Decoding hedge fund performance: Alpha-beta analysis and model pitfalls

GSEM Professor Olivier Scaillet, David Ardia, Laurent Barras, and Patrick Gagliardini co-authored an article published in the top-tier Journal of Financial Economics. It introduces a new method to examine hedge fund returns, highlighting the inadequacy of traditional models like CAPM and the importance of factors like momentum and variance. The study analyzes over 5'000 funds from 1994 to 2020, emphasizing the role of investor sophistication in fund valuation and selection, and suggests a convergence between hedge fund and mutual fund performance. The researchers introduce an innovative method for return decomposition and model comparison, backed by substantial data and institutional support.

The authors received funding from the Canadian Derivatives Institute and the Natural Sciences and Engineering Research Council of Canada.

ABSTRACT

We develop a novel approach to separate alpha and beta under model misspecification. It comes with formal tests to identify less misspecified models and sharpen the return decomposition of individual funds. Our hedge fund analysis reveals that: (i) prominent models are as misspecified as the CAPM, (ii) several factors (time-series momentum, variance, carry) capture alternative strategies and lower performance in all investment categories, (iii) fund heterogeneity in alpha and beta is large—an important result for fund selection and models of active management, (iv) performance is increasingly similar to mutual funds, (v) fund valuation is sensitive to investor sophistication.

The study is available open access: Is it alpha or beta? Decomposing hedge fund returns when models are misspecified

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