Delivering alpha is exceedingly difficult

This article is part of
Alternative Investing - November 2014

Alpha can be broadly explained as performance generated through manager skill; it is the return achieved beyond what otherwise would be expected based on the risk taken.

Investors allocate to absolute return or hedge funds for a number of reasons. High on their list of objectives is portfolio diversification and the potential to deliver superior risk-adjusted returns when compared to traditional asset classes.

It has been noticed that since markets bottomed in March 2009, the alpha generated by hedge funds when measured over a five-year rolling period is at record lows. Meanwhile, five-year rolling R-squared – the percentage of return that can be explained by movements in the benchmark – is at record highs.

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We have analysed hedge fund returns since 1990 using the HFRI Fund Weighted Composite index – an equal weighted index of 2,000 hedge funds – and compared it to the S&P 500 index. We reviewed four distinct periods: January 1990 to October 2007 (pre-Lehman Brothers bankruptcy), April 2009 to June 2014 (the current bull market), as well as two prior bull markets for equities (June 1994 to March 2000, and March 2003 to October 2007).

What is interesting is that beta – a measure of risk compared to the benchmark – is relatively stable throughout all periods. It is also interesting to note the similarities between the S&P 500’s performance and risk statistics for the periods April 2009 to June 2014, and from January 1994 to March 2000.

During these periods the S&P 500 index generated a similar annualised return (22.78 per cent versus 22.86 per cent) with similar volatility (13.89 per cent versus 14 per cent).

In contrast the performance and risk statistics of hedge funds over these periods are vastly different. While risk-adjusted returns, as measured by the Sharpe Ratio, are attractive for both periods, it is the lack of alpha (skill) and high R-squared (movement that can be explained by the benchmark) from April 2009 to June 2014, which drew our attention.

After all, we are seeking managers who can produce alpha and provide diversification in order to justify the high fees they typically charge. The natural questions one should ask as a result of this analysis are, why is alpha negative and are the causes temporary or structural?

With central banks anchoring short-term interest rates near zero and providing vast amounts of monetary stimulus through quantitative easing, the period since 2009 cannot be considered normal. Since March 2009 the S&P 500 index has generated risk-adjusted returns rarely seen in the past 25 years.

High risk-adjusted returns from the market, along with the uncertainties generated by quantitative easing, could explain the lower alpha. But it does not fully explain why alpha has turned negative.

For this we can look at how the hedge fund industry has changed over the years. To begin with, the number of funds and assets managed by the industry has grown significantly since 1990, with approximately 8,200 funds now managing roughly $2.7trn (£1.7trn) as at March 2014, according to Hedge Fund Research.

Furthermore, the industry has shouldered increased regulation, greater competition from long-only products, a move towards more liquid assets and advancements in technology.