The Little Book of Hedge Funds

Chapter Five

The Alpha Game

In Search of El Dorado

Gaily bedight,

A gallant knight,

In sunshine and in shadow,

Had journeyed long,

Singing a song,

In search of El Dorado.

But he grew old—

This knight so bold—

And o’er his heart a shadow

Fell as he found

No spot of ground

That looked like El Dorado.

—Edgar Allan Poe, “El Dorado”

In 1849, Edgar Allan Poe masterfully wrote the allegorical poem entitled “El Dorado,” whose two-of-four stanzas are stated at the beginning of this chapter. According to the legend, El Dorado was thought to be a magical, unattainable city of gold that led many a brave men to their untimely and tireless demise. And yet, many a noble knight continued to search for this mystical world that was impossible to find in the physical realm.

Although hedge funds didn’t exist during Poe’s time, his never-ending quest for a land of wealth and spiritual treasures seemingly mirrors that of a hedge fund manager—to achieve alpha, the land of absolute returns. Often referred to as the Holy Grail for investors, alpha is attained when a manager achieves positive, nonvolatile returns no matter the movement of the market. These returns are entirely reliant on the investment skill of the hedge fund manager and are uncorrelated to the market index.

Just as many skeptics would have you believe that El Dorado is a fictitious place that can never be found, so do many academics prophesize that the investment world is a zero-sum game where alpha—excessive returns regardless of market ...