Date: January 26th, 2012
Cate: Finance, Systems

Long/Short Hedge fund alpha to disappear by 2019?

As a specialist in understanding sources of business value and applying that to investing I was interested to see how the Long/Short Hedge funds are doing. Running through some data from the EDHEC database, I created the charts below. The first chart is a visual showing the L/S hedge fund index vs. the S&P 500.  There isn’t a lot to see there. You would find that the L/S index outperformed the S&P 500 etc. There are of course back-fill, survivorship and other biases associated with any fund database which significantly lead to over stating performance. The L/S hedge fund index shows a .77 correlation with the S&P 500.

Long short equity hedge fund vs. sp 500

The more interesting graph is the one below.  It is a 60 month rolling annualized return alpha calculated by taking the last 60 months of hedge fund returns and subtracting the S&P 500 returns. This shows an annualized alpha experienced on a rolling 5 year period.  From the hedge fund index perspective it seems L/S hedge fund alpha has a negative trend and is due to hit zero by about 2019.

Now hedge fund alpha isn’t really running out, the more likely story is that over the last decade more and more managers having been piling into hedge funds recognizing them firstly as a great compensation class and then selling them to others as an asset class. The alpha hasn’t disappeared, but the number of the participants without alpha generating skill has likely grown so much as to mask the real alpha making it difficult to find the signal amongst the noise of the 2/20 crowd.

Generating long term positive returns means applying a stable allocation process over time and possessing a deep understanding of the source of value from that process. If you run a fund and want a good analyst or portfolio manager call this guy He has delivered 1,000 bps of alpha each year since starting out in 2007 without a down year and is looking for a place to put his analytical and portfolio management skills to work. Columbia University Press is publishing his book The Nature of Value later this year.

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