The Road to Hedge Fund Replication: The Very First Steps

TL;DRAbstract

The debate on sources of hedge fund returns is one of the subjects creating the most heated discussion within the hedge fund industry. The industry thereby appears to be split in two camps: Following results of substantial research, the proponents on the one side claim that the essential part of hedge fund returns come from the funds' exposure to systematic risks, i.e. comes from their betas. Conversely, the “alpha protagonists” argue that hedge fund returns depend mostly on the specific skill of the hedge fund managers, a claim that they express in characterising the hedge fund industry as an “absolute return” or “alpha generation” industry. As usual, the truth is likely to fall within the two extremes. Based on an increasing amount of empirical evidence, we can identify hedge fund returns as a (time-varying) mixture of both, systematic risk exposures (beta) and skill based absolute returns (alpha). However, the fundamental question is: How much is beta, and how much is alpha?There is

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