Measuring the Alpha of a Convexity-creating Fund: A Two-factor Approach

Abstract

We show that CAPM alphas of convexity-creating funds are consistently underestimated due to the average cost of their strategies, while the reverse is true for concavity-creating funds. Consequently, we develop an asset pricing model that disentangles convexity/concavity creation from the fund manager’s actual value-added. We illustrate the model using asset class by asset class returns data from a convexity-creating investment strategy, the Epsilon Global Trend Program (trend-following strategy on financial futures). The measurement differentials of value added between the CAPM and the model are found to be qualitatively and quantitatively significant.

Keywords: asset pricing, asset management, hedge fund, alpha, convexity

JEL Classification: G11, G12