Morgan Stanley strategist Adam Parker did an analysis of HFRI equity hedge index and found out that hedge funds do not have alpha anymore. The first finding of the analysis is that correlation between the HFRI index and the S&P 500 index passed 90%. The second finding is that HFRI’s alpha is now zero.

Let me start with saying that this isn’t unexpected. The increasing correlation doesn’t really mean anything. You can have perfect correlation and still generate alpha. You can try this at home. Open an excel spreadsheet and copy+paste daily returns from the S&P 500 index (you can make up the numbers if you want). Then enter a formula in the second column where the value is equal to 1 + S&P 500’s return. This is a hypothetical hedge fund’s return where the fund has a daily alpha of 1% meaning its daily return is always 1 percentage point higher than that of S&P 500 index. Now calculate the correlation. What did you get? Correct, the correlation between the our hypothetical hedge fund and the S&P 500 index is 100%.

You now know that correlation doesn’t really mean much in terms of a hedge fund’s alpha. How about the disappearing alpha in Adam Parker’s analysis? This just means that you must be really dumb to hand your money to an average hedge fund. There are two explanations. Successful hedge fund managers are flooded with money. They usually don’t have 50 great investment ideas. They may have 5 great investment ideas and maybe another 5 good investment ideas. The rest will be average investment ideas. When they are flooded with money they have no choice but to invest in all of their investment ideas. Their other choice is to return money back to their investors but in that case they wouldn’t be collecting the 2% fee.

The second problem is more sinister. There are a lot of unskilled fund managers. Maybe they themselves know this or maybe they don’t. The problem is an average investor usually doesn’t know who is a good manager and who isn’t. As the number of hedge funds explode investors have only three bad choices. First they can invest in an average hedge fund. This is a bad idea because they don’t have alpha anymore. The other two choices are to hand their money to a fund of hedge funds or hand their money to one of the large reputable hedge funds. Both choices are bad. Fund of hedge funds charge more than what they contribute. Large hedge funds invest in marginal ideas.

So what is the solution? The solution is to find the best hedge fund managers based on their recent track records and invest in their best stock picks. Soon we will publish an article describing how to do this.