The Economist Overstates Hedge Fund Complexity

by: Christopher Holt

This week’s Buttonwood column in The Economist says there is a paradox (a “catch two-and-twenty”) at work in the alternative investment industry.  But when you think about it, the reasons for recent muted returns may be a lot simpler than they appear.  

“Catch” #1: If everyone invested in hedge funds, the average hedge fund would not beat the index. 

…suppose that every institution handed its portfolio to hedge-fund managers. The average fund manager cannot earn more than the market. After costs, he must earn less…

Put forth as a sort of “victim of its own success” argument, this is a restatement of William Sharpe’s oft-cited 1991 article in the Financial Analysts Journal.  In a way, everyone is already “investing in hedge funds” since every investor who is not a passive investor necessarily owns a small piece of (pure) active management embedded in their portfolios.  So this argument, while entirely valid, isn’t specific to alternative investments.  It’s also a “Catch 2%” for mutual funds or a “Catch 50 bps” for active long-only institutional investors.

“Catch” #2: Endowments and pensions pride themselves on their ability to earn an illiquidity premium, yet they strive for diversification. 

…a more diversified portfolio should offer a better trade-off between risk and return—the appeal of absolute-return portfolios is that they settle for lower returns in the best times in exchange for protection in the bad ones. But is this what pension funds and endowments really want? Traditionally they have invested in shares and property—both volatile—because they are in for the long haul and can ride out short-term price fluctuations.

As The Economist pointed out in late 2006 (see posting), university endowments have smoked many other institutional investors over the past 20 years since they have the capacity to undertake riskier investments.  But they also suggested this wasn’t necessarily at odds with the goal of diversification:

The idea they helped develop in the 1970s and 1980s—deemed eccentric at the time—was to break the portfolio into a mix of standard and ‘alternative’ assets, as uncorrelated with each other as possible so as to spread risk.

So the twin objectives of investing for the long term (thus accepting volatility within asset classes) and portfolio diversification (thus rejecting volatility across asset classes) aren’t necessarily in conflict and aren’t necessarily a Catch-22.   

“Catch” #3: As the hedge fund industry grows, it will succumb to investor emotion. 

When they [asset classes] become big…they become lumped together as risky assets; bought when investors are feeling confident and sold when they are nervous.

Unlike buying and selling a true “asset class,” buying and selling hedge funds does not, at least directly, influence their returns.  (Sure, redemptions could conceivably start a liquidity-driven domino tumble, but unlike other asset classes, hedge fund values do not directly respond to investor demand for the funds.)  Indeed, hedge fund assets under management may be correlated with equity markets as a result of such sentiment.  But it’s unlikely that general hedge fund return correlation will increase markedly due to this mechanism.

Whatever the reason behind it, it’s true that broad hedge fund indices are becoming dominated by equity market beta.  So we suggest that “Catch #1″ (above) provides the simplest explanation for this - although not because of changes to the hedge fund industry per se.  Instead, the sheer size of the hedge fund industry means that more and more of the pre-existing alpha-producing resources of the money management industry are beginning to fall within its boundaries. 

So The Economist is nevertheless right to observe that,

It is possible for asset classes to be uncorrelated when they are small, as private-equity groups and hedge funds still were in the 1990s.

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