Quote from Smoker:
Maybe this is better. You know for certain and without question the way the successful hedge funds/CTAs got big and then stayed big and sometimes even keep growing from big to huge had to be because of generating alpha because if they didnât generate Alpha they never would have never gotten big in the first place.
This is similar to the statement that a good bet is that generally a player in the NBA is a better basket ball player than the other guys he played with on his high school team due to the fact he is playing in the NBA while the other guys for whatever reason or circumstance are not playing in the NBA.
I will clarify right away that I am talking about return on capital, not absolute P&L. From the absolute P&L perspective, the best bet is to be running the most capital you can get your hands on - it maximizes your traders option. If you running a few yards under 2/20 model, you don't need alpha at all, you just keep punting and hope for a good year. As long as you can ensure no massive redemption flows, you are going to make out just fine - just look at some of the "creme de la creme" of the hedge fund industry.
The real reason why big funds got bigger (and will continue to get bigger until some sort of de-crowding event happends) has very little to do with alpha, as defined by risk-adjusted excess returns. For almost every fund, the risk-adjusted metrics decline significantly with the AUM and their absolute level of correlation with the market increases. Simply comparing the risk-adjusted returns of any broad HF index to a mixed basket of assets ("portable beta" style) shows that most hedge fund returns can be explained by a few market factors. So, no, on average there is very little alpha there.
While most managers probably were alpha producers at some point in their lives, the sheer size of capital forces them to become more and more of a macro/beta players. The growth of large funds has mainly to do with their attractiveness to allocators (size breeds size) and the ability of the fund to retain AUM.
Now, to your NBA analogy. A basketball player has massive amounts of quantitative data that allows people to asses his skills. We both know that even in 20 years of performance of an average PM, the statistical significance for results is pretty low. Managing money is not a sport with a lot of repetitive actions, it's an activity where the noise from randomness and the overall market "drift" overshadows the actual skill in the majority of cases. Someone who's been continuously long bonds over the past 20 years has done handsomely and probably attributed it to his own skill, even though in basketball terms this would be equivalent to getting on the court and lying down for the duration of the game. There are plenty of other type of examples where supreme salesmanship has enabled the "player" to take large punts at the right time and subsequently raise tons of AUM.
All this said, there are good reasons for institutional investors to concentrate on large funds only. DD and monitoring capacity is limited, so you can't write too many small tickets. There is reputation considerations as well as established "lateral" information sources about the fund. However, I can't imagine that any FoF is still under illusion that they are investing into funds like Paulson or Citadel for their alpha.
Quote from Smoker:
Anyway just curious about how you define your âlarge beta betâ term.
My definition of a "large beta bet" would be a set of positions/strategies that mainly show profit given a particular market direction. For example, long-short equity funds (despite having the short component) in general are long-beta bets, while fixed income funds are (or at least used to be) more of a short beta bet. To contrast, an "alpha bet" would be a set of positions/strategies that is mainly driven by non-directional factors, so it is able to produce a P&L decorrelated from the broad market performance.
