Sometimes it's hard to tell the alphas from the betas.
Hedge fund managers in particular are supposed to provide alpha, or added value. So it's disturbing to learn you're getting beta otherwise known as market exposure when paying a hedge fund a 2% management fee and 20% of the upside.
But why are these managers investing in beta when they're supposed to be providing alpha?
Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology Sloan School of Management, Cambridge, as well as a hedge fund manager, says innovations in finance and technological developments have rapidly escalated the time in which alpha turns into beta.
In his speech last month at the CFA Institute's annual conference, Mr. Lo turned back the clock to 1971, when the first equity index fund was introduced by Wells Fargo Bank. The index fund now viewed as a commodity product and pure beta added alpha at the time it was introduced, he said. As more competitors started offering indexed strategies, that alpha turned into beta.
Similarly, many other market slices have turned into beta as more money has been poured into them. Years ago, styles such as value and growth, and factors such as momentum and earnings surprise, transformed into betas as increasing numbers of managers adopted them. More recently, equity market-neutral and the carry trade evolved into betas.
Hedge funds with more than $1 trillion in assets and more than $2.5 trillion when leverage is included have forever changed the investment landscape, Mr. Lo said. With their rapid trading, they have an impact way beyond their size, he said. Plus, they spawn imitators. The upshot: Alphas become betas much more quickly.
But is it such a bad thing to be paying high fees for these exotic betas? Perhaps the real test of skill is not only how much alpha is produced from securities selection, but also how good the manager is at picking betas.