| Hedge funds pursue beta strategies dressed up as alpha |
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| 04/03/2007 | |
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Beware of hedge funds offering beta strategies dressed up as alpha. Once coveted for their outperformance, a number of hedge fund strategies, including fixed income and convertible arbitrage, are turning into laggards, according to a Bridgewater report. What has helped hedge funds boost performance is not these strategies, but their use of leverage: up 70% in the last three years. "To the extent that investors are able to use hedge funds to get access to more and better alpha sources to overlay their portfolios, the dive into hedge funds is worth taking," says the report. Too often, however, hedge funds continue to mix their alpha and beta decisions. "The general perception right now is that hedge funds are providing alpha. In truth, many hedge funds are packaging up beta and selling it at alpha prices. But when we strip many hedge fund strategies from the underlying beta, we find that quite often, they are not wearing any clothes at all." One of the classic hedge fund beta strategies has been fixed income arbitrage. These hedge funds take three principle risks. "The primary systematic risk is buying risky illiquid securities and shorting more liquid ones. The second strategy consists of positive carry trades (long US Treasuries vs. cash), and the third of selling volatility. In the aggregate, fixed-income arbitrage funds have simply returned the beta of buying illiquid fixed income instruments and highly correlated strategies." Indeed, Bridgewater's estimates of betas in hedge funds are 90% correlated to the aggregate hedge fund index. "The returns of hedge funds in 2006 were slightly below the betas we use to replicate them. The exotic betas did well in 2006, but the spreads are now as tight as a drum." Another favourite hedge fund strategy has been convertible arbitrage, which also has a strong beta component. In the past decade, there has been more supply of convertible bonds than demand, producing "extremely narrow premiums." Meanwhile, emerging market hedge funds have an 80% correlation, with a 50/50 mix of emerging market equities and bonds and are failing to outperform this basic combination." In 2006, hedge funds performed relatively well because of their exposure to alternatives. "The low volatility would have been a problem except for the levering up of hedge funds," concludes the report. "The problem on a forward looking basis is that there is very little left to squeeze out of risky assets. Our aggregate risk spread is at the tightest level in 40 years. With so much levered money chasing a limited number of illiquid beta, it is not surprising that risk premiums have collapsed. While a lot more than hedge funds have caused spreads to be so tight, the increasingly levered money in hedge funds means that a stumble in the spread area could easily turn into a stampede." Bill Gross of Pimco has also sounded a note of alarm. He recently cautioned that hedge fund leverage had reached its limit. He estimates that an average hedge fund can generate at most an alpha of 200 basis points, and any attempt to exceed that significantly raises the likelihood of loss. VB |
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