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.”