Capacity Effect or Incapacity Effect?
Noël Amenc
By Noël Amenc, PhD, Professor of Finance at Edhec and Director of the Edhec Risk and Asset Management Research Centre.
For several months, investors and their advisors have been worrying about the profitability prospects for hedge funds.
Modestly entitled the “capacity effect”, the analysis of the reasons behind the fairly disappointing performance in 2004 constitutes, if we believe those who are putting the argument forward, a serious calling into question of the alternative investment industry’s value proposition. Alphas would be tending to become rarer, for two main reasons:
- The significance of the sums drained into the alternative investment industry are making the implementation of “niche arbitrage” strategies more and more difficult (for example, convertible bonds or arbitrage on small stocks); more globally, the increase in operational volumes is reducing market inefficiency and market anomalies, which are allegedly the main source of performance for hedge funds.
- The windfall represented by the remuneration model and the very strong growth in assets under management is attracting more and more managers, which is leading to a dilution of the talent available in the industry. The “democratisation” of hedge funds is making them increasingly dull.
The capacity problem that is supposedly linked to the disappearance of arbitrage opportunities has not been demonstrated and cannot, in our opinion, be demonstrated. On the one hand, the alternative industry, even taking the leverage effects into account, represents less than 2% of worldwide stock market capitalisation and, on the other, even when considering specific market segments (the raw material derivatives market, stock loan/borrowing market, etc.), it is true that one can reach very significant proportions of activity relating to the intervention of hedge funds, representing up to 30% of operations on certain stocks or up to 50% of some open positions, but these volumes rarely correspond to arbitrage operations. They generally involve bets that are directional (CTA, Global Macro) or related to the unfolding of events on securities that by definition are intended to move between market segments in accordance with speculative opportunities. In certain situations, hedge fund profits can be limited by the depth of the market, but it is not strictly speaking a reduction in inefficiency, simply a concern on the part of managers not to be the only providers of liquidity.
It has not been demonstrated either that the new entrants into the industry have less talent than the initial entrants. Academic research and empirical work on the “age” effect on hedge fund performance gives conflicting results. Besides, estimating a hypothetical increase in the number of fund failures is not possible either, given the reporting biases and the insufficiencies of databases in this area.
In fact, the essential part of hedge fund performance comes from their betas. Their talent resides in the management of those betas, namely, correctly taking risks for which the premiums, i.e. the “normal” returns, are less easy to capture in the equity and bond markets. Allowing investors, for example, to access the credit and volatility markets in good timing and price conditions undeniably constitutes added value which justifies turning to specialists. Even the performances of so-called “Relative Value” strategies such as Long/Short Equity and Equity Market Neutral are conditioned by bets on particular risks like, for example, the evolution of the Large Cap – Small Cap spread.
By constantly highlighting arbitrage alphas that are difficult to measure, hedge funds have themselves fallen into the trap of the capacity effect, with the risk of forgetting their true virtue – that of offering new betas to investors who are always looking for effective diversification.
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