What’s it all about, Alpha?

Alpha (above market returns) is what hedge funds are supposed to bring investors. Alpha is why they get away with charging outrageous fees (usually 2% of capital and 20% of performance).

Alpha is why (developing a case of ‘mission creep’) the funds then began speculating rather than hedging.

But after that came news of another extraordinary development: Hedge funds started going public. The lay public, it seems, was willing to pay more for alpha than alpha was making for the funds. What gives?

Take a look at the amazing sale of shares in the Blackstone Group. Blackstone is one of the multi-billion dollar groups of ‘private equity’ money that prove to us that Wall Street is no place for an honest man.

Think about it for a minute, and it almost makes you stop breathing. The idea of the hedge fund is, primarily, that it can protect investors by hedging risk; and it does so by being able to go both long and short.

Mutual funds, by contrast, are always long. You buy a fund that invests in China, for example, because you want a little sliver of the China pie. If Chinese shares go up, you want to go up with them. But you know you’re not competent enough to select shares in China yourself, so you don’t mind paying a mutual fund manager to help you. It wouldn’t make any sense for the manager to hold cash...you could do that yourself without paying a commission or fee.

Then along came the hedge fund with a different mandate - to make money even if shares go down. The idea was to protect the investor on the downside. It’s all very well to own shares in China and the United States, but what if the shares go down? The hedge fund manager hedges an investor’s bets, by shorting (selling shares he doesn’t own) or by using put options (giving him the right to buy shares at a lower price) or other strategies designed to make money when most investors lose it.

Then came the curious news that a few hedge funds were selling shares to the public. This too took our breath away. The only justification for the high fees was the ‘alpha’ performance; but if a hedge fund manager could get ‘alpha,’ why would he want to sell shares to perfect strangers? Hedge fund managers can do math. They wouldn’t sell shares of their own fund unless someone else thought they were worth more than they did. From this you could infer that either the public was paying more for alpha than alpha was worth...or, that there really wasn’t any alpha at all.

And now, before us is private equity - the hottest thing on Wall Street, because it delivers alpha. In theory, you can’t really beat the public market - because it has so much more information than any individual investor or group of investors. But along came private equity money...and phyzzzt went the theory. In fact and in practice...the smart, well-informed, well-funded private investors were letting us know that they were the ones making money, not the rubes in the public marketplace.

But private equity is going one step further now...a step too far, in our opinion. The Blackstone Group is going public to raise billions of dollars. “Look,” it says to the rubes, yahoos, and lumpen capitalists, “We can get you alpha; buy our shares.”

But the Blackstone Group is not a religious or charitable order. They are not going to give away alpha. Nor are they innumerate; they can do the math. The only circumstance in which they would possibly sell their shares to the public was if they felt their alpha was over-estimated by the share-buying public...or, they didn’t have any alpha.

What is happening to private equity is what has happened to hedge funds...and what happens to everything else in the markets...and indeed, to the rest of life. Alpha - the extraordinary, the special, the above-market - is in short supply. And the more people chase after it, the harder it is to get.

As more capital sought out more above-market returns, the returns fell. That’s why hedge funds are already yesterday’s news.

Now private equity too, is running into the Law of Diminishing Returns. Or, the Law of the Declining Marginal Utility of Capital Chasing Alpha.

Private equity is probably selling to the public for the same reason hedge funds did: They’ve lost alpha.

Meanwhile a look at the headlines tells us immediately what ‘gives’ in the market these days:

“Subprime Bust Forces Families From Homes,” says the AP.

“American dream becomes nightmare as millions face foreclosure,” trumpets the AFP.

Is the problem containable, as Treasury Secretary Paulson says?

We don’t know...and we wonder if he does either.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.