Hedge Fund Returns, Risk and Fees and Systematic Equity Factors

Abstract

We investigate the extent to which hedge funds earn alpha - the component of returns that can be attributed to manager skill - in excess of a set of systematic equity factors. We find that a 4-factor performance attribution model explains between 15%-45% of hedge fund returns, depending on hedge fund style. We also document a strong positive relation between alpha-generation and systematic risk, implying that funds must take on more systematic risk exposure to earn larger alphas. There is no clear-cut relation between hedge fund fees and alpha, however, as the average alpha earned by high-fee funds is approximately equal to the average alpha earned by low-fee funds. Moreover, no hedge fund style consistently earns sufficient alpha to cover average management fees. The dispersion of hedge fund alpha supports the idea that manager skill exists, but in small supply, implying that access to skilled managers is critical. After accounting for other database biases identified by previous researchers, hedge funds' net alpha generation is significantly negative. We find little evidence that, as an overall industry, hedge funds create value for investors.