Factor Modeling and Benchmarking of Hedge Funds

Abstract

The hedge fund industry is starting to recognize that the main component of its returns corresponds to risk premia rather than market inefficiencies, i.e. from “beta” instead of “alpha”. This has some implication for the industry and investors, among which is the endeavor to construct investable benchmarks for hedge funds on the basis of an analysis of the underlying systematic risk factors. This issue is closely linked to the rationale for constructing investable versions of hedge fund indices. An important question is whether investable benchmarks based on risk factor analysis offer a valid, more theoretically sound and cheaper alternative to the hedge fund index products currently available? This article reflects on this most recent discussion within the global hedge fund industry about the “beta versus alpha” controversy, investable hedge fund indices, and finally, capacity issues. It illustrates how the current research might turn the hedge fund industry upside down in coming years.