ension funds searching for higher returns from alpha (manager skill) rather than beta (market movement) have looked to hedge funds and funds of hedge funds as an obvious source of pure alpha.

But are hedge funds really delivering alpha? Studies by Nice-based Edhec-Risk's asset management research have shown that most equity hedge fund strategies are positively correlated with equity market returns. Therefore, for much of the time they are delivering beta rather than alpha. From the investor's point of view, the beta ‘drowns' the alpha, making it hard for them to discern how much of the return is due to manager skill and how much to the movement of the market.

Some hedge fund strategies, however, are more likely than others to deliver pure alpha. In particular, equity market neutral is a strategy that has historically shown little correlation to equity markets, chiefly because it relies on skilful stock picking.

Laurence Siegel, director of research in the investment division of the Ford Foundation suggests that "a high quality market neutral long-short fund driven by skilful insights is the highest expression of the art of active management and it represents what hedged investments ought to be".

So a fund of equity market neutral hedge funds would be an attractive proposition for pension funds. However, the problem with equity market neutral is its lack of capacity. Equity market neutral funds represent only 4% of the total hedge fund universe. That is not nearly enough for a pension fund which may wish to invest €200m or €300m in a single hedge fund strategy.

The solution is to look for a more popular hedge fund strategy like long/short equity and then strip out the market risk by hedging, says Neill Brennan, chief executive of Armajaro Asset Management.

"The way to create capacity is to invest in long-short equity managers, not only because they sell themselves as good stock pickers but also because they constitute the largest group of equity hedge fund managers. Out of that very large population the likelihood of finding good stock pickers is higher," says Brennan.

The larger universe of long-short equity managers can be used to provide the capacity necessary to create a ‘synthetic' equity market neutral fund that gives investors the benefit of the stock selection skills of the managers (alpha) with minimal exposure to the equity market (beta).

"We can do this using a managed account platform where we see the positions of each manager on a daily basis, aggregate them up into a single portfolio, work out what the equity market exposures are, hedge them out, and produce a pure alpha product."

This is the thinking behind Armajaro's Wentworth Fund, launched last year. The fund calculates and hedges the net aggregate equity market exposure each hedge fund manager's portfolio with an appropriate number of equity index futures every day.

Armajaro has been advised by John Godden, the former head of HFR Asset Management's European business and now chief executive of IGS Advisory. Godden says the appeal of this idea to pension funds will be the access it gives them to pure alpha.

"Equity market neutral has always been there as a pure alpha generator, but it's been restricted to a very small part of anyone's portfolio. First because there are very few funds doing it properly, and second, there is a capacity restriction," he says.

"So we're solving that issue here. We're actually taking something that has been constrained by size and turning it into a fully scaleable entity."

Armajaro expects the fund's returns to be around 10-12% a year, with a standard deviation of 4-5%. "Managers will perform 20% either side of that potentially, because they've got beta, and beta drowns alpha if you put the two together," says Godden.

"It's swings and roundabouts. Where a significant component of the managers' return has been beta, the fund of funds would be paying for that. But the rest of the time when there's negative beta - which recently has been a key factor - the fund is under-paying for alpha - it's getting free alpha.

"In this situation you're not being drowned by the beta. So you can have a month where, because markets have been super-active, the alpha generation could be outsize, say 1.5-2% in a month, but the funds themselves could be down 4%, the markets being down 8-9% in those circumstances. In those kind of environments equity market neutral looks very good."