Redefining Hedge Fund Alpha and Risk Exposures after the Financial Crisis

Abstract

The hedge funds industry has evolved tremendously in recent years. According to the CASAM CISDM Industry Report, assets under management in hedge funds had grown from less than USD 50 billion at the end of 1990 to over USD 2.1 trillion at the end of 2007. However, assets managed by hedge funds have dropped significantly since then to less than USD 1.3 trillion at the end of June 2009. Since hedge funds have been marketed to investors as risk diversifiers in addition to being return enhancers, the actual “manager skill” or “value added” or “alpha” deserves careful examination at this time. In this article we examine the validity of the concept of “alpha”. We use both single factor (Jensen’s alpha) and multi-factor models to estimate alpha. We use three different indices with vastly differing construction processes and compositions. Unlike most previous studies, we choose specific factors for each strategy. Our results show that strategy specific factors had greater explanatory power but were insufficient to explain the wide variety of fund exposures. Multi-factor models were an improvement but nevertheless insufficient. We conclude that quantitative analysis is generally insufficient when it comes to measuring manager skill (alpha). Manager skill or “alpha” should be determined in a qualitative setting as well. Unfortunately, there is no measure that encompasses both quantitative and qualitative attributes although hedge fund ratings agencies have made some headway in this regard.