Hedge Fund Strategy Classification: My Perspective

A common topic of discussion in hedge fund circles is how strategies are related and should be grouped or classified. Putting strategies into broader groupings may be useful to the risk management effort. Of course, one can argue about how coarse or fine the strategies should be.

On one hand, one could argue all manager's strategies are unique (thus making any classification meaningless) or one could group it in only two or three categories. In the Handbook of Alternative Investments, Mark Anson classifies strategies into three groups: strategies taking market risk, strategies taking credit risk, and those taking low market and credit risk.

Under market risk focused, Anson lists Equity long/short, short selling and Global Macro. Under Credit Risk, he lists convertible arbitrage, event driven, merger arbitrage, fixed income, and relative value. Under low market and credit risk, he lists market neutral and market timing.

We had occassion to independently classify twenty-two strategy indices into meaningful categories and we came up with six (including managed futures). Since managed futures is technically not a hedge fund strategy, it is not part of Anson's hedge fund classification scheme. Our classification used a factor analysis that we performed on approximately 10 years of data for two providers: CSFB/Tremont and Evaluation Associates.

Our Market Neutral category has only one index, the Evaluation Associates Market Neutral index.

Our Equity category includes Equity Long/Short (except for Emerging Markets and Equity Global) and Short Sellers. It excludes Global Macro.

Our Global classification includes Equity Global, Emerging Markets, and Evaluation Associates Discretionary.

Our Relative Value category includes Convertible and Fixed Income Arbitrage and Relative Value Multi-Strategy.

Our Event Driven category includes Merger Arbitrage and Distressed, as well as Emerging Markets, and Event Driven Multi-Strategy.

Relative Value and Event Driven shold not be lumped together, as they have very different correlation to the second factor.

Our Managed Futures category has Managed Futures and Systematic indices

Finally, two indices did not fit well in our clasification scheme: CSFB Tremont Global Macro and the CSFB/Tremont Equity Market Neutral index. Both have too much exposure to the first directional factor.

In summary, our chief disagreements with the Anson classification scheme are the placement of Global Macro in the market risk category and the failure to distinguish between relative value and event driven strategies.

But What is Hedge Fund Alpha Anyway?

We've thrown around the word alpha the last few posts as if everyone knew what it is. It does have a common Capital Asset Pricing Model (CAPM) definition, typically applied to stocks. But we think the same analysis is quite inadequate for hedge funds.

Moneychimp.com offers this definition for alpha:

Measure of a stock's performance beyond what its beta would predict

So, we now need a definition of beta:

A measure of an investment's volatility, relative to an appropriate asset class. For stocks, the asset class is usually taken to be the S&P 500 index

So, an equity's return can be broken down into a market-related component (multiplied by a factor which takes into consideration a stock's riskiness or uncertainty) and an unexplained factor, the alpha.

Now, if the world really operated with only one factor, "the market", this might be a usueful analysis. It has applications in evaluating mutual funds: you can measure a manager's performance by looking at his beta exposure to the market to see if the resulting alpha is positive or negative.

Unfortunately, in a hedge fund world, managers are exposed to more than a single factor. It is quite easy to look at returns relative to credit spreads and volatility and see that managers may, depending on the strategy, make bets on the direction of these factors as well as market direction.

So reliance on a one factor model for hedge funds is likely to be misleading. If some of the other major influences are included, a beter idea of which strategies are producing alphas can be derived.

We'll provide more discussion of hedge fund alpha in a later post. But, for now, we would suggest that gap between the best and worst alpha strategies may be as large as 7-8% a year, a substantial spread.

Further Thoughts: Alpha and Return Expectations

We titled our last post "Is the Hedge Fund Game Over?" and left you for a few days: we hope readers did not think we left this venture and forgot to turn off the lights. But we have reflected on one paragraph in that post:

William Sharpe contends:

"On average, the clients are going to get less than Treasury bills."

On some level, we agree: alpha is a limited commodity and the more funds there are pursuing the same or similar niches, the less opportunity there is for good returns.

We can be accused fairly of "intellectual hydroplaning" with those comments.

In short, William Sharpe's contention that clients will get less than Treasury bills may be accurate in the short run. However, an expected return below Treasury bills (net of fees) is not a viable long term return objective. Very simply, assets will leave the hedge fund industry in droves (perhaps as fast as they came) if this were to be the case.

The result we expect will be an expected return above Treasury bills for hedge funds. Nevertheless, we do not mean to question the impact of increased assets on returns. We believe alpha exists for a variety of structural reasons and that it is reasonably finite (or grows marginally as the underlying asset classes grow).

For example, investing in illiquid securities like distressed probably has a positive expected returns because there are debt holders that cannot or do not want to carry sub-investment grade debt on their books. The amount of distressed debt obviously is a function of the business and credit cycle. The returns are a function of that supply and the amount of funds chasing that supply.