Is there an optimal mix between alpha and beta in hedge fund returns?

By: Diana Raluca Calin, Reading University
Published: April 2006

EurekaHedge highlights an interesting paper on alpha and beta in hedge funds.  Written by a Masters student at the ICMA Centre at Reading University, the paper (a Master’s thesis using the EurekaHedge database) contains some interesting findings about the amount of alpha in hedge funds.

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.

But it does make a passing comment that we at AllAboutAlpha find somewhat contradictory:

“This excess return could be a result of market inefficiencies rather than manager skill.”

As regular readers will know, we believe that “manager skill” and “market inefficiencies” are essentially the same thing.  When these inefficiencies are patently obvious, it may not take much skill to turn them into alpha.  But after the low-hanging fruit has been picked, it takes significantly more skill to identify market dislocations.  In fact, the prototypical “skill-based” manager (for example: a bottom-up fundamental stock picker) is essentially required to make the argument that markets are not properly valuing individual securities – i.e. that they are inefficient.

Like many researchers, Calin shows that by adding more risk factors to the regression mix, the amount of “real alpha” decreases (however, she does not discuss the notion of a middle ground containing “exotic” or “alternative” beta):

“A superficial review of risks, an omission of some, [or] an underestimation of their impact on the hedge fund can lead to a small estimate of beta and a bigger than the real value estimate alpha.”

Although the paper’s title suggests there might be a magical “optimal” split between alpha and beta, there is alas, no such thing.  Still, Calin points out the obvious to us as a consolation:

“It is therefore clear that, from an investor’s perspective, the optimal mix can be attained by the maximisation of alpha and the minimisation of beta.”

You consultants may be rolling your eyes right now.  After all, you have plugged hedge funds into optimizers for years only to find out 100%+ of a client’s portfolio ought to be in hedge funds. 

Read Full Paper

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One Comment

  1. rckang
    October 19, 2006 at 3:22 pm

    Just a thought about beta in hedge funds. If you look at any of the major hedge fund indices (I know they all have their flaws) and compare their 3 year charts with the S&P 500, you’ll see that they track fairly well. Actually it’s suprising how close they track in many cases. I’m talking about the broad indices, not the specific sub-indices for the various hedge fund strategies. For us in Canada, it’s even stronger. The growth lines for the Scotia Capital Hedge Fund Index (both equal weighted and dollar weighted) are basically on top of the TSX Composite Index since December 2004 (I know it’s a short time period). To me, it’s a good thing. The market was going up, it was the right time to be a closet indexer. During 2000-2002, you saw the CSFB-Tremont and HFR basically flat lined while the equity indices fell. Thus, the hedge fund indices, in the long term look like the equity indices with occasional put options in play during major market downturns.

    On a separate note, I see more academic papers about beta and alpha in hedge fund returns. They always have a conclusion about significant alpha in their returns. I find papers focusing more on the beta component coming from the industry (ABP guys discussed earlier and others like Lars Jaeger). Cynical by nature I am, but if I were a grad student hoping to work at a hedge fund in the not too distant future, I’d also be wary of downplaying the potential for finding alpha in hedge fund strategies. That’s just obvious.


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