New trends in hedge funds

(April 2007) Alternative investments signify a fast-moving, opportunity-driven world. Now there’s alternative beta. Yes, alternative beta, as in the Capital Asset Pricing Model alpha and beta.

You may remember the concepts of alpha and beta from studying CAPM in school. That’s when you were told that returns come from two sources (roughly speaking): Beta, or generating returns from taking more risk (through exposure to different sources of risk) than the market, and alpha, or generating returns from factors unrelated to the market (such as manager skill, company-specific advantages, and the like).

Enter alternative beta. What’s that? Simply put, it refers to new sources of market risk (and return of course) such as foreign exchange risk, liquidity risk, commodity risk, credit risk, and the like. But is foreign exchange risk alternative? What about liquidity risk?

Harry Kat of the Cass Business School in London claims that the “alternative beta” moniker is mainly marketing — new name, old concept. What is new, perhaps, is the undivided focus on such sources of risk for investment structuring and return mining purposes. The true question, then, is what kind of returns can “alternative beta” bring, for what risk and at what price?

Another trend is hedge fund replication. As the alternative investment industry matures, it risks facing increasing scrutiny from regulators, which has been the subject of much debate, and sustains some heat from perceived high fees. Hedge funds purport to provide alpha as well as beta — multiple sources of returns above risk-free investments, stemming from market-provided risk exposures and manager-provided talent to find and trade value-adding assets.

The problem seems to be that several managers add less alpha and more beta. If that’s true, should one compensate hedge fund managers for specific “unique” talent, or rather for the ability to structure more “generic” investments designed to capture market-based return-risk exposures? This wouldn’t be such an issue if hedge fund fees were lower, or if hedge fund selection through funds of hedge funds was less involved (with several layers of management, and fees).

Hence the new ‘new thing:’ Hedge fund replication. Instead of having managers pick and choose investments, why not replicate hedge fund returns by identifying their exposure factors and then structuring derivatives-based strategies designed to replicate them? One reason to do this is would be to lower costs — much lower, according to Lars Jaeger of Partners Group. He claims that cost reductions can reach 400 basis points per year or more (that’s 4%, folks), and such reduced drag on returns can mean huge performance gains.

Jaeger seems to be saying that investing should bite the bullet and recognize that most of the value added from hedge funds comes from beta. From there, it becomes possible to isolate beta-driven return factors and “package” them. In fact, Partners Group, Merrill Lynch and Goldman Sachs are already offering these products and services.

But there is some dissidence from people like Fran¸ois-Serge Lhabitant, an associate professor of finance at the EDHEC Business School in France. Lhabitant is no lightweight. He believes replication may not replicate the dynamic behaviour of hedge funds over time. Clearly, this is work in progress.

What does this mean? Given hedge fund complexity and investor unease (and possible disappointment), the highly competitive hedge fund industry is more or less permanently reinventing itself. Consider that few knew about hedge funds five years ago. But with financial engineering and huge profit potential, you get a highly dynamic development environment. Think of it as analogous to ETFs as compared to mutual funds: Lower fees, reasonable returns, generic structure.

And what about retail investors? In fact, much of all this will depend on regulation — or the absence thereof — of the hedge fund field. U.S. Security and Exchange Commission chair Christopher Cox recently said that “Hedge funds are not, should not be and will not be unregulated.”

Increased regulation will likely reinforce trends towards transparent managed accounts and passive replication products. Hence, I believe that we will, sooner or later, see hedge funds regularly appear in retail products like funds of funds.

Ironically, it is more regulation, not less, that will allow this to happen: Indeed, the regulators will need to approve hedge funds for general consumption before any major push occurs. In fact, the deal for the retail investor will then be more transparency (through prospectus-like documentation perhaps) in exchange for fees likely higher than those of mutual funds.

Caveat emptor again: Will investors get the alpha (and beta) they deserve for their money?

This article originally appeared in Advisor’s Edge Report. Pierre Saint-Laurent, M.Sc, CFA, CAIA is president of AssetCounsel Inc. He can be reached at PSL@AssetCounsel.com.

(04/04/07)