Are hedge fund managers really “alpha craftsmen”?
By: Tim Bennett
10.01.2019
In his latest video, Tim Bennett explains why investors should be wary of the latest piece of hedge fund marketing jargon.
To Receive Tim’s videos straight to your inbox, please click here.

Are hedge fund managers really “alpha craftsmen”?

Hedge fund managers claim to add something called “alpha” (in effect, additional skill) which they say justifies their high fees. What’s more, they now say they add this in multiple different ways, making them what the sector calls “alpha craftsmen”. So, this week I take a look at this latest piece of industry jargon and ask whether investors should fall for the hype.

Background

Traditionally “alpha” has been defined as better than average stock selection. However, fans of “alpha craft” say there is more to it than that.
The problem is that recent data doesn’t really support their claim. A quick look back at the fourth quarter of 2018 for example reveals a pretty dismal picture.
So, let’s recap what equity hedge funds do for a living before taking a look at what this latest buzz phrase is supposed to convey.

Equity hedge funds

One of the challenges facing investors in this sector is that the phrase “hedge fund” covers a wide range of structures and strategies.
So where does “craftsman alpha” fit into this framework?

Craftsman alpha

Definitions vary, but here is one that captures the essence of this rather grand phrase;
The first thing, then, that a manager needs to decide on is their investing style. Whilst there are many possible ones, here is a summary of the most commonly adopted.
Alpha craftsmen then shape a portfolio by making certain choices once a style, or combination of styles, has been selected. Here are just a few examples, using the “value” style (looking for good stocks that appear cheaper than others) as our framework.

Defining value stocks

First off, there are many ways to define “value” and thereby screen for cheap stocks. Here are just three of the most commons ones;

Crafting portfolio weightings

Once a particular screen has been applied, there are then decisions to be made about what proportion of the total portfolio will be allocated to those stocks. This is where some of the “craft” comes in.

Blending different styles

Where a manager decides to adopt more than one style (say, value and momentum), there are then different ways of blending them together.

Rebalancing

Having constructed a portfolio using certain criteria, a hedge fund manager will then need to decide how often to rebalance it and on what basis.
So far, we have just looked at a value-based approach but already a hedge fund manager will claim to have added various layers of alpha and skill (or “craft” as the latest jargon puts it). And bear in mind that there are many other decisions about portfolio construction where a claim can be made to have added alpha.

The problem

It should be clear already that one of the challenges for an investor in any hedge fund is working out where and how a manager has decided to try to generate their extra alpha.
This is particularly so when recent results have, in most cases, been pretty poor and the gap between the best and worst funds has widened.

Conclusion

To dismiss hedge funds out of hand for using yet another piece of jargon would be a mistake as some managers add a lot of value (alpha). However, more than perhaps in any other part of the funs world, investors must be selective. Some hedge funds are little better than expensive ways to bet on share prices rising. Worse, some in effect just take leveraged bets on popular stocks that anyone could buy more cheaply elsewhere (the “hedge fund hotels”). Others do deploy sophisticated strategies that can generate market-leading returns. Ray Dalio’s Bridgewater Associates demonstrated this in 2018 by soundly beating the returns available from all the major global stock indices, including the S&P 500. The key for investors is to look under the bonnet and understand where and how any extra alpha is going to be generated. If that is not something you are prepared to do, then I would suggest steering clear of anyone claiming to be an “alpha craftsman”.