Imaginary Alpha

Alpha is what hedge funds sell. It is the skill of the investment manager(s), allowing them to earn a higher return than justified merely by the amount of risk they take. In practice this means earning more than a simple index fund. For this excess return, hedge funds charge higher fees. Presumably this is justified. In an efficient market alpha would be zero – there would be no way to earn (on average) higher returns than the market as a whole. No one (except economists and some MBA students) believes markets are efficient anymore. However, since 1998, hedge fund clients (in the US) have earned on average only half the rate of return on treasuries.

Self-selection bias

Indices of hedge fund performance suffer from a crucial flaw which make them (in my opinion) all but useless. Reporting to the indices is voluntary. And as such only hedge funds that perform well will start to report. Those that perform badly will stop reporting. The indices thus overstate hedge fund returns.

It has been argued that this may well be offset by the fact that the top-performing hedge funds may also choose not to report. They may do so because they have already raised enough capital or because they no longer need the exposure.

It would, however, appear that the latter effect is far smaller than the former, making any studies based on this data (which is most studies up to this point) suspect.


A recent study by Aiken, Clifford and Ellis indicates that hedge fund alpha may well be much lower than previously thought. They find that, in fact, most of the alpha of hedge funds is explained by their decision to report (or not) in the commercial indices. In order to get past the self—selection problem they use the figures of funds of funds registered with the Securities and Exchange Commission. These funds invest in other hedge funds, whose returns can thus be scrutinised.

Funds that stop reporting afterward have dramatically lower returns than those that continue. The delisted funds continue to operate for some time and contribute zero alpha. This would still mean a positive alpha for hedge funds overall, but smaller than given by only examining the reporting funds.

Why not invest only in funds that do report returns? The hedge fund sector is illiquid – it takes time to get your money out. There is also a lag in the reporting of returns. An investor cannot be sure that a hedge will report its most recent returns.

Another problem (not tackled by the paper) is that some funds may perform well when they are small, which allows them to attract more money. This performance may or may not be simply due to luck. However, when (not if) the fund performs badly, its cash losses may well exceed all previous gains, simply because it now has more money. Investors, on average, lose out.

The above can be applied to the industry as a whole. When it was small, it was making high returns, and attracted capital from various sources. However, the losses in 2008, may have wiped out all cumulative gains in the industry going back ten years.


The Aiken, Clifford and Ellis paper does suffer from flaws and these should be considered when evaluating the results. For instance, the period studied is from 2004 to 2009. It may be that a longer time period (or a future time period) gives different results. There is at least one study that finds no evidence of a selection bias due to the fact that funds that perform well may choose to stop reporting after having raised sufficient capital. The Aiken, Clifford and Ellis study itself has a selection bias, in that it only examines hedge funds that are invested in by funds of funds reporting to the SEC. The authors do, however, perform various tests which suggest that this results in no systematic errors. The statistical methods used are based on normal theory and as returns patently do not follow normal distributions, results should be treated with some scepticism. However, this latter point applies to most financial papers.

The dilemma

Hedge fund managers earn very large fees. They have done so, despite that their clients have walked away with meagre returns. This raises the question of whether the alpha displayed by some managers is anything more than mere luck. People have trouble believing in luck. They attribute high returns to skill. This is good for hedge fund managers, but it may be very bad for investors.

Some references
  • Aiken, A. L., Clifford, C. P., & Ellis, J. (2010). Out of the dark: Hedge fund reporting biases and commercial databases. Finance.
  • The Economist. (2012a). Hedge fund returns: More damning data. The Economist. Retrieved January 21, 2012, from http://www.economist.com/blogs/buttonwood/2012/01/hedge-fund-returns?fsrc=scn/fb/wl/bl/moredamningdata
  • The Economist. (2012b). Rich managers, poor clients. The Economist. Retrieved January 21, 2012, from http://www.economist.com/node/21542452
  • Wikipedia. (2012). Alpha (investment). Wikipedia. Retrieved January 21, 2012, from http://en.wikipedia.org/wiki/Alpha_(investment)


  1. Nice read. I'm still wondering how a manager can add value in a hedge fund. Although hedge funds typically use cash as their benchmark. I'm really not sure if there is a systematic way of continuously beating the market and coming up with good investment strategies.

    1. Even if there is. How do you know? Things change so much, so much is random, you can never be sure.

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