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03/08/2011

Book Review: Hedge Fund Alpha


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Hedge fund alpha Generating and understanding performance are two distinct processes that often require different skill sets and are typically performed by different arms within a hedge fund organization. The former falls under the realm of the portfolio manager; the latter is often provided by the CFO, COO, or investor-relations functions at the hedge fund. Editor John Longo skillfully combines explanations of both processes in the Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance.  The essays in this book elucidate what the alpha-generation process is, as well as how the outcome of that process is assessed, evaluated, and monitored. While these are separate questions, there is a feedback mechanism between the two, which reinforces the importance of understanding both topics.

In the first section, “Generating Performance,” Longo starts by addressing the question of whether alpha exists. Concluding that it does, at least on an individual basis, he then focuses on how alpha generation by hedge funds differs from the traditional long-only model. A fertile ground for alpha can be found wherever inefficiencies exist, such as across regions and across asset classes. Alpha can be delivered via superior investment mosaic and superior execution, and it can be enhanced through the diversification of strategies via multistrategy funds and through the diversification of portfolio managers via fund of funds, to name some of the broader methods. Longo and a selection of experts delve into each of these sources of alpha. For example, when it comes to the emerging markets of the BRIC countries, the authors provide a foundation for understanding each market, detailing its history, regulations, psychology, and peculiarities.

The second half of the volume, “Understanding Performance,” addresses the following questions: What drives a portfolio manager’s decision-making process? And, how do we evaluate the achieved performance? In the chapter on “The Psychology of Hedge Fund Managers,” Longo examines the incentives for portfolio managers, specifically noting that they may not be perfectly aligned with the investors’ interests due to the call option nature of hedge fund compensation. In addition, portfolio managers may suffer from a number of psychological biases that may impact their decision-making processes.

Performance can be evaluated relative to the risk taken and relative to market indices. This and other quantifications of performance and risk are the subject of Saad Rathore’s chapter on “Risk Management for Hedge Funds.” The author discusses various metrics such as alpha, beta, the Sharpe ratio, the Treynor ratio, the Sortino ratio, and others, highlighting the importance of delta- and beta-adjusting exposures, as well as tracking leverage and liquidity. The important subject of due diligence is covered in detail by Erman Civelek, an expert on this topic.

One of the most fascinating chapters is the concluding one, which identifies seven trends in the hedge fund industry. Longo believes that there is a tendency toward lower fees, increased transparency, and a greater focus on niche strategies and markets (such as trading carbon credits or investing in emerging and frontier markets). The former two trends, one could argue, have already been observed to some extent in the market place. The third one may take longer to come in full force, as there appears to be a plethora of opportunities that utilize more-traditional strategies.

The title of the book suggests an ambitious agenda covering a broad set of topics, and this breadth is achieved. A rigid structure, stand-alone chapters, and numerous short sections within each chapter help the book live up to the promise of its title; it is, indeed, a “framework.” While the book contains more information than a review could possibly cover, in some cases the reader may find herself asking for more content, real-life cases, and intuitive explanations of the concepts. But, what is particularly unique and appealing about this book is Longo’s skillful combination of the portfolio manager’s and the investor’s perspectives. Those perspectives represent two sides of the same coin, and this book will benefit anyone who is familiar with only one side of it.

–Boriana Handjiyska, CFA, is an associate at Morgan Stanley, where she provides portfolio analytics services to hedge fund clients.

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