The Third Source of Returns

Last month I discussed the increasing awareness that true alpha–gained through market timing and security selection–is not the only or even the primary source of hedge fund returns. Of course, hedge funds don’t market themselves that way. They prefer to be viewed as alpha-generators which, in turn, justifies their higher fee structure.

While I agree that hedge fund managers are less constrained and have greater incentive to produce alpha, not to mention an irrefutable history of better risk-adjusted returns than traditional managers, alpha is not a constant and is often absent from hedge fund returns. On the other hand, traditional betas (via long-only exposures to equities and fixed income) are a less acknowledged but more reliable source of hedge fund returns.

This is not new thinking, as evident from research by Yale International Center for Finance & Roger Ibbotson (Sources of Hedge Fund Returns, August 2005), UBS Investment Research (The Critique of Pure Alpha, March 2005), Goldman Sachs (The Secret Sauce of Hedge Fund Investing, November 2004), and others that have focused on a third source of hedge fund returns. I refer to this third source as “skill-based beta”–returns generated from exposure to systemic risk or market factors. Yet like traditional betas, skill-based betas (SBB) are identifiable and, similar to true alpha, require a greater element of manager skill to pick up these betas as they are only obtained through the use of leverage, short-selling, and derivatives.

Alex Ineichen of UBS defines these betas as “systematic risk premiums that require a slightly more sophisticated strategy than a long-only strategy.”

Examples of SBB include factor timing, volatility risk, risk transfer premiums, and various forms of arbitrage such as fixed-income–including, perhaps, credit risk spreads–and merger arb.

Some of the research demonstrates that depending on macro market factors, anywhere from 60% to 100% of hedge fund returns are attributed to a combination of traditional betas and SBBs. The presence of beta in hedge fund returns is often intuitive. For example, for most of 2004, up until the November elections, hedge funds on average were flat as was the return of most equity indexes. The November-December equity rally resulted in an equal run-up in the composite hedge fund indexes as traditional betas–and very little alpha–accounted for most of the returns.