The game’s up: hedge funds must come clean. They make money by tapping three sources of return, said Cliff Asness, founding principal of quantitative hedge fund AQR Capital Management, but only one is worth paying two and 20 for. Most hedge funds derive investment returns from three sources – true alpha, hedge fund beta and market beta – and most managers will tell you it comes from just one.

For Asness, who is the keynote speaker at next month’s ‘Alternatives: Best of Breed*’ conference in Melbourne, said hedge returns are very rarely driven by alpha alone. “Hedge funds are not all about alpha. They play in all three of these areas. It’s not a bad thing, but it’s bad to charge two and 20 for it,” he said. For some time, hedge funds have held net long exposures to public markets, implicitly betting that markets rise in time. “One way you can make money is by owning things,” Asness said, but these simple exposures should not be relied upon by hedge funds. “It’s cheap and available to everyone”.

And as hedge funds have grown in popularity, amassing US$1.6 trillion in funds under management (FUM), much of this capital has been drawn – “as if by gravity” – into net long positions, while some strategies, such as merger arbitrage and currency carry trading, became so methodical that the skills used to execute them circulated widely among managers, making them a form of beta. “On days when we feel like geeks, we call this hedge fund beta,” Asness said. These strategies are active, and require characteristic hedge fund tools, such as shorting, so they aren’t classic passive market exposures, or plain old beta.

“I’ve just told you what I’m going to do,” Asness said, after explaining how merger arbitrage and currency carry trading strategies can be systematically implemented, “and it’s not a true and unique skill, it’s a good implementation of a known strategy.” There is nothing unique about net long positions or hedge fund beta. But alpha is rare and special, and worth paying two and 20 for. And while true alpha will always have a role to play in hedge fund strategies, the prevalence of the other return sources means that managers should be more honest with investors.

“The hedge fund world often sells itself as being uncorrelated to markets. You’d think that could be true if the whole hedge fund world was producing alpha – true, unique, uncorrelated alpha.” But since this isn’t the case, Asness said hedge fund fees should gradually be lowered as clients demand more transparency about managers’ investment strategies and operations after the scares of 2008. Essentially, fees should be commensurate with the sources of return a hedge fund taps into, and only alpha can command high fees. But this will happen slowly.

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