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How Unique Is Your Strategy?

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NEW YORK (–A money manager who claims to make alpha returns is in effect claiming to have a special approach that’s very hard to duplicate. Otherwise, why isn’t everybody else getting those extra profits?

Truth is, much of what hedge funds do can be learned and imitated. Indeed, recently a mutual fund company, Rydex Investments, started offering retail products that promise to reproduce the performance of certain hedge fund strategies, and at lower cost to the investor.

A new report from Rydex explains the underlying analysis. These funds make no attempt to provide alpha, said Jeff Joseph, managing director at Rydex Capital Partners. But the beta return they target is not just what comes from straightforward exposure to markets.

It includes a skill-based component. People have been unpacking beta: It is no longer seen as one thing. There’s the kind of return one gets from a long-only mutual fund and then there’s the kind that requires non-traditional activities–short selling, derivatives trading, use of leverage.

Skill-based beta is a hybrid–it’s more complex than traditional beta but more easily copied than alpha. Then again, it is not widely replicable, as long-only managers typically don’t have the skills.

Rockville, Md.-based Rydex has been offering unconventional mutual funds, including short-only vehicles, for many years. So its managers have developed the short-selling and derivatives trading abilities necessary to extract hedge fund beta.

Hedge funds claim to get alpha returns but really make both alpha and beta, said Mr. Joseph. The power of market exposure, or beta, as the driver of performance shows up vividly at times, as in late 2004 when many hedge funds gained substantially from a steep rise in equities toward the end of the year. There could not have been much alpha in those returns.

The two types of beta account for 70% or 80% of overall hedge fund returns, but managers always charge performance fees as if they’re delivering pure alpha, Mr. Joseph said. His point: The Rydex funds don’t promise alpha but neither do they charge 20% for performance.

Perhaps one should dispense with Greek letters and go with a star system, as in restaurant reviews–four stars if the strategy is absolutely unique, three stars if only a dozen managers in the world can duplicate it, and so on.

Industry people who have pointed to hedge fund beta include Clifford Asness, manager of AQR Capital Management LLC, who distinguishes strategies that can be expressed as a systematic, repeatable process from those that cannot be. The notion of alpha rightly applies only to the latter.

Robert Jaeger, chief investment officer and vice chairman of the fund of funds firm EACM Advisors LLC, part of Mellon Financial Corp., also has argued that particular strategies can be replicated and these are the ones that got crowded, like convertible arbitrage.

The new internally managed Rydex Absolute Return Strategies Fund and Hedged Equity Fund are separate from the company’s Sphinx Fund, which tracks the Standard & Poor’s hedge fund index and invests with outside managers–who presumably deliver some alpha.

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Contact Bob Keane with questions or comments at [email protected].


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