While hedge funds underperformed the S&P 500 (INDEXSP:.INX) and the MSCI AC World Index last year, those aren’t necessarily the best benchmarks to use for comparison since hedge funds have had lower volatility than equities in recent years, and a recent J.P. Morgan report argues that hedge funds generated alpha in 2013. Hedge funds grew to $2.63 trillion in global assets under management last year, with $376 billion in performance gains and $64 billion net inflows, now representing 2.6% of the universe of bonds and equities, passing the pre-crisis high of 2.3%.

Instead of looking at stock markets, J.P. Morgan analyst Nikolaos Panigirtzoglou suggests looking at a more realistic portfolio for comparison. The Hedge Fund Research fund weighted composite index (HFRI) was up 9.2% for 2013 and the HFRX global hedge fund index was up 6.7%, compared to 5.7% returned by a 55/45 bond equity portfolio using the US Aggregate Bond Index and MSCI AC World, which would have a comparable volatility (the HFRI has a Sharpe ratio of 0.82 compared to a ratio of 0.78 for the 55/45 portfolio).

GS hedge fund alpha 0314

Comparing hedge funds to HF replicators

Alternatively, hedge fund performance can be judged by looking at hedge fund replicator strategies.

“Hedge-fund replicators typically try to mimic hedge fund strategies by relating most recent hedge-fund returns to different assets or by using systematic models to exploit common HF strategies such as carry and momentum,” explains Panigirtzoglou. “HF replicators can be considered as a measure of ‘beta’ for HFs and thus the return that HFs generate in excess of their replicators can be considered as ‘alpha’.”

Panigirtzoglou favors HF replicators for a direct comparison because investors don’t usually allocate part of their portfolios to hedge funds looking for the highest relative returns, they’re looking for convexity and non-linear exposure to traditional assets. HF replicators were up 6.1% in 2013 on average, so hedge funds generated some alpha by this measure as well.

Macro funds suffered from low market beta

Even though hedge funds produced alpha for 2013, equity long/short strategies outperformed precisely because they increased beta in February 2013, while macro strategies reduced their beta, missed out on last year’s bull market, and were punished for it with poor performance and outflows by the end of the year. Equity long/short funds may have had it easy last year, since other strategies have a mandate to keep beta low, and considering the rocky year stock markets have already had it wouldn’t be surprising for these trends to reverse in 2014.

GS hedge fund betas 0314