The message from can- adian hedge fund manufacturers and managers over the past 10 years has been: “We have found a way to produce positive alpha; and for that, we intend to charge 2% of assets plus 20% of any profits above 10% — the ‘2 & 20 rule’.”

As a result, pension fund managers, institutional investors and private clients are flocking to the hedge fund sector because they all recognize how difficult it is to produce positive alpha — even though private clients are probably more focused on the returns than the mathematics. Whatever the reason, it comes down to paying up for positive alpha.

What is positive alpha? Es-sentially, it measures the ability of a money manager to produce positive risk-adjusted returns. (Note that we are talking about risk-adjusted returns, not just returns.) And these risk-adjusted returns are being measured against appropriate benchmarks.

For example, let’s assume that a Canadian equity fund manager is being benchmarked against the S&P/TSX 60 index. Over the past 10 years, the S&P/TSX 60 index has returned 8.88% compounded annually, not including dividends.

You would think if the Canadian equity manager generated a return of, say, 9.1% compounded annually over that same period, he or she would have generated positive alpha — that is, a return higher than the benchmark.

But that’s not quite the case, because, at this point, the return has not been adjusted for risk. If the manager is taking on greater risk — through leverage or by selecting higher-risk stocks, for example — the manager would expect to earn a higher return. But is that return the result of good selection by the manager or is it simply the result of higher risk? Alpha attempts to measure that by comparing the risk-adjusted return of the manager against the benchmark’s risk-adjusted return.

Risk is measured as the standard deviation of return, which measures the daily dispersion of the portfolio. The S&P/TSX 60 index — not including dividends — had a standard deviation of 18.03% over the 10 years. So, now, knowing both sides of the equation, we can say the S&P/TSX 60 index produced a return of 8.88% with a standard deviation of 18.03%.

If our Canadian equity fund manager was able to produce a 9.1% compound annual return with the same risk (a standard deviation of 18.03%), the Canadian equity manager would have produced positive alpha. This means the manager had better risk-adjusted returns than the benchmark.

Hedge funds are touted for their ability not only to produce better returns with less risk but also to produce returns during periods when other asset classes are not doing well. Many hedge funds are marketed as “absolute return” strategies on the notion that the fund can produce good returns in any market environment. It’s not clear how much of that is marketing hyperbole and how much is reality.

Hedge funds do two things: one, they are able to go long and short with securities, which means they attempt to profit from the variation in the movement of two securities; and, two, they are able to employ leverage. On the one hand, leverage increases the risk within the fund. On the other hand, when performance is based on the uncorrelated movement of two securities, leverage does not necessarily translate into higher standard deviation.

The bottom line, however, is that hedge funds charge enormous fees, have latitude in their investment choices and can use leverage to ramp up returns. Good managers do that successfully; bad managers tend to blow up. There doesn’t seem to be any in between.

If the main concern is the risk associated with any one fund or hedge strategy, a good approach is to hold a basket of hedge funds using strategies that tend to have a low correlation with one another. The fund-of-fund approach reduces the risk of any one fund disaster ruining the client, but adds another level of fees to the program.

With a market that provides healthy advisory fees and clients interested in reducing portfolio risk, it is little wonder hedge funds continue to grow exponentially.

What does this have to do with covered call writing? Everything! Covered call writing is a long/short strategy designed to profit based on the divergence between the value of the underlying stock and the price of the option. The strategy has limited upside, to be sure, but it also has a long history of producing positive alpha — probably at a much lower cost than hedge funds.

@page_break@Returning to the risk-adjusted performance numbers of the S&P/ TSX 60 index (8.88% return, 18.03% annual standard deviation), it is interesting to note that over the past 10 years, a passive covered call writing strategy on the S&P/TSX 60 index would have produced superior returns (9.1% compounded annually, not including dividends) with less risk (annual standard deviation of 12.41%), according to the MX covered call writers’ index.

We know covered call writing generates positive alpha, but the performance numbers are not the double-digit returns that the “2 & 20 rule” implies exists in hedge funds.

But hedge funds employ leverage. What if we looked at the same performance data using a leverage factor of, say, 30%? That is, we borrow 30% of the value of the portfolio to implement the same passive covered call strategy.

When you use leverage, the numbers — at least, over the past 10 years — look eerily similar to what one would expect to get from hedge funds. The 30% leveraged passive covered call writing strategy produced a return of 11.6% (not including dividends) with a standard deviation of 16.13%. These are significantly higher returns with less risk when measured against the S&P/TSX 60 index benchmark.

And, because we are using a Canadian equity index as the underlying security, there is little chance of having it blow up — even with 30% leverage. IE