Know if you’re getting alpha or absolute return from your hedge fund manager
Investors have become obsessed with the quest for alpha. It’s the metric that dictates manager hiring, compensation and dismissal. However, alpha is not a regularly observable or stable phenomenon, and it’s not necessarily earned in the period in which it’s measured.
A manager’s ability to add alpha depends on forces beyond his or her control, such as the emotions of other investors. The market, not the manager, ultimately determines prices. In contrast, a successful absolute return manager allows the market to dictate portfolio inclusion, sizing and exposure.
Despite its advantages, absolute return actually represents a very small portion of the hedge fund universe. Pension investors should consider the following elements in evaluating an absolute return manager: active risk management, behavioural biases and volatility.
Active Risk Management
This should not be confused with risk mitigation, such as hedging and diversification. The reward of an absolute return strategy is greatest if an investor allocates portfolio capital among investments to which the market is receptive and later reclaims that capital when the market is no longer receptive to them. There should be little, if any, tolerance for allocations to investments that the market does not support.
Active risk management directly affects the entry and exit points for an investor, as well as the size of the positions it takes. It should determine the portfolio’s net exposure, based on the dominant market trend and sentiment, and also affect the portfolio’s gross exposure, which should generally be inversely proportional to the prevailing market volatility.
Behavioural Biases
Effectively managing an absolute return strategy means avoiding two destructive biases. The first is overconfidence. Alphadriven investors typically exhibit an unwillingness to discount widely available information while also overestimating the value of a proprietary inventory of publicly disclosed data, leading them to formulate non-consensus, highconviction investment ideas. However, it’s this widely available information that dictates market prices. A focus on “beating the market” only alienates the mandate from absolute return.
The second is the disposition effect: a very human but irrational behavioural trait in which individuals are unwilling to experience the pain of realizing a capital loss. Effective absolute return managers can navigate the markets’ ever-evolving collective perception of reality and emotions.
Volatility
Harnessing volatility and market dislocations can enhance an absolute return strategy, but it’s critical to avoid explicit or implicit short-term volatility exposures. In some cases, linear positions in plain-vanilla instruments (such as equities and bonds) can implicitly generate significant and potentially damaging non-linear relationships and exposures. This issue is relevant to pension committees. While a plan’s investment policy may prohibit selling options, it may permit other strategies that do not engage in option transactions yet effectively replicate a short option position.
Investors should be aware of embedded concerns such as yield for carry (applying a long/short or long-only position for current rather than future income); purely price-based strategies; illiquidity; dwelling on longer-term economic or price parameters; buy and hold; contrarian investing; and “doubling-down” on a particular position.
Only competent and qualitative hedge fund analysis and evaluation can identify true absolute return strategies.
Rene Levesque is founder and analyst with Mountjoy Capital. rene@mountjoycapital.com
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