'Alpha' is a concept that has always distinguished hedge funds. It means outperformance relative to the “beta” of the market, and alpha generation is the goal of the industry. An actively managed hedge fund that is not generating alpha, i.e., that is not outperforming a passive index tracking fund, will lose its raison d’etre.
In the early days of hedge funds, alpha was generated at a prodigious rate. The greats of 1990s, for example, such as the legendary George Soros at Quantum, were associated with bold bets and outsize returns. This continued in the early years of this century, but the Global Financial Crisis was a watermark moment. It ushered in an era of central bank intervention in markets that made generating alpha much more difficult.
That was because programmes such as quantitative easing that were utilised by central banks globally had the consequence of pushing up the value of most assets for a sustained period - spring 2009 through to the Covid crisis of early 2020, indeed. This meant it was a great time to hold assets like U.S. public equities (which were going up 15-20% a year), and passive, index tracking funds flourished because of it.
It is difficult for any active investment manager to outperform the market consistently when the market is growing at such a high-octane rate, and this was true in aggregate of the global hedge fund industry, although, of course, there were exceptions. Instead, the industry sought to redefine its value to investor portfolios, the new paradigm being one of downside protection and diversification rather than alpha. The alpha era was apparently over.
But now it may be back. And that is according to the investment banks that provide services to hedge funds, the so-called prime brokers, who arguably understand the industry as well as anyone. For example, according to BNP Paribas, we are entering a new era of alpha for hedge funds. In their recently-released 2024 Alternative Investment Survey they argue that “allocators are starting to position for an era where alpha and diversification are finally expected to deliver strong returns”. Similarly, according to new Barclays research, investors are planning to increase their hedge fund exposures this year and more allocators want to add new managers to their portfolios.
The investors themselves were making similar points during ‘hedge fund week‘ recently in Miami, where many of the largest hedge fund conferences globally take place. From their perspective, the opportunities are back for hedge funds to flourish. The return of market volatility, banished during the ’great moderation‘ of central bank intervention, creates winners and losers.
Hedge funds which, unlike their mutual fund cousins, have the ability to trade across multiple asset classes and to use powerful instruments like leverage, derivatives and shorting, should be well-placed to capitalise on these opportunities. Indeed, in Miami, some investors, speaking under the Chatham House rule, talked of all of this meaning a new “golden era” for hedge funds.
So, as this new era dawns, allocators will be looking at hedge funds with renewed interest. But that does not mean that the money will just roll in to the industry. Many institutional investors remain cautious about allocating to the space and devote great time to the due diligence of managers. In order to be rewarded with capital, a firm must avoid giving prospective allocators any reason not to invest in them. That often means having the right operational infrastructure, governance and culture, but it also means having the right reputation in the marketplace.
As many firms have found, negative reputational issues can gravely damage their capital-raising prospects, while conversely, a strong reputation can be highly compelling to allocators. Increasingly, hedge fund managers understand that reputational risk can be just as important to the success of their firms as market risk.
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Christen Thomson is a Senior Director at Citigate Dewe Rogerson
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The views expressed in this article are those of the author and do not necessarily reflect the views of AlphaWeek or its publisher,The Sortino Group
