The A’s, B’s, C’s and D’s of hedge funds

Hedge fund detractors often argue that hedge fund returns are driven by systematic risk factors (beta) not manager skill (alpha) as is often assumed.  During the hedge fund industry’s 2-decade-run of positive returns, this argument took the sheen off of hedge fund returns and suggested they could replicated using much cheaper passive investments.

But 2008 threw a bit of a wrench into the works.  If beta (or it’s exotic cousin alternative beta) was responsible for the positive returns, then were they also responsible for the negative returns?  And if so, was hedge fund alpha actually positive during the dark days of 2008?

A new study says yes, hedge funds produced alpha in 2008, just as they had in previous years.  In 2010’s “The ABCs of Hedge Funds: Alphas, Betas, & Costs“, Roger Ibbotson, Peng Chen, and Kevin Zhu update their widely-read 2006 paper of the same name.

The trio of researchers are clearly impressed with what they discover…

“The positive alpha [of hedge funds] is quite remarkable, since the mutual fund industry in aggregate does not produce alpha net of fees. The year by year results also show that alphas from hedge funds were positive during every year of the last decade, even through the recent financial crisis of 2008 and 2009.”

What’s even more notable is that this conclusion is reached after adjusting for common complaints such as “backfill bias” and “survivorship bias.”

As in the 2006 edition of their analysis, Ibbotson, Chen and Zhu decompose hedge fund strategy indices into alpha, beta and “costs” (backing out a “1.5 and 20” fee level).   In contrast to other studies that attempt to identify hedge fund alpha, they use only stocks, bonds and cash as regressors.  While many might question this approach, the trio says there is method in the madness…

“We agree that a portion of the hedge fund returns can be explained by non-traditional betas (or hedge fund betas). However, these non-traditional beta exposures are not well specified or agreed upon, and are not readily available to individual or institutional investors. A substantial portion of alpha can always be thought of as betas waiting to be discovered or implemented. Nevertheless, 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.”

For the more graphically-inclined, here’s what they found (Jan. ’95 to Dec. ’09)…

Alphas, Betas, Costs & Deltas

If you’re like us, you might be wondering how this year’s results differ from the 2006 results (which included data from Jan. ’95 to Apr. ’06).  In other words, how does the introduction of 2008 data change things?

So we measured the difference between the 2006 strategy-specific alphas and the 2010 strategy specific alphas.  As you can see from the chart below, the alphas produced by many hedge fund strategies fell as a result of adding recent data to the analysis – although the alpha of an equal weighted index of hedge funds remained about the same.  Emerging markets managers must have had a humdinger of a year in 2008 in order to increase their average annual alpha by 3%.  Given the out-performance of emerging markets equities over the S&P 500, this comes as no surprise.


The paper also contains an interesting table showing the percentage of return data for each strategy that represents “backfill” (returns from months prior to the point at which the fund began listing itself.  One might assume that a high percentage of backfill means that managers in that category tend to wait a little longer before reporting their returns to the hedge fund database.

Could it be that Managed Futures Managers and Short Managers tend to begin reporting data only after a longer track record has been established?  Are they less sure of themselves during the start-up phase?  Or is this just a statistical anomaly?

Does Size Matter?

Another interesting observation contained in the paper is that larger funds (or, we surmise, funds managed by larger managers) tend to produce higher raw returns…

But wait!  The study also found that larger funds tended to have a higher volatility.  So the smaller funds actually had the better reward-to-risk ratio (specifically, those in the 20-50% decile)…

Interesting observations aside, the main conclusion of this paper is that hedge funds do seem to produce alpha – at least, at the moment.  The 2006 edition of the paper concluded with this ominous forecast:

“A significant amount of money has flowed into hedge funds in the past several years. Therefore we cannot be assured that the high past alphas we measure are a good prediction of the future alpha in the hedge fund industry.”

By 2010, this forecast seems to have come partially true for some strategies as their alphas fell.  The trio makes the same forecast in the current edition of the study.  So the $1.5 trillion question remains: Wither hedge fund alpha?

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