By: 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…
“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.”
Ibbotson & Chen also make an important observation about “non-traditional beta”. This blog has chronicled the phenomenon of “gotcha academics” that aims to prove that hedge fund managers actually produce (low value) exotic beta, not (high value) alpha. Whether you call it “exotic beta”, “non-traditional beta” or “non-commoditized beta”, it’s rarely available to investors (e.g. in the form of an ETF). Kudos to Ibbotson and Chen for acknowledging this problem:
“Fung and Hsieh (2002 and 2004) analyzed hedge fund returns with traditional betas and non-traditional betas, which include trend following exposure (or momentum) and several derivative-based factors. They found that adding the non-traditional beta factors can explain up to 80% of the monthly return variation in hedge fund indexes. Although we agree that a portion of the hedge fund returns can be explained by non-traditional betas (or hedge fund betas), these non-traditional beta exposures are not readily available to individual or institutional investors. Since hedge funds are the primary way to gain exposure to these non-traditional betas, these non-traditional betas should be viewed as part of the value-added that hedge funds provide compared to traditional long-only managers.”
Ibbotson & Chen almost seem to be suggesting that there could be a continuum of alpha from simple exotic beta to inexplicable, “skill-based” alpha. As we have suggested before on this blog, there may be a sort of upward sloping supply curve for alpha where more expensive (exotic) supplies generally lay fallow. But when prices rise (i.e. higher hedge fund fees are charged), these complex, hard-to-exploit, market inefficiencies are pressed into service.