The A,B,Cs of Hedge Funds: Alphas, Betas, and Costs
Oct 7th, 2006 | Filed under: Investment Management FeesBy: Roger Ibbotson, Yale School of Management & Peng Chen, Ibbotson Associates
Published: September 2006
Whew! There is alpha in them there hedge funds. Ibbotson and Chen discover that hedge fund fees absorb about half of it, but it seems to exist nonetheless.
Using a database of hedge fund performance from 1995 to 2006, they adjust for commonly-cited problems such as back-fill bias (where a hedge fund manager only decides to report returns when they go public - invariably with their winning funds) and survivorship bias (where the data only includes funds that did well enough to survive). Here’s what they found…
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[…] All About Alpha recaps a paper that looks at the question of how much alpha is truly available to investors in various hedge fund strategies. One of the conclusions drawn is that some of these returns are a function of so-called “hedge fund betas” or “exotic betas.” These are in a sense systematic returns not currently available in publicly traded investment vehicles. […]
[…] The A,B,Cs of Hedge Funds: Alphas, Betas, and Costs #“In this paper, we focus on two issues. First, we analyze the potential biases in reported hedge fund returns, in particular survivorship bias and backfill bias, and attempt to create an unbiased return sample. Second, we decompose these returns into their three A,B,C components: the value added by hedge funds (alphas), the systematic market exposures (betas), and the hedge fund fees (costs). We analyze the performance of a universe of about 3,500 hedge funds from the TASS database from January 1995 through April 2006. Our results indicate that both survivorship and backfill biases are potentially serious problems. The equally weighted performance of the funds that existed at the end of the sample period had a compound annual return of 16.45% net of fees. Including dead funds reduced this return to 13.62%. Excluding backfill further reduced the return to 8.98%, net of fees. In this last sample, we estimate a pre-fee return of 12.72%, which we split into a fee (3.74%), an alpha (3.04%), and a beta return (5.94%). Overall, even after correcting for data biases, we find that the alphas are significantly positive and are approximately equal to the fees, meaning that excess returns were shared roughly equally between hedge fund managers and their investors.” […]
[…] The author conducts a factor-analysis on Asian long/short funds to identify whether they contain any of the “good stuff” (alpha). Her conclusion: yes, there is alpha in Asian long/short funds. A similar conclusion was reached in a recent study of a broader set of hedge funds by Roger Ibbotson at Yale (see posting). So hedge fund managers can breathe a sigh of relief for now - although the paper is unable to quantify said alpha. […]
[…] We at AllAboutAlpha.com would agree that index-hugging is the Achilles Heel of traditional long-only management. Studies such as this one from the Yale School of Management show that the passive proportion of US mutual funds has been growing since the early 1980’s. But the jury is still out when it comes to hedge funds. […]
[…] Research from Yale University and the London School of Economics backs him up on this.  […]