Focus

accurate. "Beta" returns should be separated from "alpha" returns, meaning that the index should separate systematic market risks from manager-specific risks. For the exam, be familiar with the problems associated with hedge fund benchmarks.

AIM 80.1: Discuss the challenges of benchmarking alpha returns.

Currently, misleading data is being published on some hedge fund returns. The trend is to show absolute returns, meaning performance data uses only one benchmark—the risk-free return. Limiting performance reporting to absolute returns is misleading since absolute returns do not account for the overall performance of the international capital markets. The best way to present hedge fund returns is to compare the overall performance of the fund with the performance of the underlying "risk premia" returns.

For example, if the risk-free rate is 3% and a hedge fund produces a mean return of 15%, the alpha, or excess return, is certainly not 12%! A significant amount of alternative risk premia must instead be considered.

In order to properly benchmark hedge fund managers' returns, the proper alpha must be determined. The betas, or systematic returns, to which the specific hedge fund is exposed must therefore be subtracted. In order to infer the alphas from betas, risk premia indicators must be identified. Indicators include risk premia such as currency carry indices, mutual funds that target "small firm" or "book-to-market" effects, long-only convertible funds, high-yield bond indices, or any number of different option strategies (e.g., long puts/calls, straddles, etc.). Once these beta sources are accounted for, the returns that remain are truly the result of the hedge fund manager's skill at taking advantage of various market inefficiencies.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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