You might have to go along way to find investment alpha. Source: NASA/JPL-Calech/University of Arizona via Bloomberg News
You might have to go along way to find investment alpha. Source: NASA/JPL-Calech/University of Arizona via Bloomberg News

I have been fascinated with hedge funds for quite some time. I began studying them in the last decade. It has been an intriguing field of investigation for a number of reasons:

No. 1. Alpha Generators: In the early days of hedge funds, they created a ton of alpha, or returns that exceeded market benchmarks . They resembled pre-expansion sports leagues; there were a limited number of teams run by a handful of talented managers, and most were superstars.

No. 2. Brilliant Characters: The managers of some better-known funds are brilliant and insightful investors. Their alpha generation suggests as much. But they are also characters in the fullest sense of that word: Quirky, charismatic, compelling, mercurial. Once you become fabulously wealthy, you follow a different set of rules from the rest of us.

No. 3. Contradiction Between Performance and Assets Under Management: Over the past decade, that elusive alpha has gone away as AUM has ramped up to all-time highs. I was reminded of this when I saw this headline yesterday: ``Hedge Fund AUM Hits Another Record High In Q1 2014.''

I have described the love affair with hedge funds as ``Romancing Alpha, Forsaking Beta.'' The approach I have taken to analyzing this phenomenon is to look at it as a form of cognitive bias. Even as performance of the average fund has lagged during one-year, five-year and 10-year periods, they continue to attract huge assets.

This is perplexing.

But I have begun to sort out the appeal of expensive so-called 2 & 20 funds (managers collect a fee equal to 2 percent of assets and 20 percent of any investment gains). Some of it is rational, some much of it isn't. Here is what I have found in the broadest of terms:

Pure Alpha: Alpha doesn't follow the usual Gaussian distribution, or a standard bell curve. Rather, it is very much a fat-head, long-tail distribution, with a handful of superstars capturing the vast majority of outperformance. The long tail, made up of those who generate neither alpha nor beta (matching market benchmarks), must find solace by capturing outsize management fees for their underperformance.

Performance Chasing: The elusive alpha is the bait that sends many pension funds, endowments and family offices chasing top managers. Money manager Rick Ferri calls this the “Curse of the Yale Model.” What worked when David Swensen pioneered this hasn't worked for the legions of copycats since. (I have tried unsuccessfully to get Swensen, Yale's chief investment officer, to sit for an interview).

When endowments and allocators find they can't gain entry to top-tier funds, they move down to managers willing to accept their money. But even decent performers must overcome an incredible hurdle: The compounding drag of the 2 percent management fee and 20 percent performance fee. Except for the very best funds -- let’s say the top 10 percent -- that makes this an exercise in futility.

Structure and Consultants: The status quo is hard to change. There is an enormous structure of consultants and money raisers and sales people who are happy with the way things are. They dazzle the uninformed with presentations. They rationalize underperformance as hedging. They have enormous incentives to maintain the way things are.

Star Managers: The cult of personality that has sprung up around some managers serves as an alternative to alpha, whether it takes the form of golf outings, conferences, lunches or soirees.

We all know the old adage, if you want a friend, get a dog. Perhaps an amended version should be, if you want alpha, get into a top-tier hedge fund; if you can't, then stick to beta.

To contact the author of this article: Barry Ritholtz at britholtz3@bloomberg.net.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.