What Are the Alpha Characteristics of Hedge Funds?

Hedge fund managers have historically generated excess, skill based returns (alpha) through active management, and a paper by UBS scrutinizes the value of security selection and market timing to understand the industry's risks and returns.

(March 18, 2012) — Hedge fund managers enjoy a large amount of freedom in capitalizing on investing opportunities and generating above-average returns — but this freer form of active management is not without its costs, a paper by UBS Alternative Investments asserts.

The paper’s authors note that while it is widely agreed upon that securities selection has the potential to generate alpha in investing, not much is known about the value generated from market timing decisions alone. “To the extent that hedge fund managers can employ dynamic trading strategies, and have more flexibility to execute market timing, it is important for both managers and investors to understand the risks they are exposed to; and whether those risks are ones that generate returns.”

Hedge funds, often perceived as a pure form of active management, have drawn increasing investor attention as traditional assets have suffered from lowered long-term return expectations. However, according to the paper’s authors, the alpha in hedge fund returns has been reduced by market timing decisions. While hedge funds have significantly outperformed on both an absolute as well as on a risk-adjusted basis in secular equity bear markets, in secular equity bull markets they have sacrificed some upside but have been less volatile, outperforming on a risk adjusted basis.

The paper states: “Hedge fund manager returns are seen to be a combination of passive exposure to general market factors (referred to as beta) and active investing decisions resulting in market outperformance (referred to as alpha). Alpha, in other words, is the skills based return component accruing from (i) an ability to time the markets i.e. to directionally lever and de-lever positions, thus magnifying or diminishing levels of exposure to markets and (ii) from security selection (to go either long or short).”

The research concludes, however, that hedge fund managers, on the whole, have demonstrated near persistent ability to create skills based returns in almost all market environments through security selection.

Click here to download the entire paper.