But What is Hedge Fund Alpha Anyway?

We've thrown around the word alpha the last few posts as if everyone knew what it is. It does have a common Capital Asset Pricing Model (CAPM) definition, typically applied to stocks. But we think the same analysis is quite inadequate for hedge funds.

Moneychimp.com offers this definition for alpha:

Measure of a stock's performance beyond what its beta would predict

So, we now need a definition of beta:

A measure of an investment's volatility, relative to an appropriate asset class. For stocks, the asset class is usually taken to be the S&P 500 index

So, an equity's return can be broken down into a market-related component (multiplied by a factor which takes into consideration a stock's riskiness or uncertainty) and an unexplained factor, the alpha.

Now, if the world really operated with only one factor, "the market", this might be a usueful analysis. It has applications in evaluating mutual funds: you can measure a manager's performance by looking at his beta exposure to the market to see if the resulting alpha is positive or negative.

Unfortunately, in a hedge fund world, managers are exposed to more than a single factor. It is quite easy to look at returns relative to credit spreads and volatility and see that managers may, depending on the strategy, make bets on the direction of these factors as well as market direction.

So reliance on a one factor model for hedge funds is likely to be misleading. If some of the other major influences are included, a beter idea of which strategies are producing alphas can be derived.

We'll provide more discussion of hedge fund alpha in a later post. But, for now, we would suggest that gap between the best and worst alpha strategies may be as large as 7-8% a year, a substantial spread.