Fund Returns? Further Evidence

While investors generally consider hedge fund investments as pure alpha products, academic research has shown that hedge funds earn most of their returns from systematic exposures. Jaeger and Wagner (2005), among others, argue that hedge fund returns are derived from a mix of traditional and alternative beta exposures and skill-based returns. Alpha is simply defined as the part of the returns that cannot be explained by exposure to systematic risk factors and is a measure of the manager’s skill. Traditional beta is generated as part of the returns derived from long-only investing, while alternative beta is the return that can be specified in a systematic way, but which involves techniques often used by hedge funds, such as leverage and short-selling (Anson, 2006). Jaeger and Wagner (2005) find that 80 percent of hedge fund returns originate as a result of beta exposure (systematic risk factors) and that only 20 percent is accounted for by the manager’s skill or risk factors that have yet to be determined. They argue that much of the alpha in hedge funds is actually repackaged alternative beta. These findings are consistent with those of Fung and Hsieh (2006), who argue that much of the alpha of hedge fund returns could be explained by the various biases that are known to plague those indices. The popular academic jargon that hedge fund returns are simply beta in alpha clothing is an important case for passive replication of hedge fund returns. If much of the return from hedge funds is not true alpha, but rather beta, it may make more sense to replicate them rather than to invest directly in hedge funds. Furthermore, hedge funds typically follow the two and twenty rule when it comes to fees, where the investor pays a 2 percent annual management fee and 20 percent of the profits that fall above a certain