Is it Alpha or Beta? Decomposing Hedge Fund Returns When Models are Misspecified

81 Pages Posted: 18 Sep 2020 Last revised: 26 May 2023

See all articles by David Ardia

David Ardia

HEC Montreal - Department of Decision Sciences

Laurent Barras

Universite du Luxembourg - Department of Finance

Patrick Gagliardini

University of Lugano; Swiss Finance Institute

O. Scaillet

Swiss Finance Institute - University of Geneva

Date Written: June 2, 2021

Abstract

The decomposition of hedge fund returns is hampered by model misspecification. To address this issue, we develop a novel approach to compare models in a large population of funds. This comparison, which accounts for misspecification-driven estimation errors, sharpens the separation between alpha and beta. Our analysis reveals that: (i) prominent models are as misspecified as the CAPM, (ii) several factors—primarily time-series momentum, variance, carry—capture hedge fund strategies and lower performance, (iii) alpha and beta components correlate negatively and vary substantially across funds, consistent with equilibrium models featuring search costs, and (iv) fund valuation is sensitive to investor sophistication.

Keywords: Hedge fund returns, alpha, beta, model misspecification, large cross-section

JEL Classification: C55, C58, G11, G12, G23

Suggested Citation

Ardia, David and Barras, Laurent and Gagliardini, Patrick and Scaillet, Olivier, Is it Alpha or Beta? Decomposing Hedge Fund Returns When Models are Misspecified (June 2, 2021). Swiss Finance Institute Research Paper No. 20-82, Available at SSRN: https://ssrn.com/abstract=3661751 or http://dx.doi.org/10.2139/ssrn.3661751

David Ardia

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

Laurent Barras (Contact Author)

Universite du Luxembourg - Department of Finance ( email )

L-1511 Luxembourg
Luxembourg

Patrick Gagliardini

University of Lugano ( email )

Via Buffi 13
Lugano, TN 6900
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Olivier Scaillet

Swiss Finance Institute - University of Geneva ( email )

Geneva
Switzerland

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