You know what alpha and beta is in investing: Beta is the primary source, and often the exclusive source, of returns in the traditional long-only, relative return universe. Beta (“market risk”) is the systematic risk for which the market compensates you. Alpha is the other way to make money in the financial markets. Alpha, the excess return a manager provides, is a measure of a manager’s skill. That skill is rare, and therefore, the price of alpha is expectedly higher than in traditional investments that rely on beta as their primary source of returns. Examples of alpha include market timing and active security selection.

Alex Ineichen, who has led UBS Investment Bank’s research into hedge funds in addition to other alternative investments since 2000, wrote in a March 2005 UBS Alternative Investment Strategies Report, The Critique of Pure Alpha, that alpha “is not stable” and that “the reward from applying the skill is not static.” Moreover, Ineichen points out that “not everyone who is talking about alpha is generating it, and not everyone who is expecting it is getting it.”

Acknowledging the elusive nature of alpha is critical to hedge fund and absolute return investors, particularly because most think of alpha as the primary–if not the exclusive–source of hedge fund returns. But more and more hedge fund industry researchers and practitioners alike have come to the conclusion that an assortment of betas, from both traditional and alternative sources, actually account for the majority of the attractive risk-adjusted and absolute returns that hedge funds have historically delivered.

Recently, a partner at one of the largest European asset management firms authored a paper–Factor Modeling and Benchmarking of Hedge Funds– proposing that hedge fund products constructed by financial engineers and based on risk-factor analysis and replication might offer a sounder and perhaps more affordable alternative to the hedge fund products that are currently on the market.

Written by Lars Jaeger, a certified financial risk manager at Partners Group, based in Zug, Switzerland, Factor Modeling addresses the current hot issues in the literature of financial engineering, including the respective roles of beta and alpha in hedge fund results and the differences between hedge fund beta and traditional-investment beta.

A Hedge Fund CAPM?

Industry practitioners are looking for a general equilibrium model that will value the systematic risk exposures of various hedge funds given their strategies and portfolios, and that will accordingly play a role akin to the one that the Capital Asset Pricing Model (CAPM) plays in contemporary understanding of the equities markets. Jaeger is convinced that there is likely more beta than alpha in hedge fund results, in roughly a 4:1 ratio.

He proposes a new alternative for hedge fund investors that he calls the replicating factor strategy (RFS) that seeks to make passive use of the beta-side causes of hedge fund success. Applying RFS to the data of the last two years, and comparing it to hedge fund database and index results, he finds that “performance of the RFS is better for every single strategy sector with the exception of the distressed [securities] strategy.”

Next month we will look into the alternative betas in hedge funds, relative to both alpha and traditional beta, in greater detail.–Jeff Joseph

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

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