As an insider at a large L/S equity hedge fund I would say that for sharp practioners there is plenty of alpha. Beyond my deep knowledge of our robust, diversified, consistent performance the spectacular performance of various quantitative groups — the most visable being Renaissance — completely settle this argument.

The challenges for a fund like ours (and I would imagine its similar for the quants) are 1) how to find very intelligent, creative, motivated individuals and 2) how to keep them motivated after a few $10M paychecks. The simple fact is elite individuals are rare and they have other opportunities. For example, the weath creation in software and internet companies seems to make us hedge fund practioners distinctly 2nd class.

It is interesting to ask oneself - Does the existence of $100M in personal alpha (say 30% of delivered alpha perf) for some elite individuals AFFIRM or CONTRADICT the “efficiency” of financial markets?

In the period up to 2000 “indexing” was in vogue, as was long speculation. And as markets tend to do, the exxageration of one idea engineers its own downfall. Is not the “IPO-process” a Boggle-style indexing killer? If most of the world money is index invested, cant I just IPO at absurd valuations, tie-up most of the float and force “market-cap” weighted indexers to buy at my price? So the system engineered that and we have moved on.

I think how one defines alpha “scarcity” at present is something fruitless (like - CAPM, efficent market, significance-test) that will occupy academics time in place of common-sense. But I think there are related questions which are interesting:

Do we think the current environment, with so much hedge fund money is very healthy for our capital markets? (YES!, so many pricers, so much diversificiation, so many innovators)

Do we think more hedge fund money is healthy? (YES!)

Finally, might we be sowing the seeds of some correlated unwind that we cannot envision?

To that I answer - yes. But we certainly cant run prior stats or some equation to quantify this! And it probably will not be so simple as “interest-rate” or volatility run up.

I take Eric Larsson’s point that more hedge funds almost certainly means a decline in the average skill of the universe of all hedge fund managers (and a corresponding increase it the dispersion of such skill across managers.) That said, I sense that even the best funds are experiencing greater difficulty finding good alpha opportunities than was true ten years ago.

Just a quick point regarding Nick Barcia’s comment about creating random portfolios: not changing the market average depends on the underlying distribution from which the sampling is made (Nick’s conclusion is correct given a uniform distribution, which would also imply a relatively “negative” view on the capabilities of the investment managers). On a related note, I firmly believe that it is quite dangerous to draw any strong conclusions from the falling average returns without taking into account the plethora of more or less inexperienced fortune seekers entering the hedge fund space.

It seems to me that while efficient markets would rule out the possibility of positive alpha, there are still several points that can be made. First, we have seen that markets are not always (maybe not ever, depending on who you ask) weakly efficient. That means that in the short term alpha can be positive. Second, while we are often talking about the market as a whole being efficient, that doesnt mean that sample portfolios (i.e., any hedge fund picked at random) cannot exhibit positive alpha in the short run (several years). If I were to create several thousand portfolios randomly, some would have results well above and some well below market average. That would not change the market average.

For those deeply interested in the whole alpha-beta debate www.allaboutalpha.com is an excellent resource. One very interesting post in January (http://www.allaboutalpha.com/blog/2007/01/09/  a-financial-period-of-enlightenment) discusses work by Alexander Ineichen. It points out that effective market timing may look like beta in retrospect since, after-the-fact, the return for a given period will be explained by systematic market factors that were moving favorably. In the popular sense, however, this is really a form of alpha if the manager is able to adapt to a regime shift in a timely manner.

Clearly markets can never be perfectly efficient and there will always be some unsystematic returns available. In addition, not all managers seeking to exploit inefficiencies are equally adept. Thus the surge of investment in hedge funds in the past decade does not necessarily imply a proportional increase in EFFECTIVE exploitation of arbitrage opportunities. (This is closely related to Schachter’s point that the addition of less skilled managers pursuing a hedge fund strategy could actually lead to herding behavior and increase the available pool of alpha.)

The debate about the possibility of enhancing returns through active management is as old as the hills and as perennial as the grass. I remember it being actively debated at The Wharton School in the late 1960s. In the end it comes down to the point made by Merton Miller, namely “To beat the market you’ll have to invest serious bucks to dig up information no one else has yet.” The question is whether enhancing returns is getting harder as more and more investment managers deploy more and more funds with less and less constraints (such as long-only mandates) in an effort to take advantage of the hard won information they assemble. What we loosely call “the alpha pool” is not about to be drained. It just seems to me that what may have been easy pickings back in the late 1980s and early 1990s are unlikely to be so readily available going forward and investors would be wise to formulate their expectations accordingly.

David,

Great topic. I hope to hear more from you on this given your background and unique perspective.

My feeling is that the total worldwide supply of alpha is shared between the “hedge fund community” (however we define it) and the rest of us. Lars Jaeger and Christian Wagner of Partners Group have an interesting way of calculating worldwide alpha based on an arbitrary proportion they said would be exploited by hedge funds…

http://www.allaboutalpha.com/blog/2006/10/19/

Factor Modeling and Benchmarking of Hedge Funds: Can Passive Investment in Hedge Fund Strategies Deliver?

David Hsieh and Bill Fung also argue that alpha per investor is shrinking. But I’m still not convinced that the proportion of all markets that is “inefficient” is actually getting smaller. New geographies and new types of securities constantly replenish the alpha pool. So like “peak oil”, I’m not sure I totally buy into “peak alpha” theory…

http://www.allaboutalpha.com/blog/2006/10/04/

Peak Alpha Theory 

http://www.allaboutalpha.com/blog/2006/10/07/

“Peak Alpha” Theory: Perspectives from Around the Blogosphere

http://www.allaboutalpha.com/blog/2006/11/23/

Peak Oil Theory Springs a Leak - Is “Peak Alpha” Theory Far Behind?

I accept Michael Storm’s point that markets will never be 100% efficient, certainly not in a world where information is costly and often obscure rather than free and universally available to all as in the theoretical world of neo-classical economics. Indeed, it is the relentless search for alpha that makes markets as efficient as they are. That said, the question is whether there is enough alpha to provide all the burgeoning flow of investments into hedge funds with the type of returns that many naively expect. The best and savviest hedge funds can continue to deliver healthy returns simultaneous with a decline in the average hedge fund return and an increase in the number of blow-ups. My concern is that a considerable share of the money flowing into hedge funds is doing so based on past performance and some vague unstated fear of missing the boat. As Milton Friedman taught us, there ain’t no such thing as a free lunch.