The Road to Hedge Fund Replication: The Very First Steps

The debate on sources of hedge fund returns is one of the subjects creating the most heated discussion within the hedge fund industry. The industry thereby appears to be split in two camps: Following results of substantial research, the proponents on the one side claim that the essential part of hedge fund returns come from the funds' exposure to systematic risks, i.e. comes from their betas. Conversely, the “alpha protagonists” argue that hedge fund returns depend mostly on the specific skill of the hedge fund managers, a claim that they express in characterising the hedge fund industry as an “absolute return” or “alpha generation” industry. As usual, the truth is likely to fall within the two extremes. Based on an increasing amount of empirical evidence, we can identify hedge fund returns as a (time-varying) mixture of both, systematic risk exposures (beta) and skill based absolute returns (alpha). However, the fundamental question is: How much is beta, and how much is alpha? There is no consensus definition of ‘alpha’, and correspondingly there is no consensus model in the hedge fund industry for directly describing the alpha part of hedge fund returns. We define alpha as the part of the return that cannot be explained by the exposure to systematic risk factors in the global capital markets and is thus the return part that stems from the unique ability and skill set of the hedge fund manager. There is more agreement in modeling the beta returns, i.e. the systematic risk exposures of hedge funds, which will give us a starting point for decomposition of hedge fund returns into ‘alpha’ and ‘beta’ components. We begin with stating the obvious: It is generally not easy to isolate the alpha from the beta in any active investment strategy. But for hedge funds it is not just difficult to separate the two, it is already quite troublesome to distinguish them. We are simply not in a position to give the precise breakdown yet. In other words, the current excitement about hedge funds has not yet been subject to the necessary amount and depth of academic scrutiny. However, we argue that the better part of the confusion around hedge fund returns arises from the inability of conventional risk measures and theories to properly measure the diverse risk factors of hedge funds. This is why only recently progress in academic research has started to provide us with a better idea about the different systematic risk exposures of hedge funds and thus give us more precise insights into their return sources.1 Academic research and investors alike begin to realize that that the “search of alpha” must begin with the “understanding of beta,” the latter constituting an important — if not the most important — source of hedge fund returns.