Morningstar Advisor - Spring 2007 - (Page 16)

Gray Matters Less Alpha and More Beta Than Meets the Eye by Paul Kaplan and Jodie Gunzberg 1 How do I measure how much a hedge fund hedges and how much alpha it provides? It might be called a hedge fund, but that does not mean it actually hedges. Hedge funds are free to pursue a wide variety of strategies, some of which can be described as hedging in that they take positions to isolate returns that are not related to broad market movements. Such strategies are said to generate returns from alpha as opposed to beta. A hedge fund that produces only alpha would be ideal for return enhancement and diversification, but the reality is far more complex. Many hedge funds provide only a partial, imperfect, or transitory hedge. Hence, they contain significant market exposure or beta at least part of the time. Some “hedge” funds provide no hedge at all.2 Further, some pursue alpha by investing in only a few equity positions, regardless of the level of beta this might produce. There are even some hedge funds that look just like plain vanilla mutual funds, while charging the high fees of typical hedge funds. Given the high fees hedge funds charge, an investor needs to identify the benefit by determining the sources of returns generated by the hedge fund. Exposure to one or more unconventional passive strategies might generate returns that, in the context of a typical longonly stock and bond portfolio, “look” like alpha. If it is difficult to replicate, this strategy may be worth paying for. But it is not an easy decision. The statistical properties of hedge fund returns make it difficult to discern how much alpha and beta a hedge fund really provides. To measure how much a fund hedges and how much alpha it has provided, we must first decide what constitutes beta. For example, if we define beta as exposure to stock and bond indexes, most hedge funds provide substantial alpha. However, if we consider exposure to factors such as volatility, credit spreads, and commodity returns as beta, less of the hedge fund’s return may be attributed to alpha. There’s also the problem of “smoothing” when analyzing a fund’s returns to measure alpha and beta. Many hedge funds hold illiquid or difficult-to-price securities. The lack of market prices may give managers a certain amount of flexibility in determining how they value such positions when calculating returns that they report to hedge fund databases. Some observers argue that managers take advantage 16 Morningstar Advisor Spring 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Spring 2007

Morningstar Advisor Spring 2007 Features Departments Letter from Joe Mansueto Get to Know Morningstar’s Fund Managers of the Year Is Your Client a Stock or a Bond? Less Alpha, More Beta Than Meets the Eye Your Mileage May Vary A Clear-Eyed Look at Hedge Funds Lower Risk, Higher Returns, What’s Not to Like? Without Cash and Clout, Advisors and Clients Get Short End of Stick Get the Strategy Minus the Headaches Analyzing Funds of Hedge Funds Not All Hedge Funds Are Created Equal A Fund with a (Long) View Laying Low and Prospering A Menu of Ideas to Fill Five Market Baskets Oil and Gas Gushing with Values Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web You Can’t Always Get What You Want

Morningstar Advisor - Spring 2007

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