Our friends at Novus put together an interesting article called “The Worst Year Ever for Hedge Funds” that used statistics to analyze which market environments are easiest for fundamental investors to generate alpha. The conclusion was that 2014 was the hardest year ever for hedge funds to generate alpha because the dispersion between winner returns and loser returns were the tightest in hedge fund history (read the article for a thorough explanation). I will not attempt to articulate any deeper, for doing so would basically require me to read you the article. What I will attempt is a few basic observations:
1) I really hope the premise of this article is correct and 2014 marks a nadir for hedge fund outperformance. As my partner, Benn Dunn, keeps saying, “what hedge funds really need in 2015 is a good down 5% for the S&P 500.”
2) For the hypothesis of this article to hold in practice, there is an assumption of luck. Basically, if we pick random portfolios, 2014 was the toughest year to produce outperformance. If alpha generation were pure skill, the evidence for 2014 wouldn’t stand-up because the skillful manager would buy the very high performers and short the very low performers…even though there were a limited number. The truth lies somewhere in between.
3) If there is a prospective element (these variables are forecastable) then a manager could use them to determine leverage (i.e. when it is easy, lever up, when it is like 2014, lever down). However, I’m finding it difficult to find variables in the analysis that are forecastable or are even stable. If they were at least stable, then you can use a tight current spread to suggest lower leverage, but the spreads can change rapidly.
Overall, this is a great read and made me think critically about disaggregating alpha. If you haven’t read the author Joe Peta’s book “Trading Bases”, you should. Finally, I’ll leave you with my favorite quote from the article, an excerpt I chose for clearly selfish reasons given Alpha Theory’s focus on position sizing:
“At Novus we’ve examined the performance of many hundreds of hedge funds and we’ve found that, by far, the most important skill to possess is the ability to size positions effectively. That’s because unlike Exposure Management, and to a lesser degree Security Selection, the ability to size positions efficiently is the most persistent and consistent alpha-generating skill that a portfolio manager can possess.”