William Fung and David A. Hsieh
Hedge funds have grown substantially in the past few years even as hedge fund performance has declined with the rapid increase of capital. History tells us that over-priced, active managers will be replaced by low-cost, passive, index-like alternatives. Could the same process be taking place in the hedge fund industry? Much of the innovative technology central to the creation of rule-based passive (or “synthetic”) hedge funds can be traced to the past decade’s research, which endeavored to address the fundamental question in hedge fund investing: do hedge funds add value? The key to answering this question lies with the separation of hedge fund returns into “alternative beta” and “alternative alpha,” terms that were coined by Fung and Hsieh (2003) to distinguish the problem from the familiar alpha–beta separation in measuring performance of traditional asset managers. In this paper, we extend the concept of alpha–beta separation for analyzing mutual fund performance to hedge funds. In particular, we argue that at the portfolio level, separation of alternative alpha from alternative beta involves the additional complexity of identifying alpha created by successful timing across strategies as opposed to security selection within strategies. Using historical hedge fund returns, we provide examples to illustrate the additional technology needed to successfully mimic this dynamic asset allocation process. Finally, the existence of index-like hedge fund products also act as a catalyst to improve the price-discovery process in the hedge fund industry—more efficient fee structure with equitable risk-return sharing between investors and managers. Ultimately, whether hedge funds will become index-like products will depend on the answer to the fundamental question that precipitated this process, but with this qualification, namely do hedge funds add value (have alpha) that cannot be replicated at a lower cost?