“Alpha is a Finite Resource”
- Joshua M Brown
- April 6th, 2013
You can’t have thousands of hedge funders running around – most of them cordial enough with each other and with a similar enough background – and still keep outsized returns across the industry.
Come on, you know better.
Every gold rush in history ends with too many wannabes plunging their pans into the same stream, in search of the same glint beneath the surface.
And so it is with the overgrown “alternative” universe of hedge funds. I put alternative in ironic quotes here because, according to a recent study hedge funds have never been more correlated – both to each other and to the traditional asset class benchmarks they were made to repel from. Lots of these guys came up from the same private schools and Ivy League colleges and Wall Street investment banks and so forth – nobody should be expecting much heterogeneity here in any case.
And now, all of this sameness and the mass-pursuit of market inefficiencies has led to an industry filled with intelligent players stifling each others abilities. Of course it did. If the world’s top fifty surfers all had to ride the same wave at the same time, how well could any of them do it? Jostling and elbowing each other for space and clear blue, whatever edge they originally paddled out with would be negated by simple physics.
Here’s Larry Swedroe on the topic, taking a page from William Bernstein’s new book Skating Where the Puck Was: The Correlation Game in a Flat World:
For the period 1998-2012, Bernstein analyzed Hedge Fund Research’s Global Returns series using a three-factor analysis – meaning analyzing the exposure to the risks of the stock market, small stocks and value stocks. He found that while hedge funds showed significant outperformance early on, that outperformance shrank and then turned negative as investors chased those returns. From 1998 through 2002, hedge funds produced an incredible alpha (or outperformance) of 9 percent. However, from 2003 through 2007, their alphas went to -0.7 percent. And from 2008 through 2012 the alpha sank even further to -4.5 percent.
Why did that happen? David Hsieh, professor of finance at Duke’s Fuqua School of Business, provided a simple explanation — alpha is a finite resource. In 2006, Hsieh estimated that there was about $30 billion in alpha available to the entire hedge fund industry. The implication is that as more money enters the industry, there’s less and less alpha to go around per hedge fund. This wasn’t good news for hedge fund investors, because dollars had been flowing in at a rapid pace.
Assuming his estimate is correct, we can now determine what that means for hedge fund investors using simple math. Hsieh estimated that at the time the industry had about $1 trillion under management. Thus, $30 billion of alpha spread over $1 trillion of assets is 3 percent alpha for the industry.
What happens now?
People need to give up and close up shop. Which is happening – but unfortunately there are births for every death, new entrants undeterred each time an old hand says “f*ck it, I’m done”.
And if it’s you getting into the outperformance business, well, you’d better be pretty unique.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.