger).  Was alpha going to run out?  Would the party be over soon?  Was there a “peak alpha” theory?  These became the dominant questions of 2006.

Now it appears those concerns were so “last year“.

Both Hsieh and Jaeger were among a dozen experts to address a packed audience in New York today at the inaugural US edition of Terrapinn’s “Alternative Beta & Hedge Fund Replication” conference.  This time aorund, Alpha Male took a turn at being master of ceremonies. (see related postings on sister events in London and Geneva earlier this year).

Instead of worrying about the finite size of the world’s alpha supply, Hsieh, Jaeger et al argued that hedge funds would likely survive on a diet of “alternative beta” even if their traditional food source (alpha-generating market inefficiencies) ran out.

More…