Hedge fund managers and investors in hedge funds are generally very smart and
very sophisticated. They like to talk a lot about risk-adjusted returns, and
especially about "alpha" and "beta" – central components
of the Capital Asset Pricing Model. And yet, after all that highfalutin’ talk,
the way that hedge fund managers are paid is very unsophisticated indeed. There’s
no risk adjustment there: just a percentage of the funds under management, and
a percentage of the raw profits.
It’s easy, if you’re a hedge fund, to bump up returns a lot using simple leverage.
Let’s say I think the S&P is going up, and I want to invest $1,000 so that
it returns more than the S&P. All I have to do is borrow $1,000 from the
bank, add it to the $1,000 that I have in cash, and invest $2,000 in an S&P
500 index fund. At the end of the year, let’s say the index has gone up 10%,
so my $2,000 has become $2,200. I pay off my bank loan – let’s say I borrowed
at 4%, so that’s $1,040 – and have $1,160 left: a 16% return on my original
Now let’s say that rather than going through that operation myself, I hired
a hedge fund manager to do it for me. I’d pay him 2% of the $1,000 – that’s
$20 – and another 20% of the $160 profits – that’s $32. So the total
fees would be $52, leaving me with $1,108. If I’d invested in the S&P 500
directly, I’d only have $1,100, so even after fees, I can tell all my friends
that my hedge fund manager has beat the market.
Of course, there’s no reason why my hedge fund manager should stop at borrowing
just one dollar for every dollar he invests. Let’s say he takes my $1,000, borrows
$4,000, and invests $5,000 in index funds. At the end of the year, he’s made
$500 in profits, and has paid $160 in interest, leaving him with a $340 or 34%
return. His investors pay fees of $20 plus $68 for every $1,000 they invest,
leaving them with total profits of $340 – $88 = $252, or more than 25%.
In the real world, hedge funds, and their investors, are much more sophisticated
than that. They know the difference between smart investing and leveraged investing,
and they measure that difference using their beloved alpha and beta. Alpha is
an attempt to measure how smart an investor is: to work out what his returns
are after taking into account the riskiness of his investment portfolio. Beta
is simply the riskiness of the portfolio.
In my examples, the S&P 500 has a beta of 1, or 100%; the first hedge fund
manager has a beta of 2, or 200%; and the second hedge fund manager has a beta
of 5, or 500%. The riskier and more volatile the assets you’re investing in,
the higher their beta. And, of course, as you increase your leverage, you increase
your beta proportionately. What hedge fund managers are looking for is alpha,
which is return over and above whatever the beta of their portfolio
might be. So if the beta of your portfolio is one, and you manage to do better
than the S&P 500, then you’re a smart investor with positive alpha. In my
cases above, the hedge fund managers might have managed to beat the S&P
500, but they did so by increasing their beta and decreasing their alpha. In
fact, their alpha in both cases is negative.
Hedge funds, then, are always on the lookout for ways to increase their alpha.
One way to do that is to get high returns; another way to do that is to decrease
your beta. If one manager manages to get a 16% return with a beta of 110%, and
other manager gets that 16% return with a beta of 85%, then the second manager
has a much higher alpha, or risk-adjusted return, and is likely to be much more
popular with investors.
At the end of the year, however, the fees that those two hedge fund managers
charge to their investors will be identical. Hedge fund managers might spend
their lives chasing alpha, but that’s not what their pay is tied to. Their pay
is simply tied to total return.
This, I think, is the point that Jenny Anderson was trying to make in her
column on Friday. Jenny is an excellent reporter, as I said
on Tuesday. She covers the hedge fund beat for the New York Times, she has
great sources, and she’s generally dead-on in knowing who’s bullshitting her
and who isn’t. The broad thrust of her column is quite right. But the substance
of it is way off base: in order to make a perfectly valid point, she uses all
manner of erroneous arguments.
Firstly, she doesn’t seem to really understand alpha and beta: a problem, when
the headline on the column is "Hey, You Have a Problem Paying Alpha Fees
and Getting Beta Returns?". Here’s the meat of her argument:
Where are the "alpha" generators, those that are supposed to create
performance above the market? (Market returns are called beta.) From May 1
through May 19, the Standard & Poor’s 500-stock index dropped 2.9 percent.
… The GLG European Long-Short fund fell 5.13 percent through May 19, posting
a 13.70 percent gain for the year. …
To be fair, one month of data is not an indication of how closely a fund is
tied to a particular market or how that fund will perform for the year. Any
number of things can happen to turn around the performance. But the question
that many investors should be asking is: Am I getting alpha or beta? And if
the answer is beta, why the high fees?
Simply put, hedge funds that claim they are not correlated to the markets
should not be correlated to the market. In bull markets, investors do not
There is a lot of very confused logic here. Firstly, alpha is not the same
as "performance above the market," as we’ve seen: you can have performance
well above the market, but if your beta is high enough then your alpha can still
be negative. And beta is not a measure of "market returns": it’s a
measure of risk, or volatility. Anderson seems to be assuming here that all
hedge funds have a beta of one, before rephrasing her assumption, mildly garbling
it in the process, and then giving it to us as a definition of beta.
Anderson then spends a lot of space (I snipped out most of this) running down
a list of hedge funds and looking at how they performed over the period May
1 to May 19. What on earth is this supposed to prove? For starters, we have
no idea of these hedge funds are representative of hedge funds as a whole, or
if Anderson picked them precisely because they fell significantly in
that short time. But in any case, what point, exactly, is she trying to make
when she says that the GLG European Long-Short fund is down 5.13% in May so
far but up 13.7% over 2006 as a whole? And why is she comparing a European fund
to the performance of the S&P 500?
Looking at various hedge funds’ performance over a period of three weeks will
tell you absolutely nothing: most smart investors won’t even look at a fund
manager until he can demonstrate his performance over three years at
the minimum. Hedge funds are difficult to get in to and difficult to get out
of: the people who invest in them do so for the medium to long term. Looking
at short-term performance is something that market analysts do in order to get
a feel for where hedge fund money might be positioned. It is a very silly way
of judging hedge fund managers. Anderson admits as much with her "to be
fair" sentence, but if she really believed it, she wouldn’t have spent
the previous two paragraphs detailing a series of short-term returns.
Anderson is quite right that investors should be asking whether they’re getting
alpha or beta: whether their funds’ returns are positive, on a risk-adjusted
basis, or whether they’re simply following the market as a whole. But this isn’t
news to any investor, or to any hedge fund. While fees might be tied to total
return rather than alpha, investors tend to pull their money out of any fund
whose beta is higher than the return that they’re getting. When hedge funds
report their performance to their investors, they tend to emphasize risk-adjusted
returns over nominal returns for precisely that reason.
And none of this has anything to do with correlation. Yes, Anderson is trivially
correct that "hedge funds that claim they are not correlated to the markets
should not be correlated to the market". But neither alpha nor beta is
related to market correlation. In fact, Anderson implies that "hedge funds
that claim they are not correlated to the markets" are exactly the same
as "the ‘alpha’ generators, those that are supposed to create performance
above the market". But of course that’s impossible: if you’re not correlated
to the market, you can’t promise above-market returns.
I once wrote a profile of a large, conservative hedge fund called Elliott Associates,
which is very much one of those funds which claims that it is not correlated
to the market. The idea is to get consistent good-but-not-spectacular returns,
no matter whether the stock market is going up or down or sideways, and to do
so with a lower risk than the S&P 500 to boot. Elliott definitely promises
alpha, but it never promises to beat the market. If Elliott returns 20% with
low beta in a year when the S&P 500 returns 30% with high beta, then Elliott’s
managers will be happy. Over the long term, Elliott has outperformed the S&P
500, but not by an enormous amount: the really impressive numbers emerge when
you look at its risk-adjusted returns, since it managed to outperform the market
while taking on substantially less risk than someone who simply invested in
the market as a whole.
Anderson, on the other hand, concentrates in her column on "emerging-market,
commodity, small- and mid-cap and currency funds": hedge funds which are
specifically designed to give investors exposure to emerging markets,
commodities, etc. If I invested in Elliott Associates and it underperformed
the S&P 500 in a good year for US equities, I wouldn’t be upset, since no
one invests in Elliott Associates in order to get exposure to US equities. On
the other hand, if I invested in an emerging-market fund and it did badly in
a year which was good for emerging markets, I would be upset: investors
in such funds want correlation with those asset classes.
When hedge fund managers or investors finish reading Anderson’s column, then,
they’re likely to have less respect for Anderson personally, and for the New
York Times business section generally, than they did at the beginning. And that’s
bad for both franchises. The Times wants desperately to be taken seriously in
the financial world, and "added-value" columns like Anderson’s are
a large part of that effort. But it’s worth noting that the Wall Street Journal,
the gold standard of daily financial journalism, has precious little in the
way of journalist-written commentary. Opinion is cheap; news is expensive. If
the Times continues to emphasize the former in its own pages while outsourcing
the latter on its website, it will never join the likes of the Journal or Bloomberg
News as a respected source of financial information.