The ABCs of Hedge Funds: Alphas, Betas, and Costs

The authors decomposed their estimated pre-fee 1995–2009 hedge fund return of 11.13 percent into fees (3.43 percent), an alpha (3.00 percent), and a beta (4.70 percent). The year-by-year results show that alphas were positive during every year of the past decade, even during the recent financial crisis. Despite the retrenchment of the hedge fund industry in 2008, hedge fund assets under management are currently more than $1.5 trillion. The authors analyzed the potential biases in reported hedge fund returns—in particular, survivorship bias and backfill bias. They then broke the returns down into three components: the systematic market exposure (beta), the value added by hedge funds (alpha), and the hedge fund fees (costs). They analyzed the performance of a universe of about 8,400 hedge funds from the TASS database over January 1995–December 2009. Their results suggest that both survivorship bias and backfill bias are potentially serious problems. Adjusting for these biases reduced the net return from 14.88 percent to 7.70 percent for the equal-weighted sample. Over the entire period, this return was slightly lower than the S&P 500 Index return of 8.04 percent but included a statistically significant positive alpha. The authors estimated a pre-fee return of 11.13 percent, which they decomposed into fees (3.43 percent), an alpha return (3.00 percent), and a beta return (4.70 percent). The positive alpha is quite remarkable because the mutual fund industry, in aggregate, does not produce alpha net of fees. The year-by-year results also show that hedge fund alphas were positive in every year of the last decade, even during the global financial crisis of 2008–2009.