The Death of the Hedge Fund Alpha?

With their worst start to the year on record, hedge funds are feeling the pain. The FT reports that hedge funds lost 2.4 percent in March, and 2.8 percent so far this year, as bets on commodity prices and Samurai bond spreads went the wrong way.

Is it time for investors to worry? Well, if you compare hedge fund returns with the broader market, (most) funds are doing their job of preventing big losses: The S&P 500 has lost nearly 10 percent since the start of the year.

But on the flipside, the outsized gains that attracted many investors may be a thing of the past.

Research has shown that hedge funds do generate excess returns even when factoring in the added risk they take on. But in recent years -- other research has documented -- that alpha has been on the decline.

The latest research from Zhadong Zhong of Penn State University confirms this. Examing 8,000 active and defunct hedge funds between 1994 and 2005, Zhong found that the average hedge fund alpha declined from about 6 percent per year in the mid-90s to a little under 1 percent per year a decade later.

But Zhong goes a step further and tries to find out why: Has alpha come down because money managers with lesser abilities entered the industry? Or because the flood of assets into hedge funds made it harder to find arbitrage plays?

Looking at the distribution of returns, Zhong found that the number of under-performing hedge funds did not change over time, meaning that there hasn't been a rise in lower quality hedge fund managers.

But on the other hand, the number of funds producing large positive alphas declined, indicating that as the hedge fund industry became more popular, profit opportunities diminished.

This, of course, is the classic story of market competition. As more players wring profits out of inefficiencies, those opportunities start to vanish.

But the news isn't all bad. Strategies like directional trading and emerging markets are less affected by the negative effects of fund size, says Zhong.

The following chart showing monthly alphas for hedge funds in the mid-90s and the mid-00s illustrates the shift in the industry as more funds meant lowered profit opportunities. If you're looking for the vanishing alpha, it's that gray area on the right:

(Hat tip: All About Alpha)