Hedge Funds: Identifying Alpha and Mitigating Risk

Daniel B. Eagan

Hedge funds have historically generated higher returns than stocks with less volatility, but they also pose several significant risks that volatility alone doesn’t capture, our research suggests. That makes careful due diligence and diversification of managers crucial. 

Here are a few issues we believe it is essential to address.

Alpha uncertainty. Manager skill is hard to identify. Good performance may reflect luck rather than skill—and even a skilled manager’s strategy may be out of favor for years at a stretch. That’s true for long-only managers, of course, but it’s even more important for hedge funds, because return from skill (alpha) is a much larger part of total return: 60% on average, versus 13% for the average actively managed long-only portfolio, as the display below shows.

The Majority of Hedge Fund Returns Has Come from Alpha

In our view, the uncertainty of alpha is crucial to understanding how rewarding hedge-fund investments are likely to be. This factor should weigh as heavily as volatility and potential returns in investor deliberations about whether, how, and how much to invest in hedge funds.

Wide dispersion of manager returns. Uncertain alpha and leverage lead to enormous variation in performance from manager to manager in any one year and over time, as the second Display, below, shows. From 1996 to 2011, extremely successful long-only equity managers (those ranking at the 10th percentile) returned 9.2% per year on average, and extremely unsuccessful long-only equity managers (those at the 90th percentile) returned (1.1)%. But extremely successful hedge-fund managers returned 19.5% and extremely unsuccessful hedge-fund managers returned (8.9)% in the same period. We also found a wide dispersion of returns within hedge-fund categories. Clearly, manager selection can have an enormous impact on returns.

Diversification Across Managers and Strategies Is CriticalConditionality of hedge funds’ diversification benefit. Over the 16 years for which we have data, hedge funds had a relatively low correlation to stocks, but this diversification benefit wasn’t stable. In months when the stock markets rose, hedge funds’ correlation to stocks was almost as low as the correlation of bonds to stocks, our research found. In months when the stock markets fell, hedge funds’ correlation to stocks was much higher.

It makes sense that high-quality bonds tend to protect portfolios better than hedge funds do during bear markets for stocks. During periods of economic and stock-market stress, interest rates tend to fall, which boosts bond prices. By contrast, the aggregate performance of hedge funds is, at best, independent of economic and stock-market conditions.

Leverage and liquidity risks. The leverage employed by many hedge funds can amplify losses as well as gains and can make a fund vulnerable to a liquidity squeeze. Funds that finance illiquid investments with short-term debt may lose access to debt in a market crisis and be forced to sell assets at distressed prices. Even normally liquid instruments can become illiquid in a market crisis, so simply matching the duration or expected liquidity of assets to funding may not protect against a liquidity squeeze.

Mitigating the risks

In the world of long-only investing, investors and their consultants perform extensive due diligence that far exceeds checking for a history of positive alpha. Among other things, they seek to understand whether a manager has an experienced team and an investment philosophy and strategy that exploit a known pricing anomaly or a risk premium that is likely to persist. They also check for sound risk and liquidity management, and operating processes, as well as fair treatment of all investors.

The same considerations apply to hedge funds, although their managers offer far less transparency, which makes due diligence more difficult. The complex arrangements between hedge funds and their prime brokers and administrators, and the complications that arise from shorting and leverage, make additional procedural safeguards important. Excellent liquidity management and risk management are crucial.

Effective diversification is also critical, since there is no investable hedge-fund index. Investors in long-only portfolios typically make strategic allocations to diverse asset classes and strategies. Our research suggests that hedge-fund investors would benefit from having strategic allocations to diverse categories of hedge funds and diversifying within each of these broad categories. 

Our research found that the median return on risk (Sharpe ratio) of just one equity long-short strategy over the last 16 years was 0.14, but the median return on risk of a portfolio of three randomly chosen strategies in the same category was 0.28. That is, just diversifying to three different funds in a single category could double the return on risk. 

Diversifying from a single hedge fund to one fund in each of the 10 Lipper TASS hedge-fund categories would have increased the return on risk to 0.49, and diversifying further to three managers in each of the 10 categories would have increased the return on risk to 0.65.

Thus, we deem it prudent to make investments with at least 10 hedge-fund managers; investments with 30 or more make sense to maximize risk-adjusted return. 

The Lipper TASS database includes the net-of-fee performance of individual hedge funds whose managers have elected to report to the database. In constructing our hedge-fund and fund-of-funds indices, we included the performance of funds only after their managers decided to report to the database, and only for those funds that had at least $10 million in assets under management. We also included the performance of all funds in the database that are no longer currently reporting. Based on the above selection criteria, there were 4,766 distinct hedge funds in the database during the 1996–2011 period. The indices are asset-weighted.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Wealth Management, a unit of AllianceBernstein.

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