French business school Edhec has declared that it can find no proof that there is a ‘capacity effect’ in the hedge fund industry, by which hedge fund performance will deteriorate as the industry grows because their profitability stems from their ability to take advantage of market anomalies – what Edhec calls “pure alpha strategies.”
The increase in hedge fund volumes – so the argument advanced by Alexander M. Ineichen of UBS and Watson Wyatt goes – renders arbitrage more difficult. At the same time, the influx of new hedge fund managers lowers the level of expertise and talent in the industry.
In “The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy”, Edhec contradicts this argument. “There is absolutely no proof of a ‘capacity effect’ in the hedge fund industry,” say the authors of the paper.
They argue that analysing hedge fund performance in terms of pure alphas is mistaken, and that it is more appropriate to argue that performance depends on betas, and the capacity of hedge fund mangers to take properly rewarded risks.
In the Edhec analysis, only 25% 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% 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,” say the Edhec analysts. “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.”
Edhec adds that the statistics published by the Centre for Economics and Business Research in its briefing of 18 May were not confirmed by an exhaustive approach to the incidents of debt repayment in the alternative investment industry either. The 20% 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,” say the Edhec analysts. “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.”