Factor Modelling and Benchmarking of Hedge Funds: Can Passive Investments in Hedge Fund Strategies Deliver?

Abstract

The hedge fund industry is starting to recognize that a main part 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 and a subsequent replication of the corresponding risk premia with generic trading systems. The question touches further rationale on the sense and nonsense of the currently available investable versions of hedge fund indices. If possible, investable benchmarks based on risk factor analysis and replication offers a valid, theoretically more sound, and cheaper alternative to the currently offered hedge fund index products, especially as the latter reveal themselves more and more as questionable from a theoretical as well as practical standpoint. 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 activities in the quant groups of the large investment banks and financial academic centers might turn the hedge fund industry upside down in coming years. This article offers a follow up discussion on the broader treatment on the subject in the author's book 'Through the Alpha Smoke Screens: A Guide to Hedge Fund Return Sources'.