Do hedge funds generate alpha?

Do hedge funds, in aggregate, generate positive alpha? If they do, that’s quite

impressive, seeing as how mutual funds, in aggregate, generate significantly

negative alpha.

Of course, the question is hard to answer, for two main reasons: Firstly, measuring

alpha is very hard, and secondly, getting data out of hedge funds is even harder.

Looking at indices certainly doesn’t help, since they don’t measure alpha and

they suffer from dreadfull survivorship bias.

Still, René

Stultz has taken a stab at summarizing the research on this subject:

Ibbotson and Chen (2005) examine the performance of hedge funds from January

1999 to March 2004. Their study uses 3,538 funds. After adjusting for various

sample biases, they conclude that… the average alpha of the funds is 3.7

percent. With this estimate, the alpha of hedge funds is particularly impressive

when compared with the alpha of equity mutual funds. Malkiel (1995) estimates

the alpha of all equity mutual funds at -3.20 percent…

A study by Kosowski, Naik, and Teo (2005) using an extremely large database

comes to the conclusion that the average alpha across hedge funds from 1994

to 2002 is 0.42 percent per month after adjusting for the problems in evaluating

hedge funds we discussed. However, the alpha in this study is not statistically


Fung, Hsieh, Naik and Ramadorai (2006) investigate the performance of funds-of-funds.

The authors argue that the data is much better for funds-of-funds than it

is for individual hedge funds and does not suffer seriously from the problems

discussed earlier. They consider three separate periods: January 1995 to September

1998, October 1998 to March 2000 and April 2000 to December 2004. They find

that the average fund-of-funds has a significant positive alpha during the

second period they consider, but the alpha is insignificant in the two other


The academic bottom line on hedge fund performance is captured well by these

studies. If one picks randomly a hedge fund, one should have a positive

insignificant alpha after fees.

In other words, hedge funds, before fees, really do, in aggregate, generate

substantial alpha. But they keep most of that alpha for themselves, in the form

of fees, leaving very little left over for investors.

Stultz also looks to the future, where, according to the summary at CXO,

the small positive alpha of hedge funds in aggregate is likely to move toward

the negative alpha of the mutual fund industry in the coming years.

Personally, I’ve read through Stultz’s report, and I can’t find him saying

that in quite as many words, although he does say that there’s likely to be

more of a convergence between hedge funds and mutual funds as the former become

larger and more regulated and the latter start embracing the kind of strategies

presently used only by hedge funds.


says that Stultz predicts lower hedge fund returns over the next ten years as

new managers enter the industry who aren’t as good as the old managers –

again, that’s there between the lines, but not really in so many words.

Even so, it’s interesting to me that hedge funds have, in aggregate, generated

positive alpha at all. And I wouldn’t be at all surprised if those days are

now at an end.

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