In the course of his due diligence trips on behalf of the MDE Group, an independent registered investment adviser, John Longo has found that hedge funds often convert their portfolios to cash or significantly hedge their positions if they achieve a positive return partway through the month. Locking in such temporary gains is surely not a strategy designed to maximize investors’ long-run wealth. Rather, in Longo’s estimation, the managers’ motive is to maximize their scores on the percentage of positive monthly returns in the databases that investors and consultants use to select hedge funds.
This discovery is not an isolated case of highlighting an unusual or provocative angle in Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance. For example, Longo (the book’s editor) and two of his dozen academic and practitioner contributors suggest a “too high profile to fail” strategy of investing in state-owned Chinese companies with weak balance sheets. The rationale is that the government would rather infuse cash into such companies than suffer the embarrassment of a bankruptcy.
Longo and his collaborators also describe a “murky” area of the prohibition on front running—that is, trading by a broker/dealer in advance of executing a customer order large enough to move a stock’s price. A variant of dubious legality consists of capitalizing on the knowledge that the initial order is smaller than the customer’s typical position size and is thus likely to be followed by additional large orders for the same stock. A hedge fund may receive this valuable information from a broker/dealer, cover its tracks by executing its trade in the stock with a different broker/dealer, and then reward the provider of the information with commissions on other transactions. Longo, a clinical associate professor of finance at Rutgers Business School, stresses that he does not condone violations of U.S. SEC rules. His point is that contrary to the assumptions of traditional economic theory, information does not invariably become available to all investors simultaneously. This asymmetry creates opportunities for the better informed to generate alpha, or superior risk-adjusted returns.
Shedding light on dodgy practices is by no means the primary value of Hedge Fund Alpha. It offers hedge fund managers an array of fundamental research methodologies, together with sources of legitimate informational edges. One source of particular interest to short sellers is Negibot, a search engine that focuses on negative words (“terrible,” “poor,” “sucks,” and so on) that appear in conjunction with new consumer products. In their catalog of opportunities for generating alpha, Longo and his contributors pay particular attention to the BRIC countries (Brazil, Russia, India, and China).
Investors will benefit from the book’s comprehensive treatment of hedge fund evaluation and due diligence. The discussion is up to date, dealing with such issues as the performance of the value at risk model during the 2008 market plunge. Longo and his fellow contributors recommend numerous approaches to the all-important task of judging whether a fund’s historical performance edge truly arises from superior analysis rather than leverage and whether that edge is sustainable.
A useful perspective on the latter point emerges from an original research study included in the book. Longo and Yaxuan Qi of Concordia University simulate the annual returns of popular strategies derived from three demonstrated efficient market anomalies involving small stocks, momentum, and accruals. (The third anomaly concerns the artificial and detectable propping up of earnings by struggling companies that underperform the market once their true level of profits becomes apparent.) In each case, the strategy produces an impressive risk-adjusted return over the long run but either suffers an interim multiyear period of poor performance or produces a double-digit negative return in at least one year. Either outcome can precipitate enough investor withdrawals to put a fund out of business. Although the study’s authors do not make the point, their findings may partly explain why statistically proven anomalies turn out to be unexploitable in practice and, therefore, persist.
In view of the excellence of the book’s content, one wishes the copyediting had been more meticulous. Such hitherto unheralded characters as “Allan” Greenspan and “Bryon” Wien appear in Hedge Fund Alpha’s pages, together with such infelicities as “for all intensive purposes” and “visa versa.” The text cannot seem to make up its mind between “high watermark” and “highwater mark.” (“High watermark” is the preferred rendering in fund documentation; dictionaries give their blessing to “high-water mark.”) Page 29 refers to Appendices A and B, yet the actual appendices are designated by numerals. Furthermore, the points plotted in the graph on page 258 fail to correspond to the data in the table just above it.
Notwithstanding these flaws, Hedge Fund Alpha is an invaluable resource for both managers and investors in one of the most dynamic segments of the capital markets. It concludes with an astute listing of changes likely to sweep the hedge fund industry in the next few years. If they come to pass, Longo’s highly readable volume may soon require a new edition, which could put the book on the path to becoming a permanent and indispensable feature of the hedge fund world.