Key Concepts

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. In order to properly benchmark hedge fund managers' returns, the actual alpha (or excess return) generated by each hedge fund must be determined. Because alpha is a residual measure, the returns derived from betas to which the specific hedge fund is exposed must first be subtracted. Before beta returns can be estimated, however, risk premia indicators must be identified. Once the beta sources are accounted for, the returns that remain are truly due to hedge fund managers' skills at exploiting market inefficiencies.

A significant dilemma with current hedge fund index construction is that many of the hedge funds are closed, which presents a selection bias problem when creating the index. Performance biases include survivorship bias, backfilling, asset weighting, selection bias, autocorrelation, and time-period bias.

Attributes of a good hedge fund index include a clear unambiguous definition, representativeness, investability, and accuracy.

To be truly useful, a good hedge fund index should separate beta returns from alpha returns. The index should separate systematic market risks from manager-specific risks.

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