Alternative Beta Strategies and Hedge Fund Replication

5

The Drivers of Hedge Fund Returns

In this final chapter on hedge fund return sources, I try to bridge the gap between the promises made to investors by hedge fund marketers and the reality of hedge fund managers' performance. For this purpose I will take the reader towards a closer look into the general sources of returns common to hedge fund strategies. This will help us to see through the ‘alpha smoke-screen’ of hedge fund marketers, understand and appreciate hedge funds’ real return sources and finally guide us to the replication thereof. I intend to open up the ‘hedge fund black box’ by separating the two main elements of its returns, their ‘alpha’, which is nothing but the result of the hedge fund manager's capability to exploit market inefficiencies, and the ‘beta’, which is the fair compensation for systematic risk assumed. This lays the groundwork for the ultimate goal of this book – to illustrate how we can systematically analyze, quantify, and at last replicate hedge fund returns.

5.1 ALPHA VERSUS BETA

The discussion on alpha and beta is as old as the Capital Asset Pricing Model which defined these terms some 40 years ago. The discussion has finally reached the hedge fund industry; and the debate on the sources of hedge fund returns is creating one of the most heated discussions within the industry. Hedge fund marketers claim their funds deliver skill-based absolute returns – but do they really? And if the often quite attractive returns of hedge funds do not come purely ...