Hedge Funds Have Delivered Alpha, But Not Without Risk

Institutional investors that took the plunge into hedge funds during the past decade looking for alpha got more than they bargained for in 2008.


Institutional investors that took the plunge into hedge funds during the past decade looking for alpha got more than they bargained for in 2008. Not only did most managers lose money in the subprime-mortage-induced market meltdown, many of them prevented investors from redeeming their capital by gating funds or creating side pockets for illiquid securities. Not surprisingly, when given the opportunity, investors pulled their money, withdrawing $285.7 billion from hedge funds in 2008 and 2009, according to Chicago-based Hedge Fund Research. But a recently published academic study indicates that they may have been too quick to pass judgment.

In an article in the January/February issue of the CFA Institute’s Financial Analysts Journal, Yale School of Management finance professor Roger Ibbotson reported that in 2008 hedge funds made good on their promise of delivering alpha: returns above what the market itself would have given an investor. In fact, Ibbotson found that hedge funds delivered positive alpha every year but one from 1995 through 2009, averaging 3 percent a year.

“You can find a particular money manager that creates alpha, perhaps,” Ibbotson says. “But the fact that this whole financial sector actually creates a positive alpha is amazing.”

The article, “The ABCs of Hedge Funds: Alphas, Betas, and Costs,” was co-authored with Peng Chen, president of Ibbotson Associates, which Roger Ibbotson sold to Morningstar in 2006, and Kevin Zhu, an assistant professor at the School of Accounting and Finance at the Hong Kong Polytechnic University. Ibbotson, Chen and Zhu estimated that hedge funds returned, on average, 7.7 percent a year after fees from 1995 through 2009. That breaks down into 4.7 percent in beta return and 3 percent of alpha, after subtracting 3.43 percent in fees.

The study, which used monthly hedge fund returns from the TASS database, corrects for survivorship bias by including defunct funds. (Most databases remove failed funds, which creates a bias because they include only successful funds.) The research is an update to a 1999 paper that Ibbotson co-authored with professors Stephen Brown of New York University and William Goetzmann of Yale’s International Center for Finance.

Hedge funds may deliver alpha, but pension funds still need to be cautious, warns Andrew Lo, an MIT Sloan School of Management finance professor and director of MIT’s Laboratory for Financial Engineering in Cambridge, Massachusetts. Lo says many pension funds and other institutional investors may be wrongly basing their large allocations to hedge funds on past returns. In 1990 there were only 530 hedge funds managing $38.9 billion, according to HFR. At the end of this year’s first quarter, 7,285 hedge funds managed $2 trillion. In addition, in 1990 about 70 percent of hedge fund assets were invested in global macro strategies. Today macro strategies represent just 20 percent of assets. The rest of the hedge fund pie is divided roughly evenly among long-short equity, event-driven and relative value strategies.


Lo says the flood of capital into strategies such as convertible arbitrage has changed the very nature of the returns. Investment returns are highest in areas with little research, capital and sex appeal. As an area gets discovered, returns get scarcer, and that concerns Lo.

“It is clear that there are a lot of public funds increasing their allocation to hedge funds,” he says. “Why? Because they are under pressure to increase their rates of return and they are willing to take more risks to make up for lost ground. That’s worrisome because it’s not clear that the increased risk-taking will translate into higher returns.”

Lo explains that although hedge funds are terrific sources of alpha with relatively low risks, the returns might not persist into the future. The hedge fund industry is subject to capacity constraints because of the nature of investing in less-liquid parts of the market and because of its use of leverage to juice returns.

As an example, Lo cites the flood of money into commodity indexes in recent years. As pension funds have become enamored of commodities, the capacity of the markets to absorb those assets is strained.

Alpha, however, can persist. Ibbotson contends that hedge fund alpha has been positive for the past 11 years in a row. “There’s not much evidence that alpha is declining,” he asserts, adding that pension funds do need to be cautious about projecting the past into the future when it comes to hedge fund return expectations.

“Alternatives have lived up to the promise in terms of providing alternative sources of returns,” adds Lo. “Unfortunately, there are also alternative sources of risk. Nothing’s a free lunch.”