Is it Alpha or Beta? A Formal Evaluation of Hedge Fund Models

Abstract

Decomposing hedge fund returns into alpha and beta is challenging because any benchmark model is unlikely to capture all the alternative hedge fund strategies. We develop a novel approach to test the ability of any proposed model to capture these strategies. This approach identifies sharper models and improves the decomposition of fund returns. Our tests reveal that standard factor models are similar to the CAPM and thus unable to capture alternative strategies. In contrast, a parsimonious model based on economically-motivated factors (including time-series momentum, carry, and variance) captures commmon hedge fund strategies and delivers a sizable reduction in performance.

Keywords: Hedge fund performance, alternative strategies, misspecification, model comparison

JEL Classification: G11, G12, C14, C33, C58