How do hedge funds generate alpha?

System

Eeny meeny miney mo...

dtsazza

MatthewAinsworth wrote: »

How do hedge/topiary funds do better than other active management and the index?

Their approaches will differ. Typically, they develop bespoke technical models, that combine traditional and non-traditional data (e.g. Twitter temperament data) to make automated decisions about the real value of financial instruments.

In the cases that work, these models are both generally correct, and also work off factors that aren't common knowledge/commonly traded. The latter is important - BananaRepublic points out that LTCM did well in the past simply running Black-Scholes, but nowadays there's no way you could make money using (just) Black-Scholes as it's the bread-and-butter of how everyone else prices Options. You need to find factors that other people aren't taking into account, in order to find things that are priced "incorrectly".

It's understandably getting harder and harder, both as common knowledge expands, and as the hedge fund industry as a whole attracts more capital.

Is it that with high fees they can afford more research?

I'd say it's the other way round. In principle at least, their research means they get better results which means they can charge more for their services.

Is it that secrecy allows them to make insane risks/allocations that retail investors wouldn't tolerate?

I wouldn't say "secrecy" is the right word. But hedge funds do have a different regulatory structure that means they can invest in a wider range of securities than typical index/mutual funds. (IIRC the name comes from the fact that hedge funds can take short positions in order to "hedge" their general market exposure, theoretically meaning they can capture alpha).

Also, they might get a longer leash from their investors; there might be sufficient mystique around the hedge fund "brand" to allow them to shrug off short-term losses and convince investors it's fine, thus allowing them to take more volatile positions that other funds couldn't touch. But I'm not really sure how much that stands up to scrutiny - it probably doesn't.

Or is it just leverage making it look like they're better stockpickers when really they don't really know what they're doing?

I wouldn't say it makes them look better under any sensible metric. Hedge fund (investor)s tend to use the Sharpe Ratio rather than pure dollar earned/percentage yielded, because this adjust for exposure and means that trivial leverage doesn't inflate the number.

Though of course in the real world, leverage means that if you're doing well, you're making more money. (With the downside that if you do badly, you lose more money). If you're confident that your model can make the right call 52% of the time, then the best option is to throw those dice as many times as you can, and more leverage would help you take more meaningful positions.

If there is some sort of fund that let's you access hedge funds, are they worth it? Or can we replicate/ learn from their behaviour?

Hedge funds can usually only be invested in by so-called "sophisticated investors" (as part of their looser regulatory background). That said, many pension funds will invest in hedge funds as part of their overall portfolio (they're often considered an asset class in their own right that provides some diversification), so you might already have exposure.

As for learning from them, I highly doubt it. If it were something you and I could replicate, it would have been replicated, and then it wouldn't work (because the market price would already reflect these factors).

We could learn from their general approach:

1. do lots of research and backtesting to find a reliable indicator that no-one else has noticed
2. use it to detect securities that are over-/under-priced
3. collect other peoples' money to trade them
4. profit.

But it simply won't work on the scale of "I have a couple of hours on the weekend to manage my investments".

System

Dtsazza-

. But hedge funds do have a different regulatory structure that means they can invest in a wider range of securities than typical index/mutual funds

That could be where their opportunities lie...

I put 100% of my sipp into global small cap, volatile but 20%ish a year, much lower fees than a topiary fund, think I might do better than them! I should really get some embetter market small cap as I think after a dull 5 years that's due a surge, but the everyday volatility could be a minor problem come sale time

. (they're often considered an asset class in their own right that provides some diversification),

Their underlying assets are the same though, equities, bondage, property and derivatives?

I do find it odd that they hedge their bets one one hand and leverage them on another, like they can't decide if they actually are betting on something

I think if there's any place for research its with small + micro cap, although if it requires so much work its only viable on large amounts. Maybe if someone is rich enough they'd be better off paying a fixed fee for private research rather than a %, or just own the management of the hedge fund itself

Superscrooge

MatthewAinsworth wrote: »

How do hedge/topiary funds do better than other active management and the index?

Is it that with high fees they can afford more research?

Is it that secrecy allows them to make insane risks/allocations that retail investors wouldn't tolerate?

Or is it just leverage making it look like they're better stockpickers when really they don't really know what they're doing?

If there is some sort of fund that let's you access hedge funds, are they worth it? Or can we replicate/ learn from their behaviour?

Most hedge funds don't beat the index. See below link re Warren Buffett's $1million bet with hedge fund managers.

http://finance.yahoo.com/news/buffett-most-mportant-investment-lesson-211351601.html

Glen_Clark

In the early days hedge funds seemed to do well. But then QE turned conventional economics on its head. Everything we 'know' is wrong. For instance instead of bad economic news usually lead to a fall in share prices, now its more likely to lead to a rise in share prices as central banks print more cash, and banks are looking for cheap ways to store banknotes as rates go negative. People once encouraged to save for a rainy day are now being punished for doing so. Share prices move on the words used by politicians or central bankers. Unless you have inside information (why else do traders hire (ex) politicians?) this makes share price movements much harder to predict.
Its the economics of the madhouse, so many hedgies have lost money.