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.