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Monday, 18 December 2017

Getting beta, but paying for alpha

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Anthony Peters, SwissInvest Strategist

Anthony Peters, SwissInvest Strategist

Hedge funds are great places to work when all is going well. But who lives by the sword dies by the sword. In some cases it is even worse. Not so long ago one senior hedge fund manager resigned his position after receiving what he thought to be a derisory bonus after a sterling year’s performance.

“Ah,” you cry, “poor little mite … serves him right and his tiny bonus would probably still happily feed a clutch of families in Hartlepool for several years.” True, maybe, but not the point.

His run-in with the founder and owner of the fund was about what constituted his performance. The boss in question had decided that he was only going to pay his man for alpha but not for beta and seeing as the underlying market had rallied hard that year, the portfolio manager in question had no claim to any part of the performance that could be put down to beta. That he was still charging his investors “two and twenty” for that beta was beside the point and he was quite happy to collect significant fees for leveraged beta as if they were alpha but saw no need to share them with the people who worked for him. Heads I win, tails you lose.

This year is proving to be another tricky one in the space. The HFRI Fund of Funds Composite Index has returned all of 8-1/2% in the five years to May 2011 – that is an annualised return of 1.65%. Even something as basic as the EFFAS Euro 1–3yr Total Return index delivered an annualised return of 4.21% over the same period. But do we see the PM who runs the short guvvie fund at Trustus Asset Management come to work in his chauffeur-driven Aston Martin Rapide and fly up to his shooting estate in Ireland or down to his yacht in Antibes for the weekend?

There is no question that even the smartest of hedgies haven’t found a new recipe for making toast or boiling eggs and evidently knocking out cracking returns when leveraged in a bull market isn’t the stuff of Nobel Prizes either – although plenty of Nobel laureates have found amazingly complex ways of losing money during the same period.

So why do institutional investors so love funding leveraged hedge funds? Why are asset allocation committees at insurance companies and pension funds so keen to feed money and pay massive fees to management firms to do just what they ban their own portfolio managers from doing and which they might do just as well for free?

Although 2008 might have been a terrible year to have been running money, for chart purposes it has been a God-send. Pitch books are knee-deep in performance histories which conveniently begin at the end of 2008 – could that be just after Lehman Brothers departed the scene and when asset prices began the bounce back from their huge bungee jump? Hedge funds love to tell how they can short a market and benefit from the downside as much as the upside.

However, being short is an expensive game and one which drains performance unless one gets the timing absolutely right. Sitting on a leveraged long position is much easier and, when the veneer is stripped off, one which is significantly more common than the marketing guys would ever care to admit. Markets are hugely uncertain and with compelling investment and trade ideas at a premium, investors are paying 2% – the 20% isn’t kicking in – for their heroes to be rolling cash.

Most hedge funds are, make no mistake, populated by very bright people. However, they can no more make the market move for them than can their lowly real-money counterparts who take the train to work and not the V12. Hedge funds have been accused of all kinds of evil – it’s been a bit like burning witches – but only by those who don’t really understand the game. They do nothing other than what their clients give them money to do – even if the investment tactics are occasionally contrary to the interests of their own portfolio managers.

To put them on their spot, hedge fund investors should follow the example of our owner above and not pay for beta, irrespective of how leveraged it is.

Anthony Peters is a strategist at SwissInvest in London and will be writing a monthly column for IFR. We will also carry his daily commentary on IFRe.com.

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