Beta Worship

At a hedge fund conference earlier this year, I heard presentations from peers on the state of the business. Appropriately, the location was Las Vegas, a place where the opportunity to lose your shirt runs 24/7 and the house takes it all in the end. The meetings were at one of the glitziest, newest hotels, and the raucous volley of slot machines and craps was never too far from our Powerpoint presentations. The gathering had all the signs of a hedge fund bubble about to burst: a luxe setting, lavish entertaining and invitation-only evenings at a velvet-roped nightclub.

I used to dismiss talk of a hedge fund bubble, arguing that one can't exist in the real sense of the word, given the mix of strategies and hence the meaninglessness of "hedge funds" as a separate asset class. But in the wake of the conference, I see a looming disaster. And in the wake of a couple of recent high profile hedge fund implosions, the subject seems more pressing. What's alarming is the overwhelming conformity and blind acceptance, not of any particular strategy, but of "Beta" -- the risk measurement darling of the asset management community. As a manager of a fund myself, I'm also guilty of worshipping this particular indicator.

Beta is a simple thing. It's the measure of a portfolio's volatility relative to an index. For example, if a given portfolio tends to rise or fall the same amount as the S&P 500 Index rises or falls, we would say the Beta is 1.0 -- equal to the index. If the portfolio rises or falls 50 percent more than the index, then we would say the Beta is 1.5 percent. Under modern portfolio theory, the ideal hedge fund generates strong returns while having a very low Beta, say 0.75 percent, meaning the fund moves up or down only three quarters as much as the index. The fund is then said to have a high "Alpha" in that it provides excess return, higher than one would expect given its Beta. Such a fund is considered "low risk" because the zigs and zags are smaller than the overall market. Its highs are lower and its lows higher. This means the fund trades in a narrow band, subjecting its investors to less volatile prices.

Obviously, the restriction of price fluctuations, especially if it comes with great long-term returns, is a desirable goal. Most asset allocation strategies try to tame price movements, either by adding negatively correlated assets (such as short positions to long ones) or stable asset classes (such as short-term bonds). The problem comes when Beta is relied upon as the sole measure of risk, without regard to an examination of the underlying portfolio elements.

At the conference, a fund-of-funds manager presented his risk management strategy. He said that by choosing only funds with low betas, he was able to construct a vehicle with low overall price movement and hence low risk. I asked if this technique would have protected him from the collapse of Long Term Capital Management (LTCM), the infamous hedge fund blow-up of the late 90s, given that LTCM had a very low beta until the very day when it didn't -- that is, the day it went bust and had to be bailed out. He didn't answer the question.

Beta is a superficial quantitative indicator which is dangerous in isolation because it can give a false image of risk-free trading behavior. Beta's apathy to the intrinsic risk of the underlying holdings is what makes it so perilous.

If Beta is the ultimate superficial indicator, what's the prime fundamental one? Balance sheet analysis, probably the best measure of intrinsic risk of any individual equity holding, is an example of a risk measure which pierces through to the underlying holding. By looking at balance sheets, managers can assess the real, fundamental risk of a portfolio. Unfortunately, balance sheets are the purview of old-fashioned, stodgy value investors -- in somewhat short supply in the hedge fund world. If there had been just one person with common sense instead of a financial calculator at LTCM -- and therefore, just one person who had looked at a balance sheet of an underlying holding (in this case, the balance sheet of the Russian government), they would have avoided buying Russian sovereign bonds, and LTCM may not have blown up.

Not surprisingly, this fund-of-funds manager didn't mention balance sheets. The underlying balance sheets of a hedge fund's holdings are obscured by the "black box" of the fund itself. Since hedge funds don't have to report their holdings, no one really knows what they are. No one can supervise the manager's security selection or trading strategy, as you could with a mutual fund manager. And no one can measure risk by any other metric than Beta, the result of price points plotted along a graph -- a superficial indicator with no real relevance to intrinsic value, or to the future.

The scary thing is that pension funds and institutional investors have all joined the cult of Beta. What they can't see can't hurt them, must be the philosophy. The audience at my conference was full of such people, the folks who make decisions for countless millions of retirees. If all managers are relying on a flawed measure of risk, then pensioners will end up holding the hedge fund bag. All because of a single Greek letter that people seem to worship a little too much.