Alpha Or Beta In The Eye Of The Beholder: What Drives Hedge Fund Flows
Georgia State University; University of Cologne – Centre for Financial Research (CFR)
Emory University – Goizueta Business School
Georgia State University – J. Mack Robinson College of Business
June 29, 2015
Hedge fund flows chase alpha, yet they also follow returns attributable to traditional and exotic risk exposures. Investors appear more cognizant of exotic risks over time, with flows increasing their relative emphasis on returns from exotic betas in recent years. Investors also discriminate between which risks warrant high fees, with flows into high-fee funds being more likely to emphasize returns arising from exotic risks. Although we find strong evidence of persistence for alpha, persistence in hedge fund returns attributable to traditional and exotic risk exposures is modest, which suggests investors would benefit from employing more sophisticated risk models when evaluating fund performance.
Alpha Or Beta In The Eye Of The Beholder: What Drives Hedge Fund Flows – Introduction
I tried telling a hedge fund manager, “You don’t have alpha. Your returns can be replicated with a value-growth, momentum, currency and term carry, and short-vol strategy.” He said, “’Exotic beta’ is my alpha. I understand those systematic factors and know how to trade them. My clients don’t.” He has point.
– Cochrane (2011)
The last twenty years have witnessed considerable advances in our understanding of the unique risks that hedge funds seek out to achieve returns.1 While traditionally all returns unrelated to the market have been interpreted as manager skill (alpha), investors have begun to recognize the return implications of non-market risks such as size and value as well as more exotic risks generally only available through hedge funds. Despite the large literature on hedge fund performance and a plethora of risk models put forth by academics, it remains unclear how investors evaluate performance. Hedge fund investors are often viewed as being among the most sophisticated investing clienteles. In this article, we take a revealed preference approach to study which risks investors adjust for when evaluating hedge fund performance. We also examine whether investors’ capital allocation decisions are justified by future fund performance by decomposing returns into components related to different types of risk.
We begin by conducting a performance-flow horse race to infer which risk model hedge fund investors use when allocating capital. We measure risk-adjusted performance using a range of single and multi-factor models including the basic CAPM, the Carhart (1997) 4-factor model, the Carhart model augmented with the option-based factors of Agarwal and Naik (2004), the trend-following 7-factor model of Fung and Hsieh (2004), a 12-factor combined model which also includes an emerging market factor, and a max R-squared model which parsimoniously chooses from a set of 15 factors which best explain individual fund returns.
We find that CAPM alpha consistently wins the race. This finding is surprising and suggests that while hedge fund investors control for general market risk, they pool together manager skill (alpha) with the returns associated with a variety of non-market risks. Investors appear either indifferent to the risks inherent in certain hedge fund strategies, or they actively seek out these risks following periods of success. To help differentiate between these interpretations, we next explore whether investors react differently to hedge fund returns arising from manager skill (alpha), conventional risk exposures such as market, size, and book-to-market (traditional beta), and nonstandard risk exposures including momentum, option-like investments, macro uncertainty, and liquidity (exotic beta).
Our evidence suggests that investors do distinguish between hedge fund returns arising from conventional risk exposures that may be obtained more cheaply through mutual funds, and exotic risk exposures that can only be obtained through hedge fund investments. While investor flows respond to all three return components, they place greater relative emphasis on the returns arising from exotic rather than traditional risk exposures. For example, using the Fung and Hsieh (2004) model we find a one percent increase in lagged hedge fund returns attributable to exotic risk exposures leads to a 9.0% increase in inflows, compared to 5.0% for traditional risk exposures and 10.9% for alpha. This evidence suggests that investors credit hedge fund managers not only for their skill to produce alpha, but also for their ability to deliver returns through taking opportune exposures to exotic and to a lesser extent traditional risk factors.
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