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Hedge Funds, Alpha and The Holy Grail

 

It is amazing how much conjecture the term “hedge fund” can evoke. Nowhere else in finance is there more confusion and debate about what they actually are or what they really do. This is not surprising, given that a hedge fund is nothing more than an investment vehicle, like any other fund or pool of money that invests in other things. For the most part, there are tax or regulatory reasons which would make you choose one structure over another. But the important thing to remember is, that you can use these vehicles for any purpose, which means they can also invest in just about anything. Particularly hedge funds, which have no (or very few) restrictions, and can therefore trade the entire investment universe or use any strategy (including “short-selling”, which can be used to offset risk - hence the name “hedge”).

 

In other words, if you say: “I invest in hedge funds”, it’s like saying “I breathe”. It doesn’t really mean anything, it just means that you invest in a structure to hold assets. What you do with those, is something entirely different. So, what could (or should) you actually do in a hedge fund? Foremost, you would want to take risks that you are not otherwise getting in your other investment vehicles, e.g. I can buy stocks and bonds in ETFs for next to nothing, so why pay for the expensive set up of a hedge fund? And of course, you want to make money, which brings us to the term “alpha” and what all the fuss is about.

 

In the classic definition, alpha means the “excess” return, which essentially means you get something for nothing. And because that would be akin to discovering the holy grail, there is also so much debate about what alpha really is, why it is there and (most importantly) who can actually produce it. To be clear about one thing: there is no pure alpha (as in a risk-free return) anymore. There was some to be had many years ago, when you could arbitrage the price differences of the same securities listed on different exchanges, for example. But then the machines came in and took it all away.

 

Fact is, to generate (absolute) returns nowadays, you have to take risk. But there are many ways to make money from trading. The trick is knowing where to look and how to segregate the universe. There have to be structural, fundamental or statistical reasons for a strategy to consistently make money, which is why looking for “good traders” rarely works (in stark contrast to the image of many hedge fund managers). And beware in trying to over diversify. Hedge fund trading strategies tend to be zero sum games, e.g. for one to gain, another has to lose, which means buying all types (or categories) of hedge funds may give you a perfectly balanced portfolio, but it will also give you the average return, which is zero. Putting it all together, hedge funds are wonderful tools to diversify investment risk, you just have to make sure to pick the right ones and get over the many misperceptions.

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