From the October 2003 issue of Investment Advisor • Subscribe!

Fund of Funds or Investable Indexes?

A recent analysis by Morgan Stanley researchers revealed that hedge funds as a group have produced relatively constant (positive) alpha returns for the past 13 years, but this performance has varied significantly across strategies, and individual managers did not consistently generate such returns.

"We see no persistence in individual manager alphas beyond random chance," Bryan Boudreau, Michael Peskin, and Michael Urias, all of Morgan Stanley, wrote in "Hedge Funds--Show Me the Alpha," an article that appeared in Morgan Stanley's August 2003 Global Pensions Quarterly. However, the authors found an alpha of 40 basis points a month for the entire universe of absolute return hedge funds for the period from 1990 through 2002.

The primary benefit of absolute return investing is alpha, the excess return that is not attributed to overall market movement. But the Morgan study concludes that it is not easy to identify such persistent, skill-based investing returns at the individual manager level.

These conclusions have interesting significance for hedge fund investors. The researchers find 40 bps per month of alpha in hedge funds at the aggregate level, which certainly underscores the value of using a diversified portfolio of absolute return strategies. But the study's conclusion that there is no persistence in individual manager alphas beyond random chance refutes the primary argument offered by hedge fund-of-fund (FOF) managers.

In addition to the admittedly important benefits of instant diversification, professional due diligence, and ongoing risk monitoring that hedge FOF managers provide, most FOFs choose to differentiate themselves from their peers by virtue of their ability to identify and invest in best-of-breed managers.

Yet the Morgan Stanley researchers argue: "In sum, manager selection on the basis of alpha appears to be quite difficult because the typical manager does not repeat past performance, at least in this timeframe. This is further evidence that, compared with 'passive' portfolios, active hedge fund portfolio management is a challenging business."

This provokes the hedge fund investor to compare the performance of passive multi-strategy hedge fund portfolios, offered in the form of investable hedge fund indexes, with the more actively managed (and often higher-priced) hedge funds-of-funds, which claim to provide access to the current batch of hedge fund superstars or the next undiscovered star manager.

Over the 13 years analyzed in the study, hedge funds in aggregate benefited from tactical timing between value and growth stocks and Treasuries and corporate bonds. For instance, hedge funds made bets on value in the early 1990s, but in the latter part of that decade demonstrated a stronger preference for growth issues. The funds' direct exposure to large-cap stocks was minimal.

On the basis of alphas calculated for successive three-year periods, the study concludes that the typical manager does not repeat past performance. Selecting managers for long-term alpha may be almost impossible, this reasoning suggests.

If the holy grail of 40 basis points of alpha per month is more attributable to hedge fund strategy selection and diversification than the ability to identify superior managers, then the attributes of investing in hedge fund indexes is indeed compelling. We will take a closer look next month.

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (), a global provider of hedge fund information and investment products. Chidem Kurdas is New York bureau chief at HedgeWorld.

For further inquiries about HedgeWorld, e-mail inquiry@hedgeworld.com. Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

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