The infinite monkey theorem states that a monkey hitting keys at random on a typewriter keyboard for an infinite amount of time will eventually bang out some sort of recognizable text, such as the complete works of William Shakespeare.

Along the same lines, one might argue that Exchange-Traded Funds, or ETFs, are a version of the monkey-at-typewriter theorem because they are a synthetic composition of securities combined into something that can mimic, if not the best, at least the same strategy and returns as a hedge fund manager — eventually.

Regular readers may remember Morningstar’s inaugural survey of advisors’ and institutional investors’ views on alternative investments last year (in partnership with Barron’s). Earlier this week, the firm released the 2009 version – containing some interesting year-to-year comparisons.

As you may recall, we were struck last year by the fact that around half of all respondents felt that alternative investments weren’t just growing in importance, but that they were actually going to be more important than bread & butter staples such as equities and fixed income.

Earlier in the week, we told you about a great 100 page “mini-book” on alpha/beta separation. The authors (Analytic Investors’ Roger Clarke & Harindra de Silva and Brigham Young University’s Steven Thorley) provide a clear and cogent argument for why you’d want to separate and re-proportion the active and passive components embedded in any actively-managed investment mandate.

While the generic case outlined in the document involves a traditional long-only active fund, the authors also explore the potential role of hedge funds in alpha/beta separation. They point out that despite the popular assumption that hedge fund returns are nearly all alpha, this is “only partially true” in aggregate.

Let’s say your active equity manager beats the index one month or one quarter. Fluke? Maybe so. How about a few months in a row or a few quarters in a row? The chance of them having horseshoes in their pockets becomes less likely as the number of months and quarters grows. But how many months does it take for you to know if your manager’s alleged “alpha” is truly alpha (i.e. skill) and how much is dumb luck. Furthermore, does this time horizon depend on the volatility of the fund itself?

These questions and others are addressed by a newly released paper by Sassan Zaker of Julius Bear. Zaker describes investors' willingness to accept (and reward) out performance of any kind as a “free put option” given to the manager.

The release of a study of hedge fund due diligence reports last week was met with predictable headlines such as “Hedge funds misrepresent facts, says research“, “Is Your Hedge Fund Manager Lying To You?,” and “Some Hedge Fund Managers Don’t Tell the Truth.”

The paper, “Trust & Delegation,” was penned by an all-star cast including Stephen Brown of NYU, William Goetzman of Yale, Bing Liang of UMass and Christopher Shwarz of UC Irvine. The quartet found that 21% of fund DD reports studied contained “misrepresentations” about past legal or regulatory problems and over a quarter contained “incorrect or unverifiable representations about other topics.”

Monday we argued that value-added, not “absolute returns”, should be the key metrics in judging the recent success of hedge funds. Implicit in that argument is the assumption that hedge fund investors turn to the asset class for its diversification properties. After all, losing less than the markets in 2008 was only commendable if it was not achieved by simply un-levering a market ETF.

Today, we learned of a recent survey of institutional investors that found just that. According to Preqin (see other interesting research from this rather prolific organization), over half of institutional investors surveyed said they invested in hedge funds for diversification purposes. The runner-up reason was “to improve the risk/return profile” of their portfolio” – another reference to the diversification properties of hedge funds.

Beyond being recognized as one of the founding fathers of hedge funds, Alfred Winslow Jones (see AllAboutAlpha’s tribute here), who would have hit the lofty age of 109 last month, in 1949 also introduced a concept not seen before: an incentive fee structured as a function of realized profits, with a set management fee to offset operating costs.

Sixty years on, the concept of “2 and 20” (bumped up from “1 and 20” about a decade ago, presumably due either to inflation, greed or both), has held as the hedge fund industry benchmark. While variations have emerged over the years, ranging from “1 and 10” for funds of hedge funds to “5 and 30” for highly sought after, pedigreed enterprises, most managers have stuck with it, for the main reason that most investors have been willing to pay it.

While we’re all accustomed to numerical (70%, 80%, 90%) and letter grades (A, B, C), there was a time in our distant youth when our academic prowess was judged simply to be “unsatisfactory” or “satisfactory”. It’s hard to get that jazzed about a “satisfactory” grade (Whoo-hoo! Jimmy got straight “satisfactories” on his report card!). But hey, it’s better than the alternative.

And that’s just how the hedge fund industry was recently graded by investors according to this report published last week by France-based Olympia Capital Management. The firm writes that “…hedge funds have delivered the performance in line with investors’ expectations.”

Although hedge funds in general have displayed an uncomfortably high equity beta over the past year, there have been two bright spots – strategies that follow-through on the promise of low market correlation (and therefore, assuming returns are positive, alpha). Global Macro is one such category. Market Neutral is the other.

When you think about it, this is somewhat counter-intuitive. Market neutral funds tend to use more quantitative strategies and trade more often than their buy (/sell) and hold long/short cousins. So you’d think that they rely heavily on market liquidity to get in and out of so many positions so quickly.

The one trend market pundits seem to collectively be predicting with ease for the hedge fund industry is so-called consolidation.

Which is why a list of the 100 largest U.S. hedge funds, ranked by equity assets, buried deep in Goldman Sachs’ (GS) recently released report on the state of the hedge fund industry, caught my late summer-diverted attention.

We’re in Asia for the next two weeks (Singapore, Hong Kong and Seoul), canvassing alternative investment professionals on last year’s annus mega-horribilis and finding out what got into the water that has led to this year’s miraculous rebound for both the hedge fund and long-only communities.

As the Economist reminded us last month:

In its semi-annual report on the Asset Management and Capital Markets businesses, M&A specialist Jeffries Putnam Lovell highlighted the continued increase in divestitures as a percentage of overall M&A activity affecting the asset management business. Traditionally, independent buyers and sellers tend to dominate deal activity, but as the report makes clear in numerous charts and tables, divestitures and strategic acquisitions by pure play asset managers have been the primary deal makers as of late. In doing so, the report raises important questions about the future of the asset management industry and alternative investment managers in particular.

Overall Environment:

A paper released by McKinsey & Co. last week concludes that 28% of asset managers are not responding adequately to the recent storm hitting their industry. McKinsey chalks this behavior up to “depression and denial”.

But wait. There is hope for the future of the asset management industry. The consultancy also concludes that 13% of asset management firms are “decisive operators” who have pared back costs and preserved profits (or at least, mitigated a fall in profits).

As the Economist pointed out a couple of weeks ago, the shipping industry has seen better days:

Since the recession bit hard last autumn a lot of attention has been paid to the plunge in the Baltic Dry Index, a composite measure of the cost of shipping bulk cargoes such as iron ore and coal. It fell by over 90% between June and October last year, although it has since recovered slightly and is hovering at just above a quarter of its peak.

“Innovation” is often held up as the engine of growth for modern economies. Technological innovation, business process innovation, even social innovation, have carried the hopes and dreams of companies and economies alike.

Then there’s financial innovation.

Despite being maligned as financial alchemy, alpha/beta separation refuses to die (probably because it’s a good idea, but we’re biased). For example, Carl Hess, Watson Wyatt’s Global Head of Investment consulting said in this press release:

As we move into a different and difficult market environment, we expect there will be more rapid developments around some emerging trends. One notable theme is transparency, particularly the separate identification of alpha and beta, as well as an increased focus on risk, both from investors and managers alike.

Although it is often summarily dismissed by critics, regulation does serve an important role in correcting so-called “market failures” such as economic externalities or asymmetric information. When a buyer (investor) makes a bad purchase decision, not only do they lose out, but the economy itself suffers from the resulting misallocation of resources (a.k.a. “adverse selection”).

But when regulations stray beyond the bounds of simply fixing these market failures, they too can lead to suboptimal results for buyers (investors) and the economy as a whole. In other words, the medicine can be worse than the disease.

Today, we bring you the first in a series of exclusive interviews with key players in the world of alpha-centric investing. Approximately once a month, we’ll pick someone from the pages of AllAboutAlpha.com or from the alternative investment industry in general and pose 7 topical and straightforward questions.

By Andrew Saunders, CAIA (AllAboutAlpha.com Editorial Board)

One of the great ironies in the hedge fund industry is the propensity for many investors to favor relative returns over absolute returns. This is particularly true among retail investors who, by and large, would prefer to lose money along with everyone else than to make less than everyone else. What else could explain the complacency with which investors accept -40% market returns while crying foul at the hedge funds that “under perform” in a bull market.

Research into happiness has dispelled the notion that utility is derived from some absolute level of wealth. Instead, it appears that utility is relative, not absolute - hence the paradox of the retail investor who is petrified of under performing his neighbours, but sanguine about losing his shirt alongside them.