It is usual in the investment world to break down the returns on a portfolio into two components, “alpha” and “beta.” Alpha is the part of the portfolio return which can be attributed to the active management of the portfolio - the manager’s skill, if you like, while beta is that which is due to the general change in market prices, usually determined as those of an index appropriate to the portfolio’s investment focus. So an index fund, which carefully tracks the returns of an index such as the S&P 500, is pure beta. There is no management decision-making, it just owns a portfolio of shares in the proportion in which they are represented in the index. The index fund therefore charges low fees, typically less than 1% of assets, because all it offers is basically an administrative service.

The original idea behind hedge funds, as the name implies, is that such a fund would “hedge” away the beta, the market risk and, of course, the market return, leaving only the return due to the talent of the manager - the alpha. So the “pure” hedge fund in the traditional sense is the exact converse of the index fund because it is pure alpha.

Markets, as we have recently seen, can be subject to wild swings and serious drawdowns. Between 2000 and 2002, for example, the Nasdaq Composite Index fell by 70%. Quite apart from not wanting 70% losses, this volatility of returns means that it is very dangerous to leverage portfolios whose returns have a significant beta component. Whereas the idea behind alpha is that it should be reliable and consistent, even though it may be modest in absolute quantity. Because if alpha-based returns are stable and consistent, they can be increased by adding leverage. Since the risk of drawdown is small, little capital is needed to absorb the swings and most of the portfolio can be financed with debt. This attribute makes alpha very valuable and justifies the high fees that hedge fund managers charge. For example, a portfolio that returns 2-3% over the cost of borrowed money, with never more than a 2-3% drawdown, could safely be leveraged 10:1 to return, say, 15-20% after interest costs and management fees. Hedge funds often charge a 2% fee plus 20% of profits. Real alpha is worth it.

The problem comes when hedge funds aren’t really hedge funds. In a bubble enviroment when steadily increasing leverage keeps jacking up asset prices, the temptation is to simply leverage up the returns offered by the market - the beta - and charge clients big fees as if the returns came from alpha. It looks good for a while, so long as the beta return stays positive and drawdowns are small. But inevitably the market reverses, and then the beta-based return and the alpha-based returns diverge, often with exciting consequences. Because leverage has been used, drawdowns quickly eliminate the investor’s capital and the funds blow up in an ugly mess of margin calls, seized collateral and apologetic managers. Just as we have been seeing.

Alpha requires management talent. The huge growth of hedge funds has probably not been accompanied by a miraculous growth in the number of talented managers out there, able to deliver alpha. So it is not unreasonable to believe that there are a lot of hedge funds out there, which are really selling beta with leverage at alpha prices. Jeremy Grantham recently predicted that half the hedge funds currently in business would disappear within the next five years. I don’t expect it to take that long.