This was a weird research piece arguing that hedge funds are “passive”. Here’s the basic conclusion from the paper:
“Over the long run many hedge funds behave like alternative beta portfolios and maintain linear exposures to systematic risk factors.”
The very smart Matt Levine notes that the researchers are being very specific here when they define active and passive management:
“Active management should be manifest through nonlinear exposure to the systematic risk factors that drive hedge fund returns,”
This strikes me as misleading. The researchers took 21 different risk factors and concluded that hedge funds have a high correlation with the aggregate markets. OF COURSE THIS IS TRUE. If you take every risk factor in the world (there are supposedly hundreds by now) and compare broadly diversified funds like “hedge funds” to them then you’ll very likely find a high correlation there.¹ You can’t expect a diversified set of “hedge funds” to generate a non-linear return when you’re using an aggregate perspective in which everything essentially becomes one linear function!
Regulars know I have written a lot about this. And there seems to be a wide misunderstanding of what it means to be “passive” or “active”. Forget “factors”. Factors are just things researchers make up when they can’t explain why markets aren’t efficient. I like to keep things simple. Passive investing is a low friction asset allocation approach that tries to take the market return. Active investing is a high friction asset allocation approach that tries to beat the market return. We’re all active to some degree in our asset allocations. But the difference is that some people try to sell you a market beating return in exchange for a high fee while others are just trying to earn a market return (or something close) while reducing the frictions in that portfolio.
I’m in a weird spot with this view because my whole approach falls into my own definition of “passive” investing. So, I am not really defending hedge funds so much as I am arguing against misleading terminology and research. And let’s be honest, the conclusion of the paper is basically right – that hedge funds, in the aggregate, sell the high fees of “active”, but produce the returns of passive. But I still think this is another case of unfairly generalizing about a class of investment funds by using a misleading line of argument.
¹ – There are, in theory, an infinite number of “factors” that can explain market gyrations. Fama started with one, expanded that to three, then five and now we have this 21 factor approach used here and even hundred factor approaches. I don’t know the point where these factors explain aggregate moves, but my guess is that we didn’t need much more than one “factor” to do this. That’s the “nobody-knows-what-anything-is-worth-at-exact-moments-in-time” factor.