Hedge funds have been known to the general public thanks to the unique mindset of institutional investors, led by the Yale University endowment fund. Since the 1990s, Yale funds have invested heavily in alternative assets other than stocks or bonds, such as hedge funds, private equity funds, and have therefore achieved good returns. Hedge funds are more flexible than general mutual funds. They operate with high leverage, are free of encumbrances, have no benchmark, and are unconstrained to invest in different assets, including complex financial derivatives.
Hedge funds offer high returns but also have low transparency, low liquidity, and high fees. These characteristics attract many people to study them and try to overcome these shortcomings. Currently, the most popular method is to replicate the beta portion of the hedge fund's return in a multi-factor model using known factors. Other methods include a distribution approach, see [4]).
[Replication] The most influential studies on hedge fund replication come from Hasanhodzic and Lo[6] and Fung and Hsieh[7]; Hasanhodzic and Lo's research found that a linear multi-factor model consisting of five factors such as stocks, corporate bonds, dollars, credit spreads, and commodities can effectively describe the expected returns of hedge funds. On this basis, other factors such as emerging markets, transferable debt, default spreads, mortgage spreads, etc. were added.[8]
However, Fung and Hsieh used style factors to describe different styles of funds, and they chose the corresponding factors. For example, for equity long/short, market indices and small/large spreads are sufficient to explain their returns. For solid-yield funds, we can describe the return of 10-year government bond earnings changes and changes in corporate debt spreads.
[Sell Beta as Alpha] The successful use of the two models above shows that the majority of the alphas offered by hedge funds come from known risk factor hedges, whereas the true excess market returns are quite limited. So they are selling beta as alpha. An important reason they are able to make a return is not because they provide protection on downside risk, quite the contrary, but because they return badly enough when the market is down, i.e. they have a large hedge against tail risk.
This is consistent with the characteristics of factor investing, where the greater the "systemic" risk (especially when the condition is bad) that is taken on, the greater the factor risk premium (especially when the condition is good) that is compensated for. Thus, hedge funds are no different from other assets. When the market moves, the hedge fund classes in the portfolio have different returns and play the role of diversification, but when the market goes down, all types of hedge funds suffer losses.
It is undeniable that there are certain star funds in the hedge fund industry that can provide sustained and stable returns independent of market conditions. Moreover, different types of funds vary in their risk and cycle. For example, global macro funds that rely on macroeconomic analysis to invest did well during the 2008 financial crisis, with an average return of 4.8%, but they have been losing for several years in a low-interest rate volatility situation since the crisis.
[ concludes ] Although, copying hedge funds can only capture the average of the entire industry, leaving behind a fraction of the inexplicable alpha, this fraction of the alpha will become smaller as the theory develops, after all, star funds and their fund managers are scarce resources, and the future trend of hedge funds will increasingly focus on the application of various alternative betas. But even now, copying this highly liquid, expensive and easy-to-invest factor is still very valuable.
A large portion of the alphas marketed by the hedge fund industry can be explained by various risk factors, they are not as mysterious and unpredictable as imagined, and their success can be replicated.
[Behind-the-scenes footage by Andrew Lo] The above article mentions Andrew Lo, a professor at the MIT Department of Finance, who has witnessed the achievements in the field of finance (including hedge fund research) and was named one of the 100 most influential people in the world in 2012 by Time Magazine. I appreciate his view of the adaptive market hypothesis, AMH, see[11]. This view can be seen as a combination of the efficient market hypothesis (EMH) and behavioral finance.
He believes that it is more appropriate to explain market changes from a biological perspective than from a physical one. Different groups of market participants can be seen as different species, and various opportunities for profit are different resources. When competition over a resource is excessive, resources are depleted, and the species that depend on it to survive will also die out. This process involves various behaviors such as learning, mimicking, optimizing, etc. The principle of the survival of the fittest applies equally well in volatile markets: when a strategy concentrates too many investors, the strategy itself is also unprofitable, so appropriate adjustments can be made according to preferences to be combined with different market environments.
At the same time, Andrew Lo is also physically trying to put the theory into practice. The investment concept of the Alpha Simplex Group Diversification Strategy Fund, a hedge fund he manages, is to avoid the risks and liquidity of stocks by diversifying into non-equity-like highly liquid assets, focusing on the absolute return, in short, the search for a liquidity-alternative.
[Footnotes] The world's most profitable Yale fund is decrypted and how its assets are allocated.http://bbs.pinggu.org/thread-3128561-1-1.htmlWhat is it? This is the first time that the U.S. hedge fund industry has seen such an increase in the number of hedge funds.http://bbs.pinggu.org/thread-3132585-1-1.htmlWhat is it? [3] Hedge fund literacy post (((http://bbs.pinggu.org/thread-3116465-1-1.htmlWhat is it? He is also the co-author of a book on alternative beta strategies and hedge fund replication. [5] Some thoughts on the current trend of quantitative investing and smart beta (((http://bbs.pinggu.org/thread-3151691-1-1.html） [6] Hasanhodzic and Lo, “Can Hedge-fund Returns be Replicated?: The Linear Case”, Journal of Investment Management, Vol. 5, No. 2, 2007 [7] Fung and Hsieh, “Hedge Fund Benchmarks: A Risk Based Approach”, Financial Analyst Journal, March 2004 [8] Amenc et al, “Performance of Passive Hedge Fund Replication Strategies”, EDHEC, September 2009 [9] Baele et al, “Flights to safety”, Finance and Economics Discussion Series, Federal Reserve Board, 2014 [10] Jiang and Kelly, “Tail Risk and Hedge Fund Returns”, Chicago Booth Paper No. 12-44, November, 2012 [11] Andrew Lo, “The Adaptive Markets Hypothesis”, The Journal of Portfolio Management, 2004