How "Alternative Beta" Can Be Used to Analyze Hedge Fund Returns

By Yazann Romahi via

As the concept of beta has transformed markets, powering the phenomenal rise of passive investing, ongoing research has extended its application. “Alternative beta” can be used to analyze hedge fund returns, shedding light on the formerly obscure and proprietary factors behind hedge fund performance.

It turns out that to a great extent hedge fund returns reward risks arising from exposure to known factors. Just as index investing rewards broad market exposure, so alternative beta will reward exposure to factors such as price momentum, simple carry strategies and the relative performance of attractively and unattractively valued securities.

The exhibit shows just how much progress we’ve made in decomposing the return factors in the three most common hedge fund styles. It shows the annualized volatility (or variation around the average annual returns) for each style according to its HFRI Index, the most commonly used hedge fund benchmark today. The proportion of variation directly attributable to the static factors—not to the insights of the average hedge fund manager—is substantial. It ranges from somewhat less than half for macro hedge funds to nearly two-thirds for event-driven strategies to four-fifths of the variance in the equity long-short style.

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