EXTRACTING PORTABLE ALPHAS FROM EQUITY LONG/SHORT HEDGE FUNDS

William Fung and David A. Hsieh

This paper shows empirically that Equity Long/Short (Equity L/S) hedge funds have significant alpha to both conventional as well as alternative (hedge fund-like) risk factors utilizing hedge fund data from three major data bases. Following the terminology introduced in Fung and Hsieh (2003) Journal of Fixed Income 58, 16–27, we call these Equity alternative alphas (or Equity AAs for short). Equity AAs are extracted from Equity L/S hedge fund returns by first identifying the systematic risk factors inherent in their strategies. Hedging out these systematic risk factors, the resultant AA return series are empirically shown to be independent of systematic risks during normal as well as stressful conditions in asset markets. This provides collaborative evidence that AA returns are portable across conventional asset-class indices. By modeling the AA return series as GARCH(1,1)–AR(1) processes, it is shown that the unconditional return distributions are normal with time-varying variance free of serial correlations, skewness, and kurtosis. Alpha-enhanced equity alternative are constructed admitting higher mean return, better annual returns, and Sharpe ratios to the S&P 500 index over the sample period 1996–2002.