By Andrew Beer
A vexing issue with hedge funds is the lack of persistence of returns. Last year’s winners generally are no more likely to be this year’s. Consequently, while quantitative screening tools help investors to identify strong historical performance, they are of little use in determining which funds will perform better going forward.
Beachhead’s proprietary research demonstrates that, while alpha overall does not persist, “tactical” alpha does. Broadly speaking, hedge fund alpha can be broken down into two sources: position alpha and tactical alpha. Position alpha represents outperformance due to security selection, illiquidity and other factors, such as optionality. Tactical alpha represents medium-term relative value trades across asset classes – such as investing in credit post-crisis or shifting back to developed markets equities in 2012-13.[1] Both position alpha and tactical alpha have a low correlation to equities over time, and hence are valuable diversifiers.
In order to study the persistence of tactical alpha, we examined the performance of 679 funds over the seven year period from 2007 to 2013. The key conclusions are as follows:
- Managers that generated high tactical alpha (top quintile) in a given year outperformed the overall pool by 246 bps per annum on average in the following year.
- Outperformance was driven by greater alpha, not higher leverage: alpha to the overall pool was 275 bps per annum with comparable beta.
- High tactical alpha funds had a much higher Sharpe ratio (0.84 vs. 0.59) over the full time period.
- As expected, high tactical alpha funds performed materially better during the crisis, with aggregate outperformance over 2008-09 of almost 17%.
- Relative value funds show the most consistent outperformance due to tactical alpha: although representing only 18% of all funds, they accounted for 30% of top quintile funds.
These results lead to several important conclusions about hedge funds. First, unlike position alpha, tactical alpha tends to persist. This makes sense: high tactical alpha suggests the manager has a good understanding of the current market and, since tactical alpha positions tend to shift relatively slowly, this understanding provides a valuable edge in the near future.
Second, hedge fund managers can add material value through asset allocation. One potential implication is that hedge funds with broader mandates may have greater flexibility to capitalize on alpha opportunities among markets. It is noteworthy that equity long/short funds added less value through tactical alpha, although it is unclear if this is due to a narrower mandate or lack of skill.[2]
Consequently, in order to maximize returns, allocators to hedge funds may be better served by focusing on tactical alpha than position alpha. First, for many hedge funds, position alpha is rarely greater than all in fees; therefore, most alpha generation after fees tends to be tactical alpha. Second, since tactical alpha persists, a portfolio of high tactical alpha managers is more likely to outperform going forward. Finally, tactical alpha exposures can provide important, and highly valuable, insights into how managers collectively view the relative attractiveness of markets.
[1] Tactical alpha is distinguished from near term net exposure management, which generally does not produce consistent alpha.
[2] Interestingly, macro funds tended to add little value through tactical alpha, although this may be due to a difference in investment time horizon.
Andrew Beer, CEO: At Beachhead, Mr. Beer oversees all marketing and research efforts and is influential in portfolio construction. Mr. Beer began his career in mergers & acquisitions at the James D. Wolfensohn Company, a boutique firm founded by the forthcoming President of the World Bank. Mr. Beer worked in leveraged buyouts at the Thomas H. Lee Company in Boston during his tenure at Harvard Business School. Upon graduating, he joined the Baupost Group, a leading hedge fund firm, as one of six investment professionals. Additionally, Mr. Beer co-founded Pinnacle Asset Management (leading commodity fund) and Apex Capital Management (Greater China hedge fund). Mr. Beer is an active member of the Board of Directors of the US Fund for UNICEF, where he serves as Chairman of the Bridge Fund, an innovative financing vehicle designed to accelerate the worldwide delivery of life-saving goods to children in need. With his wife, Mr. Beer is a co-founder of the Pierrepont School, a co-educational K-12 independent school located in Westport, CT. Mr. Beer received his Master in Business Administration degree as a Baker Scholar from Harvard Business School, and his Bachelor of Arts degree, magna cum laude, from Harvard College.