Outspoken hedge fund manager, Cliff Asness, says breaking down the sources and challenges to manager performance will determine how investors should pay for alpha.The game’s up: hedge funds must come clean. They make money by tapping three sources of return, says Cliff Asness, founding principal of quantitative hedge fund AQR Capital Management, but only one is worth paying two and 20 for.
Most hedge funds derive investment returns from three sources – true alpha, hedge fund beta and market beta – and most managers will tell you it comes from just one.
Asness says hedge returns are very rarely driven by alpha alone.
“Hedge funds are not all about alpha. They play in all three of these areas. It’s not a bad thing, but it’s bad to charge two and 20 for it,” Asness says.
For some time, hedge funds have held net long exposures to public markets, implicitly betting that markets rise in time. “One way you can make money is by owning things,” Asness says, but these simple exposures should not be relied upon by hedge funds. “It’s cheap and available to everyone”.
And as hedge funds have grown in popularity, amassing $1.6 trillion in funds under management (FUM), much of this capital has been drawn – “as if by gravity” – into net long positions, while some strategies, such as merger arbitrage and currency carry trading, became so methodical that the skills used to execute them circulated widely among managers, making them a form of beta.
“On days when we feel like geeks, we call this hedge fund beta,” Asness says. These strategies are active, and require characteristic hedge fund tools, such as shorting, so they aren’t classic passive market exposures, or plain old beta.
“I’ve just told you what I’m going to do,” Asness says, after explaining how merger arbitrage and currency carry trading strategies can be systematically implemented, “and it’s not a true and unique skill, it’s a good implementation of a known strategy.”
There is nothing unique about net long positions or hedge fund beta. But alpha is rare and special, and worth paying two and 20 for. And while true alpha will always have a role to play in hedge fund strategies, the prevalence of the other return sources means that managers should be more honest with investors.
“The hedge fund world often sells itself as being uncorrelated to markets. You’d think that could be true if the whole hedge fund world was producing alpha – true, unique, uncorrelated alpha.”
But since this isn’t the case, hedge fund fees should gradually be lowered as clients demand more transparency about managers’ investment strategies and operations after the scares of 2008. Essentially, fees should be commensurate with the sources of return a hedge fund taps into, and only alpha can command high fees.
But this will happen slowly, Asness says.
“I’m pretty cynical about transparency. Part of the reason why hedge funds haven’t offered this transparency is because of how simple their strategies are.”
He says this awareness of hedge fund return sources were broadly known before the financial crisis but investors did not negotiate for lower fee deals because returns were so strong. Managers also held the balance of power because their services were in demand. But the crash of 2008 brought these concerns to the fore.
Another consideration for investors is the impact that increasing FUM has on investment performance. A manager exercising true alpha “just can’t keep doubling the money” in their strategies, Asness says. “You can’t go from $1 billion to $1 trillion and still claim to have the same percentage of alpha.”
“Hedge funds have pursued these strategies for as long as the data shows us. That’s not new. What’s new is that hedge funds are putting much more capital into them.”