Are hedge fund investors getting what they paid for?

Alternative hedge fund beta allows investors to access the returns generated by hedge funds without the pressures of finding alpha, says Fama family professor of finance at the University of Chicago Booth School of Business, Tobias Moskowitz.

Moskowitz says there are three components to hedge fund returns: unique alpha, traditional market beta, and “something else”, which he calls alternative hedge fund beta and describes as the common risk/reward exposures shared by hedge funds.

Over time, he says, the alpha component of what hedge fund managers are delivering has been shrinking.

“Betas are larger than market neutral or absolute return managers claim,” Moskowitz says. “Alpha as a concept has shrunk but the opportunity set is still the same.

“If you look at what’s inside hedge funds, there are some hedge funds with unique alpha, there is also a lot of traditional market beta, but there is also something in between. This alternative beta gives you access to alternatives without having to find the alpha.”

Hedge fund managers are paid to deliver alpha, but Moskowitz thinks the returns of hedge funds are highly correlated and he questions what investors are actually paying for.

“Alphas are smaller than average returns, you’re paying fees for index-fund components,” he says.

There has been a disconnect between what investors want from hedge funds and what they have been delivering.

By way of example, he says, over past few years the absolute return indexes have been closely correlated with the MSCI World Index.

The CS Tremont Hedge Fund index has a correlation with the MSCI of 0.83 over five years, and with the HFRI Hedge Fund Index of 0.91.

“Finding historical alpha is easy, he says, but finding future alpha is very difficult,” Moskowitz says.

“People spend too little time on whether they have the right betas, and too much time on alpha.”

Alpha and beta provide the tools for investors to achieve the goals of a higher reward for lower risk, but investors often get confused in the nomenclature, he says.

Furthermore, the alphas and betas are hard to measure for hedge funds, due to the self-reporting of returns, the illiquid instruments that are used and the lack of transparency.

A way to access this alternative beta, alternative hedge fund risk premia (the common risk factors associated with alternative or hedge fund strategies) is through managed futures.

“Simple managed futures strategies capture a significant portfolio of manager returns,” he says.

Studying the manager and index returns reveals significant exposure to multiple signals.

A way to capture this is to construct simple managed futures strategies across multiple asset classes, and regress the returns of the largest managed futures managers and indexes on the strategies’ returns.

“This applies a systematic quant style to a set of diversified and liquid instruments with trades triggered on trend-following or momentum signals,” he says.

Moskowitz, who also holds a research associate position at the National Bureau of Econoimc Research, is an adviser to AQR, which has $2.4 billion of its $47.5 billion in managed futures.

His award-winning papers can be accessed here