The Drivers of Hedge Fund Returns

This chapter discusses general sources of returns common to hedge fund strategies. One of hedge funds’ central selling points has been the claim of providing investors with absolute returns; performance uncorrelated to the direction of the global capital markets. This claim rests on the notion that hedge funds derive their returns from special manager skill rather than from systematic risk. Some hedge fund marketers claim that greater trading flexibility generates excess returns compared to traditional investments. Hedge fund managers do indeed enjoy greater freedom to short sell, take concentrated positions in single securities, leverage, or engage in derivatives trading. Yet, these techniques alone do not generate alpha. Leverage is simply a way to scale risk and return. There is a surface logic to the idea that excess hedge fund returns must be due to special manager skill. Investors’ logic is simple: if hedge fund managers produce absolute returns while most traditional fund managers do not outperform their benchmark indices, the excess returns must be due to the skill of the hedge fund managers.