What's so special about hedge funds? Part 2

First of all, I want to thank Ignacio for his thoughtful response to my first blog entry! In his reply, Ignacio claims that hedge funds differ from traditional investment portfolios because they have more freedom to invest. I don't deny this. But, as the use of the word "more" clearly implies, this means that the difference between hedge funds and traditional investment portfolios is not a black-and-white distinction but one of different shades of grey. How much more freedom does a portfolio need to have in order to call the portfolio a hedge fund?

Is the distinction one of leverage: traditional funds don't leverage, but hedge funds do? Well, even UCITS III funds are able to leverage by up to 30% (hence the recent popularity of 30:130 funds), but few people would call them hedge funds. At what level of leverage does a fund become a hedge fund? Take your pick. My key point is that any attempt to make a distinction based on the degree of leverage is an arbitrary one. Hence, the distinction is a false one.

So how about going the ability to sell short: is a hedge fund different from a traditional fund because it can go short? The answer, once again, I fear, is negative. First, as per the argument above, UCITS III funds can also go short. Second, as I argued in my first post, though traditional long-only funds do not take short positions in an absolute sense, they do so relative to their benchmark. And that means that you can turn a traditional long-only portfolio into a portfolio with long and short positions by shorting the underlying benchmark. In other words: you get a so-called hedge fund portfolio by buying a long-only traditional fund and shorting the benchmark against which that fund is managed.

To see this, consider a benchmark portfolio that consists of 3 stocks: 50% is invested in stock A, 30% in stock B, and 20% in stock C. Now imagine that the traditional long-only portfolio manager likes stock A, is neutral about stock B, and doesn't like stock C. So the portfolio manager could construct a portfolio that looks as follows: 60% in stock A, 30% in stock B, and 20% in stock C. So the alpha of the traditional portfolio manager would be generated by a 10% overweight of stock A and a 10% underweight of stock B.

Now let's short the benchmark. In that case, we end up with a portfolio consisting of 10% in stock A, 0% in stock B, -10% in stock C, and 100% in cash. By this simple action, we now have created a portfolio that aims to outperform cash by taking long and short positions in various stocks, i.e. something that is typically called a hedge fund.

Note that the performance relative to their respective benchmarks will be the same for both portfolios: the outperformance of the long-only portfolio relative to its benchmark will be equal to 10% times the return of stock A plus -10% times the return of stock B. Similarly, the outperformance of the hedge fund relative to its benchmark (cash) will be equal to 10% times the return of stock A plus -10% times the return of stock B.

So what's the difference? Both the traditional manager and the so-called hedge fund manager create "alpha" using identical relative positions. The only difference is that, when you buy the traditional fund, your return will be equal to the return of the equity benchmark (beta) plus the alpha, whereas buying the hedge fund will give you a return equal to the risk-free rate (cash) plus the same alpha. There is no reason to pick one of these managers over the other: they have the same skill. The only reason to pick one over the other is if you prefer to have exposure to cash or equity.

Once again, I recognise that what we call "hedge fund managers" typically have more freedom to take positions (they can take more leverage, take larger short positions, etc.), but these differences are differences of degree. Of course, the more freedom you have as a manager, the more opportunity there is to add alpha if you have skill. But both these so-called "hedge fund managers" and the traditional managers use the same investment strategies to try and deliver this alpha. And therefore, if you don't have skill as a traditional manager (and empirical evidence shows that the average manager doesn't have any skill), then it is unlikely that you will have skill as a "hedge fund" manager.

And that's why I am suspicious of the hype surrounding hedge funds. If you weren't able to deliver alpha in a long-only portfolio, then simply repackaging the product as a hedge fund by taking the long-only portfolio and shorting the benchmark isn't going to deliver the alpha either. Of course, not all investors understand this. And many will be wooed by your new packaging. But it remains a case of "old wine in new barrels" and any attempt to sell this same old wine at a higher fee level to unsuspecting clients is questionable to say the least.