I am always amazed at how investors look at and analyze hedge funds. Alot of investors have the misguided notion that hedge funds returns are "Alpha" in the truest sense of the word, (that little alpha in the CAPM model). As a result investors are sometimes unable to fully understand the risks that funds are taking and so unable to accurately compare funds versus each other and versus their strategic objectives.
Hedge fund managers can take advantage of many markets and strategies. However, investors often only compare returns to that of a broad market index, or other such buy and hold strategy, an industry specific index for example. This is incorrect, as this analysis does not fully capture all of the risks premiums involved. Hedge fund returns can be view as the return generated from exposure to a number of traditional betas, a number of alternative beta and a number of alphas over each of these betas / risk premiums.
Traditional Beta, this would include the usual risk premium that we are all used to. Broad market returns, bond returns, commodity returns. For all these there are a plethora of market indices that capture the relevant risk premium.
Alternative betas are generally the types of risk exposures that are not available to the normal buy and hold investor. These Alternative betas are generated from exposures to risk such as merger spreads, momentum, illiquidity, carry trades, pairs trades, volatility trades..... As well as market timing to all these betas.
Alpha (skill) can be generated over each of these betas. Without fully understanding the all of the beta exposure it is basically impossible to measure the alpha generated. Without understanding all of the various risk exposures, investors cannot full understand all of the risks that they are exposured to.
In this blog we will attempt to understand and develop strategies that capture the full extent of all the risk premium that hedge funds can exploit. Ultimately, we will try and create an efficient portfolio from these strategies. We shall also be looking at other hedge fund replication strategies on the way.
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