Atlanta Fed Q4 Economic Review: Focus on Hedge Funds

by: Christopher Holt

As mentioned last Thursday, the Atlanta Fed dedicated its Q4 ‘06 Economic Review to hedge funds, featuring lengthy articles from Fung & Hsieh, Andrew Lo and fellow academics from Columbia, UMass, & UC San Diego. The articles were based on presentations given by these luminaries at the Atlanta Fed’s scary-sounding May ‘06 conference ”Hedge Funds: Creators of Risk?”.

There are over a hundred pages of interesting, easy-to-read, research here if you ever get stuck on a Jet Blue aircraft on the runway in a blizzard. But in case you don’t have the luxury, we’ve pulled a few interesting charts and observations for you.

Fung & Hsieh Update 1997 Study on Hedge Fund Correlation to 8 Traditional Asset Classes

Fung & Hsieh provide succinct proof that hedge funds are uncorrelated to traditional asset classes by comparing the January 2005 Morningstar mutual fund data to data from various hedge fund databases. They ”re-regress” returns against 8 asset classes from their original ‘97 research and find that hedge funds continue to have a much lower correlation to these betas than do mutual funds…

If They Really Work, Hedge Fund Replication Prices Will Rise
Fung & Hsieh also argue that successful hedge fund replication will command the same prices as actual hedge funds. In other words, cheap hedge fund replication is almost an oxymoron.

“Replicating hedge fund alpha…takes us into the voluminous literature on portable alphas. Fung and Hsieh (2004a) showed that there are portable alphas in equity-related hedge fund strategies. However, we do not believe that these alphas can be replicated by statistical means at a lower cost. After all, why would anyone sell skill at below market-equilibrium price? Naturally, those who successfully generate persistent hedge fund alphas will simply join the ranks of hedge fund managers and price their services accordingly. So long as alpha remains a scarce commodity, new discoveries of alternative alpha sources are unlikely to depress the market price for alpha.”

We agree with this observation. After all, a lower cost structure (assuming for a moment that replication works), is no reason to set a low price. When was the last time a money manager said “Oh. Okay. I’ll drop my management fees now that Bloomberg has given me sweetheart a deal on those terminals.”? In a posting on February 12, we wrote:

“… the assumption that replicated hedge funds will necessarily be cheaper than real hedge funds is based on the assumption that traditional hedge funds price their services based on their costs. But the high profits earned by hedge fund managers and the extreme scalability of their business models clearly shows that hedge fund fees are currently based on their value to investors, not their underlying costs. So why would these new players want to set bargain prices for their services?”

Hurdle Rates Fail to Recognize Alternative Betas
Fung & Hsieh also discussed an issue raised on this blog recently: the apparent lack of any linkage between hurdle rates and alternative betas:

“Presumably investors are more willing to pay fees for hard-to-replicate alphas (and, to a lesser extent, hard-to-replicate factor bets or alternative beta factors) than returns from more easily replicable conventional beta-like exposures. To date, very few hedge fund contracts explicitly recognize these problems. For instance, rarely does one come across risk-adjusted benchmarks being used as part of the incentive fee hurdle. For now, there are no universally accepted investable performance benchmarks for different hedge fund strategies.”

Andrew Lo et al: an “NTSB” for Hedge Fund Blow Ups
Warning: don’t read this part if you are actually in a Jet Blue aircraft waiting to take off.

Andrew Lo and colleagues reiterate an argument put forth by him and others in 2004 that the government should establish a team of financial forensics experts to “sift through the wreckage of all major hedge fund collapses”:

“One possibility, put forward by Getmansky, Lo, and Mei (2004), is to create an independent organization along the lines of the National Transportation Safety Board (NTSB) to sift through the wreckage of all major hedge fund collapses, ultimately producing a publicly available report that documents the specific causes of the collapse, along with recommendations on how to avoid similar disasters in the future. Although there may be common themes in the demise of many hedge funds—too much leverage, too concentrated a portfolio, operational failures, securities fraud, or insufficient AUM—each liquidation has its own unique circumstances and is an opportunity for hedge fund managers and investors to learn and improve.

“In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough investigation, including interviewing witnesses, poring over historical flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder or “black box” and, if necessary, reassembling the aircraft from its parts to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a report summarizing the team’s investigation, concluding with specific recommendations for avoiding future occurrences of this type of accident. The report is entered into a searchable database that is available to the general public (see www.ntsb.gov/ntsb/query.asp), and this kind of information has been one of the major factors underlying the remarkable safety record of commercial air travel.”

Bruce Lehmann of UC San Diego: Two Distinct Governance Models for Hedge Funds
UC San Diego’s Bruce Lehmann told the Atlanta Fed that:

“…the hedge fund universe can be decomposed into only two groups for the purpose of understanding governance issues: those hedge funds that engage in proprietary trading and those that are more like private equity partnerships.”

He says that most hedge funds fit into the first (”proprietary trading”) model, while “private equity” type funds would include such things as distressed debt or buy-out funds, or activist funds. After drawing several parallels between hedge funds and either prop desks or private equity LPs, he reaches the conclusion that:

“Hedge funds should fall more under the purview of the SEC’s regulations governing broker/dealers, public corporations, or limited partnerships than under its regulations regarding mutual funds and money managers. The agency problems are more like those at Enron, Goldman Sachs, or law partnerships than they are like those at Vanguard or Fidelity.”