Where the Betas are Zero and the Excess Returns are All Above Average

Recently I became interested in ‘alternative investment management’, the nowfashionable euphemism (NFE) for hedgefunds. Hedge funds started out as unregulatedinvestments for HNWIs1, the NFE for rich guys.For 2% of your principal and 20% of the upside, they promise you Absolute Return, aname that deserves to grace a yacht or a religious rock group.

Unlike wealthy individuals, until now institutions have mostly shunned hedge funds, investing instead in simple stocks and bonds, which provide beta. Pick the beta you’re comfortable with, according to the capital asset pricing model, and the expected return will come. That notion began to look a little shopworn as the great bull market petered out, hence the recent great proliferation of hedge funds.

Welcome to Alphaville, where the betas areall smaller than any pre-assigned number and thealphas are all above average. Theoretically, alphais the intercept of the regression line of a stock’smoves against those of the market. If you haveno market exposure, alpha’s somewhat ill-defined, but who’s worried about definitions?

Now institutions have also started investingin hedge funds, and they need to understandtheir risks. In Alphaville, people do stat arb ortrade collateralised mortgage obligations, swaptions, convertibles and credit derivatives, usingcomplex dynamic strategies. Hence the rise ofthe fund of funds (FoFs) to provide both diversity and expertise. According toHedgeworld.com…: “Funds of funds are an essential source of capital for many hedge fund managers. Institutions and individuals usually enterthe alternative asset field via funds of funds,which may be responsible for channelling onethird or more of the US$700 billion in total hedgefund assets into various strategies”.

I’ve been learning about FoFs. I’ve especiallybenefited from the insights of Iraj Kani2and Andrew Weisman3. Though a FoF looks like a bunchof sophisticated proprietary trading desks withina large investment bank, there’s one big difference: transparency. At an investment bank, youcan see the traders’ positions, the foundation ofvalue-at-risk and scenario analysis. At a FoF youcannot know the positions of most of the fundsyou invest in, though that is slowly changing.

What can you do about understanding hedgefund risk? Ideally, you want to know the distribution of each fund’s future returns… dream on.You can’t always (ever?) get what you want.Broadly speaking, all you can really hope toknow in this life are a fund’s historical net assetvalues (NAV), its current positions and its style.What can you do with those characteristics?

Any hedge fund will give you its monthlyNAVs. (How accurate those marks are is questionable, and has been the subject of many articles.) With this time series you can analyse thefund’s statistics, calculate its VAR and covariance,and there are several commercial risk systemsthat do this. That’s useful, but imperfect: a sample’s estimates cannot reflect the ‘true’ distribution – some extreme events occur too rarely toprovide reliable statistics.

With positions you can go one step better.Some hedge funds will supply their positions toan intermediary, a risk management vendorwhose software and database will let you runenterprise-style risk reports on the funds’ actual positions, which are visible to the vendor butremain hidden from the FoF itself. The statisticsof a fund’s assets are better than the statistics ofthe fund, especially when some of the assetsare nonlinear. As institutions become largerplayers in FoFs and exert more pressure fortransparency, this approach is likely to becomemore common.

But meanwhile, not all funds provide positions, and anyhow, positions aren’t everything.Hedge funds can trade dynamically. A high-frequency stat-arb computer program may berolling over the fund’s entire portfolio severaltimes a day. Knowing what stocks they own atsome instant doesn’t tell you much about theirrisk. What you really want to know is what theyare doing.

The great insight of derivatives theory is thatoptions can be replicated by dynamic tradingstrategies, and that, vice versa, each such strategy is equivalent to a derivative security. Recently, several researchers, among them BillFung and David Hsieh, have pointed out theusefulness of trying to view a hedge fund as aportfolio of options. Convertible funds are obviously long options, but Fung and Hsieh havesuggested that trend-following hedge funds thatdon’t even trade options are nevertheless effectively long a straddle. A straddle is not market-neutral: though its average beta may bezero, its instantaneous beta is sometimes positive and sometimes negative.

I find the notion that hedge funds are portfolios of options immenselyattractive. An option is the ideal instrument for unlimited upsideexposure and limited downside risk, exactly

what the denizens of Alphaville are seeking. Recently, risk systems thatlook at hedge funds inthis way are beginning to appear too.

Options theory is the most successful analytical tool in finance. Therefore, if you can map afund into a proxy of options, you have a wonderful method of understanding its performanceand the nonlinear risks that can destroy its value.Alpha is, then, what a real fund earns over andabove this options proxy