Hedge fund returns: market beta, strategy beta, alpha and diversification

Where does a hedge fund’s return come from?

Traditional long-only funds earn most of their return by bearing market risk. Hedge funds try to limit market exposure and earn idiosyncratic return , return specific to the positions the manager picks. Their return splits into three sources.

Hedge fund returntotal return before fees

• Market beta Memorize broad market exposure; an index fund delivers it cheaply
• Strategy beta Memorize systematic return of the strategy itself, such as merger spreads or trends
• Alpha Memorize manager skill: security selection and timing; fees reduce it

Market beta is the broad market exposure you could buy with an index fund or exchange-traded fund (ETF). Strategy beta is the systematic return that comes from the hedge fund’s strategy applied across the market, such as merger spreads or trend following. Alpha is what is left: the return from the manager’s choice of positions and timing. Leverage can amplify all three.

$$\alpha = R - \beta R_M - S$$

Here $R$ is the fund’s return, $\beta R_M$ the market beta contribution (the fund’s beta times the market return) and $S$ the return attributed to strategy beta.

Does alpha survive the fees?

Hedge funds charge high fees, and fees come out of alpha. The investor does not receive the full return.

$$\alpha_{net} = \alpha - m - p\,R$$

Go deeper Strategy beta and alternative risk premia

Because strategy beta is systematic, it can in principle be captured by rules-based products at a fraction of hedge fund fees. This is the idea behind alternative risk premia funds, which sell exposures such as trend, carry and merger spreads cheaply. The more of a hedge fund’s return that such a product can match, the less of it is true alpha.

How reliable are hedge fund index numbers?

Hedge fund indexes are built from data that managers report voluntarily, so they probably overstate performance. Three problems matter.

Hedge fund index problemsreporting is voluntary, so performance is likely overstated

• Selection bias Memorize only funds that choose to report get in; peer groups and inclusion rules inconsistent
• Survivorship bias Memorize funds that stop reporting drop out; returns overstated
• Backfill bias Memorize a good fund joins and its past is added; returns overstated
• Equal weighting Use it most indexes ignore fund size
• Lag and no investability Know the idea published late; cannot be bought

Selection bias arises because only the funds that choose to report are in the index, and a fund with poor results has little reason to start reporting, so it is never added. Funds are also placed in strategy peer groups inconsistently (by prospectus, by style analysis, or both), and indexes use different inclusion rules. Survivorship bias arises when funds that stop reporting, often after poor results, are removed, leaving the survivors. Backfill bias arises when a successful fund starts reporting and its earlier record is added to the index database; only funds with favorable histories tend to be reported.

Most indexes also use equal weighting , so a small fund counts as much as a large one, and the data are published with a lag of about a month. The indexes are not investable. A fund-of-funds composite index avoids part of the distortion because it reflects the actual results of portfolios of hedge funds, and it is closer to investable. Its returns lean toward long/short equity funds, which are a large part of fund-of-funds holdings.

Exam tip Failed funds vanish, good histories arrive, and all funds weigh the same: the index return is too high.

Do hedge funds diversify a portfolio?

Hedge funds seek idiosyncratic outperformance rather than the market’s return. Their correlation with equities and bonds shows what that means in practice. Correlation with investment-grade bonds has been low. Correlation with equities has been fairly high, and in some periods it has risen. They do not behave like a free-standing asset class that moves on its own.

Strategy matters. Market-neutral, relative value and event-driven strategies tend to do relatively well in equity downturns and when correlations among individual stocks fall. They lag when stocks all rise together, because mispricings between stocks are harder to find.

Adding hedge funds to a traditional 60/40 portfolio has typically lowered portfolio volatility and raised the Sharpe ratio. This is the Sharpe ratio improvement investors seek, but it varies over time, so manager due diligence still matters. Quality funds attracted institutions after the 2008 crisis, which demanded more transparency and control, while many weaker funds lagged equity and bond markets.

Go deeper Operational due diligence and fraud

Light regulation and large minimum investments leave room for misreporting, and some funds have been frauds or run complex strategies that failed in turmoil. Careful investors examine the fund’s service providers, valuation process, reporting practices and fee calculations. Alpha that cannot be verified is not worth paying for.