Citigroup’s Neil Brown and Rui de Figueiredo see hedge funds not as a distinct asset class, but as a distinct governance structure - one that is ideally designed to generate alpha. As a result, they view the competition between hedge funds and traditional long-only funds as a “competition between governance structures”. And they are clear that hedge funds have an inherent structural advantage when it comes to creating alpha.
“Why do the traditional governance structures exist at all? One answer may be that traditional (long-only) active managers care relatively less about alpha generation than hedge fund managers do. Before the emergence of more sophisticated financial instruments, many investors had no choice but to bundle alpha with beta.”
We here at AllAboutAlpha agree. We believe a loosening of the requirement to track a benchmark shifts control from the investor to the manager. Naturally, this requires re-writing the manager-investor compact. This new governance framework that results has many warts (including, for example, a lack of transparency, potential “style-drift”, and less frequent reporting). But it also enables manager skill (a.k.a. alpha) to freely bubbled to the surface.
Brown and de Figueiredo continue:
“Asset management is experiencing an unbundling of value-producing services and is creating more choices for investors. The active management industry, like all industries, undergoes phases of change. The current phase is characterized by the unbundling of services and the expansion of consumer choice—specifically, the emergence of separate delivery mechanisms for alpha and beta. Hedge funds, unlike traditional long-only funds, are more focused on the delivery of alpha.”
“…the hedge fund structure, although imperfect, ultimately is better suited for managing the separate production and delivery of alpha than the traditional long-only fund structures.”
But although hedge funds have a unique governance model, they participate in the same battle for alpha as all other investors (hedge and long-only alike). As a result, “hedge fund capacity” is really a misnomer. Lars Jaeger and Christian Wagner highlighted this fact in their interesting approach to calculating the theoretical capacity of the hedge fund industry. For this reason, Brown and de Figueiredo also believe the capacity of the hedge fund industry “must be examined in a larger context”.
“The hedge fund ‘industry’ is not really an industry at all. Discussions about the future of the ‘hedge fund industry’ are misguided because we do not believe that hedge funds alone constitute an industry. Hedge funds, rather, represent a particular business model and governance structure within the broader active management industry.”
With their greater proportion of active risk, Brown and de Figueiredo calculate that hedge funds punch above their weight when it comes to active risk. While they represent about 5% of the asset management industry, they account for 12% of active risk. Still, this is only a portion of a much “broader active management industry”. So, they ask, why should alpha be zero-sum within that 12%?
The report continues:
“The implication for investors is that while hedge funds may operate in an industry that theoretically is zero-sum over the long run, the imposition of the zero-sum constraint on the industry as a whole may not be a meaningful predictor of hedge fund returns. Within a segment, alpha is not necessarily zero-sum, even over the long run.”
Positive alpha within the hedge fund industry assumes either a) hedge fund industry participants provide value to non-economic players on the other sides of their trades (e.g. farmers, oil companies, insurance companies), or b) hedge fund managers are smarter than the rest of us.
For a) to be correct, we would have to further assume that the alpha voluntarily given up by non-economic players is not proportionately exploited by the long-only industry - that it is tilted toward the managers who self-select as “hedge fund managers”. This might be true given that looser governance might give hedge funds the latitude required to pursue such strategies.
For b) to be correct, we would have to assume capital is artificially constrained from sloshing to the hedge fund side of the bathtub to drown such out-performance and iron out any advantages held by the hedge funds. After all, isn’t that the way financial markets are supposed to work? Capital flows toward higher returns until those returns come in line with market risk premia?
This might not be so far-fetched given regulations (and a cultural bias in many countries) against hedge fund investments. In fact, we propose that a) and b) might work in concert to create a sustainable alpha for hedge funds - at least in the short and mid-term. In other words, exotic strategies might better exploit non-economic players, then regulatory constraints provide barriers to the capital inflows required to equalize alpha (at zero-sum) between the hedge fund and traditional long-only funds. Just a theory. If you think we’re on drugs, click “register” and comment on this posting.
In any case, we wonder if Brown and de Figueiredo are AllAboutAlpha regulars. Because if they’re not, they should be. Their observation about twin trends of ETFs and hedge funds aligns very closely with our view.
“As the asset management industry has evolved, investors increasingly have been able to access beta exposure inexpensively and easily—through the development of low-cost index tracking funds, ETFs and derivatives. It is not surprising that hedge funds—which provide investors with a purer form of alpha—have rapidly expanded at the same time. Investors now can choose alpha and beta separately and can mix and match to their precise specifications.”
They provide three reasons why a hedge fund structure may be more conducive to alpha generation than a traditional long-only structure: protection of intellectual property (a.k.a. opacity), performance incentives (whose asymmetry, they say, can be mitigated through manager co-investment), and lack of constraints (a la Grinold’s “Fundamental Law of Active Management“).
In conclusion, Brown and de Figueiredo say that hedge fund governance and traditional long-only governance will converge in the form of 130/30 strategies and re-bundling of separate alpha and beta components by one firm:
“For customers who want packaged solutions, these combined solutions are effectively the same as buying the pieces, with the same economics as if the pieces had been purchased separately. The key point is that the incentive characteristics are aligned to each of the pieces more appropriately.”
This lengthy article is thought-provoking and highly recommended.