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Is it Alpha or Beta? Decomposing Hedge Fund Returns When Models are Misspecified

Author

Listed:
  • David Ardia

    (HEC Montreal)

  • Laurent Barras

    (University of Luxembourg)

  • Patrick Gagliardini

    (Università della Svizzera italiana; Swiss Finance Institute)

  • Olivier Scaillet

    (University of Geneva; Swiss Finance Institute)

Abstract

The decomposition of hedge fund returns is hampered by model misspecification. To address this issue, we develop a novel approach to compare models in a large population of funds. This comparison, which accounts for misspecification-driven estimation errors, sharpens the separation between alpha and beta. Our analysis reveals that: (i) prominent models are as misspecified as the CAPM, (ii) several factors—primarily time-series momentum, variance, carry—capture hedge fund strategies and lower performance, (iii) alpha and beta components correlate negatively and vary substantially across funds, consistent with equilibrium models featuring search costs, and (iv) fund valuation is sensitive to investor sophistication.

Suggested Citation

  • David Ardia & Laurent Barras & Patrick Gagliardini & Olivier Scaillet, 2020. "Is it Alpha or Beta? Decomposing Hedge Fund Returns When Models are Misspecified," Swiss Finance Institute Research Paper Series 20-82, Swiss Finance Institute, revised May 2023.
    • Handle: RePEc:chf:rpseri:rp2082
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3661751
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    More about this item

    Keywords

    Hedge fund returns; alpha; beta; model misspecification; large cross-section;
    All these keywords.

    JEL classification:

    • C55 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Large Data Sets: Modeling and Analysis
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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