Investors are becoming more familiar with the return sources of hedge funds and have started to ask more questions and look beyond historical returns as the primary investment decision criterion. However, other investors remain sceptical of hedge funds as such investment vehicles are often still viewed as too mysterious and secretive. A deeper understanding of hedge funds reveals that their returns are in fact not mysterious at all but the result of a powerful combination of risk premiums and the specific skills of talented managers.
When looking at hedge funds, it is useful to distinguish the following two sources of returns: economic risk premiums and manager skill. The consistently high risk adjusted returns of hedge funds suggest that financial markets are not efficient, and inefficiencies and price anomalies can be exploited through specific skills or competitive advantages. In the asset pricing theory language the corresponding return is referred to as ‘alpha’. At the same time, hedge fund managers expose themselves to certain (systematic) risks. The corresponding returns are economic risk premiums and correspond to the ‘betas’ which constitute the other important source of hedge fund returns. Over time, these ‘beta risk’ premiums provide an inherent and permanent return, the source of which does not disappear if spotted by other investors
Although many believe that investing in hedge funds is all about ‘the search of alpha’, the author believes that the ‘search of alpha’ must begin with the ‘understanding of beta’. Despite certain overlaps and ambiguities that result from this classification scheme, distinguishing ‘risk premium strategies’ from ‘pure skill strategies’ provides a proper framework for an analysis of the hedge fund returns.
Conventional finance theory teaches that investment returns are directly related to the amount of (systematic) risk taken. Any excess return above and beyond the return for taking risk is the result of particular manager skills (or pure luck), eg, detecting mis-priced securities, having superior and price relevant information, or correctly timing the market. Conventional finance theory calls this return the manager’s ‘alpha’ and states that consistent alpha generation should not be possible in efficient markets ‘efficiency market hypothesis’, ‘EMH’. However, often the excess return is related to systematic risk factors not considered in the model. To better understand the ‘battle of alpha’ within the hedge fund industry, it is important to be familiar with some of the basic assumptions of common asset pricing models including:
o The return distributions of investments can be sufficiently described by a normal distribution. Therefore the evaluation of risk and return can occur in a mean-variance framework.
o Investors have the same forecast of risky assets’ expected returns, variances and co-variances.
o Trading is frictionless, ie, there are no transaction costs, taxes, etc.
o Investors can sell short securities without any restrictions.
The first assumption becomes questionable when the probability distribution of investment outcomes is skewed (non-symmetric) or leptokurtic (possesses ‘fat tails’). In these cases, the conventional measure of risk, namely standard deviation, provides an insufficient basis for risk measurement. Numerous hedge fund strategies – comparable to option strategies – have non-symmetric (negatively skewed) return distributions. It is commonly agreed that the return distribution of most financial instruments are leptokurtic.
The second assumption is plainly false, as investment strategies, particularly hedge funds, are subject to numerous other risks beyond broad market risk. To add further to the complication, hedge fund strategies are not ‘buy and hold’ strategies. They change their positions often, can make use of leverage and short selling and also invest in derivative instruments. Considering only broad market risk leads to the incorrect impression that superior returns are always the result of unique manager skills or superior access to information. The reality is that investors who are willing to assume risks beyond broad market risk (eg, credit risk, event risk, volatility risk, liquidity risk) expect to earn additional return unconditional to possessing superior information, short lived market inefficiencies or the direction of equity markets.
The third assumption is at best only partly true. Transaction costs are indeed a factor for any investor. Many investors are constrained in selling short securities or investing in derivative instruments, which can create inefficiencies in financial markets that hedge funds try to exploit.
Further insight into of risk premiums can be obtained by assessing the diverse economic functions of investors’ activities in financial markets. The following provides a qualitative discussion of the relationship between risk premiums for hedge fund strategies and these various economic functions. The most commonly known economic functions in capital markets are:
o Capital formation - providing companies access to capital;
o Risk transfer in financial markets - providing commercial hedgers with the possibility of transferring unwanted risk;
o Insurance of extreme risk – providing participants the opportunity to hedge the risk of very large losses;
o Price transparency and efficiency - making markets more efficient;
o Providing liquidity - making a market for less liquid investments;
o Providing market completeness –Creation of a wide range of return profiles for investors.
Risk premiums as inherent sources of returns are most apparent for relative value strategies (fixed income arbitrage, risk arbitrage, and convertible arbitrage, equity market neutral). These ‘arbitrage’ strategies earn returns in the form of price spreads between two or more strongly related financial instruments. These spreads are compensation for very particular risks such as sector (or even firm) specific risk, credit risk, duration risk, liquidity risk, FX risk, commodity price risk, or deal risk (eg, for mergers). The table summarises the diverse risk premiums in the hedge fund universe.
Risk premiums as a source of return are less (if at all) obvious for some opportunistic strategies like global macro, short selling, and many long/short equity strategies. The returns of these strategies are derived from the manager’s skill in forecasting price developments, detecting market inefficiencies and acting quickly upon anticipated market moves. The underlying opportunities and market inefficiencies are usually temporary and quickly disappear when spotted by other investors. But the distinction between manager skill and risk premium as a source of return is not always absolutely clear.
As discussed above, the main hedge fund performance sources are risk premiums and investment skills of individual managers. The very fact that hedge funds take particular risks is surely not undesirable. However, hedge fund portfolio managers should only accept risk that is intended, understood, well managed and correctly priced. Following the argument that risk premiums are an essential part of hedge fund returns some go on and claim that generic systematic trading programmes (eg, a systematic strategy of writing options) could thus achieve similar returns as hedge funds. Conversely, the ‘alpha protagonists’, on the other hand, would state that hedge fund returns depend mostly on the skill of the specific managers, a claim that they express in characterising the hedge funds industry as an ‘absolute return’ or ‘alpha generation’ industry. The truth is probably a combination of these two contradictory views. An important part of the confusion arises from the inability of conventional risk measures and theories to properly measure the diverse risk factors and return sources of hedge funds. One conclusion of this article is that the hedge fund return puzzle remains far from being solved.
Lars Jaeger and Erik Kaas are partners in Partners Group in Zug
Some of the ideas that are elaborated in more details in Jaeger’s book ‘Risk management for alternative investment strategies’, published by Financial Times/Prentice Hall.