A new study by Edhec contradicts the conclusions of two recent reports on the capacity effects in the hedge fund industry.
"The Critique of Pure Alpha", by Alexander M Ineichen, UBS Investment Research (March 2005), and "Capacity in the Hedge Fund Industry", Watson Wyatt LLP Investment Consulting (March 2005), both postulate that the essential part of hedge fund performance comes from the intervening parties' capacity to take advantage of market anomalies (pure alpha strategies). The increase in volumes, so the argument goes, would render arbitrage more difficult on the one hand, and on the other, the influx of managers would be lowering the level of expertise and talent in the industry.
But Edhec's study '"The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy", suggests that this approach to hedge fund performance in terms of pure alphas has not been proven, and it would be more appropriate instead to consider that it is the betas and the managers' capacity to take properly rewarded risks that contribute to the essential part of their performance.
According to Ehdec, only 25 per cent of the variability in the returns of hedge fund strategies is due to pure alpha (i.e. security selection) and pure alpha accounts for less than 4 per cent of the returns of hedge fund strategies.
Alternative investment alpha is linked more to a capacity to time risk factors correctly than taking advantage of market anomalies. No microeconomic study has proven that the positions taken by hedge funds are so significant in certain market segments that they would durably prevent them from making profits.
Most contributions on the capacity effect evoke short-lived and intermittent "cornering" phenomena and are based essentially on an observation of poor overall performances that do not distinguish between the beta effects (degradation of factor premiums or returns) and the alpha. Moreover, one should note that the low number of observations on which hedge fund performance statistics are based mean that they are neither representative nor statistically significant.
Finally, it is appropriate to recall that the statistics published by the Centre for Economics and Business Research in its briefing of 18 May are not confirmed by an exhaustive approach to the incidents of debt repayment in the alternative industry either. The 20 per cent of hedge funds for which closure is predicted in the next two years are not bankrupt funds, but funds that have ceased their activities, notably because the investors were not satisfied with their performance.
This selection of managers by the market is a natural and virtuous phenomenon. Interpreting it as a major difficulty and equating "natural" closure with bankruptcies that are liable to provoke a crisis in financial markets neither complies with the elementary rules of scientific prudence nor is it relevant in relation to industry practices.