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Benefits and Pensions MonitorThe Truth About Hedge Funds Alpha – The Hedge Fund Word For ‘Value-add’ There are different definitions for ʻAlphaʼ in the hedge fund world. Without getting too theoretical, Alpha can be defined as value added by a hedge fund manager through skill as opposed to pure random chance. ʻBeta,ʼ very loosely speaking, refers to the broad markets. Some hedge funds do not promise to be uncorrelated with the markets, but rather are trying to beat the market. The Alpha, in this case, is defined to be the amount of return above beta, or the fundʼs outperformance of the appropriate index. Those that do beat the market consistently, and do so because of skill rather than chance, are adding Alpha. Market-neutral hedge fund strategies are non-correlated to the broad indices. These hedge funds are striving to deliver an absolute return, regardless of how the markets perform or what the market conditions are. This pure uncorrelated return can be thought of as Alpha. The amount of Alpha that these hedge funds are targeting will vary from fund to fund. There also exist hedge funds that are hybrids. There are hedge funds that try to offer a ʻbleedingʼ strategy – one that will be negatively correlated to the markets and produce mostly negative returns, with the goal of providing a good ʻhedgeʼ when the markets turn. Ultimately, though, one has to determine if the hedge fund is adding value in terms of risk and return. Returns – The Gretzky Rule Wayne Gretzky, when asked to comment on his extraordinary success as a hockey player, stated that, as a child, his father instructed him to “skate to where the puck is going, not to where it is.” Smart investors realize fairly early on that it is not a winning strategy to simply chase the returns puck and, in the hedge fund space, this is particularly dangerous. Last yearʼs winner is often the next yearʼs loser. Even comparing the returns of two hedge funds is like comparing apples to oranges. From a purely statistical point of view, hedge funds often exhibit characteristics that require a deeper analysis than just the return and volatility. The return of a fund that had the higher return might have had much more Beta, so it is the Alpha return that should be compared. Hotel California And Other Risks In evaluating a hedge fund, one is not only determining if the trading strategy is a viable way to make money, but also examining the business structure. This means that all risks have to be examined. For instance, is a reputable, independent administrator calculating the net asset value of the hedge fund? If not, then that is a show-stopper and you should stay away. It is wise to be very risk averse when it comes to validation and accounting issues. Proper operational due diligence and risk management controls are of the utmost importance. Many hedge funds realize that the deepest pockets will stay away if these areas are not satisfactory, and hence are striving to improve. This is ʻthe institutionalization of hedge funds.ʼ Proprietary is one of the favourite words used in this space. Everybody has something proprietary and they want you to think that their secret process is the most intelligent and best process available. Naturally, it is wise for managers to be discreet and it is unrealistic to expect too many details. Still, one should understand how they are generating their returns. If they donʼt give you enough transparency, do not invest. Liquidity risk should not be neglected. If you do decide to invest in a hedge fund, what is the lock-up? The Eagles song ʻHotel Californiaʼ is applicable in the hedge fund world. You may be able to “check out anytime you like, but you can never leave.” One must understand exactly how onerous the redemption clauses are. How Do I Get Me Some? There are numerous avenues to gain hedge fund exposure. As can be guessed there is no one right universal answer. Each investorʼs needs are unique and care must be taken to craft what is best on a case-bycase basis. A direct investment into a single hedge fund requires proper due diligence and monitoring. Investing into several hedge funds adds diversity to a portfolio, but, as can be guessed, requires more capital and more resources in conducting due diligence and monitoring. Large pensions and endowments often have the infrastructure to do this, but it is difficult for smaller shops to do effectively. A single multi-strategy hedge fund offers more diversification than a single-strategy hedge fund. However, it is often a challenge for the multi-strategy shop to keep their good traders from spinning off on their own. Funds of hedge funds might be the easiest way to enter the hedge funds arena, largely because a good fund of hedge funds is doing the work – combing the hedge fund universe, selecting good hedge funds, conducting due diligence, constructing the portfolio, monitoring it, and then repeating this cycle. However, it is important to do proper due diligence on the fund of hedge funds. Make sure that they are really working hard in scouting different hedge fund opportunities and conducting proper due diligence. As well, beware of shops that are style over substance. The newest way to get hedge fund exposure is via hedge fund indices that are investable. However, usually the best hedge funds are not part of a hedge fund index. There is much research currently being done, both academic and industrial, on hedge fund indices. All of this might seem rather overwhelming, but the truth is that to get started in hedge funds, one does not need to get fluent with portable alpha or risk budgeting. There are numerous studies which prove that adding hedge funds to a portfolio greatly increases the risk-return performance and many of the worldʼs finest pensions have been using hedge funds to add value for years. Hedge fund products that are uncorrelated to traditional assets offer diversification and can improve the risk return profile when injected in a traditional only portfolio. Diversification is the only free lunch in finance. ■
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Ranjan Bhaduri is with Graystone Research, Global Private Wealth Management, Morgan Stanley 