Battle for Alphas: Hedge Funds versus Long-Only Portfolios

TLDR

Potential explanations for the findings include lack of data reliability and differences between hedge funds and actively managed long‑only funds in compensation, investment constraints, and structures. The study empirically examined whether the alphas of hedge funds and those of long‑only portfolios have different distributions and are derived from different risk factors. The multifactor style‑risk analysis presented here can effectively monitor a hedge fund’s exposure to systematic versus idiosyncratic risks and volatility‑risk factors over time. Hedge funds provide more consistent alphas than long‑only portfolios, especially when adjusting for volatility, and risk factors derived from asset prices better capture their systematic and idiosyncratic risks than market‑index‑based factors.

Abstract

The study reported here empirically examined whether the alphas of hedge funds and those of long-only portfolios present different distributions and are derived from different risk factors. Adjusted for return volatility differences, hedge funds seem to offer more consistent alphas for potential transfer to either equity or bond asset classes than do long-only portfolios—even under extreme market conditions. Potential explanations for the findings include lack of data reliability and differences between hedge funds and actively managed long-only funds in compensation, investment constraints, and structures. Factors related to market index returns do not adequately detect hedge funds' risk postures beyond a fund's exposure to the market-directional risk of standard asset classes. Risk factors derived from asset prices in financial markets do provide timely and systematic descriptions of the risks underlying trading strategies used by hedge funds. The multifactor style-risk analysis presented here can effectively monitor a hedge fund's exposure to systematic versus idiosyncratic risks and volatility-risk factors over time.