Lesson 7 of 8 · 13 min
Where hedge fund returns come from, and why indexes flatter them
Hedge funds try to earn idiosyncratic alpha rather than market beta, so their return splits into market beta, strategy beta and alpha, but fees eat much of the alpha and self-reported hedge fund indexes overstate what investors actually earn.
In short
- Traditional funds diversify away company risk and earn mostly market beta; hedge funds limit market exposure and seek idiosyncratic returns (alpha).
- Return = market beta (available cheaply via index funds) + strategy beta (the strategy's systematic exposure) + alpha (manager-specific selection).
- The main source of hedge fund excess return is market inefficiency, often short lived, plus the manager's skill in exploiting it, frequently with leverage.
- High fees reduce the alpha investors keep; liquidated funds may pay out less on their positions.
- Index biases: selection (voluntary reporting by good funds), survivorship (failed funds drop out), backfill (good past records added), equal weighting and reporting lags, all tending to overstate performance.
- Fund-of-funds composite indexes are often used as benchmarks: they reflect real portfolios, reduce biases and are investable.
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