Frequently Asked Questions

What is alpha?

Alpha is a measure of returns generated by a manager which are attributable to his or her skill. It is return achieved above some benchmark, where the benchmark is a passive, diversified investment into the manager’s market at the same level of systemic risk as the manager is taking. A manager who does not achieve positive alpha is necessarily inferior to simply investing passively. A complete, intuitive discussion of alpha is available here.

What is Alpha Gauge?

Alpha Gauge performs a textbook calculation of alpha for any track record a user cares to input. Alpha is measured against 7 benchmarks or factors: 3 equity market factors, 2 Treasury market factors, 1 commodity factor and 1 credit factor. As such, it determines

·         if a manager is achieving something superior to a passive investment in stocks, bonds or commodities,

·         the beta factors that fund was exposed to. These beta factors constitute the replicating portfolio for the fund.

Are these factors appropriate for the fund I wish to investigate?

The vast majority of investment returns are simply compensation for taking some combination of exposure to the factors used by Alpha Gauge. Of course, there are many other types of “beta” risks. Thus a manager could be sourcing returns from some other beta source which Alpha Gauge would “mistake” for alpha. However, a large fraction of “alternative” investments actually source returns from these conventional sources. Hence Alpha Gauge is an excellent starting point to determine how much return is actually coming from somewhere alternative to simple stock and bond investments.

What is the difference between out performance and alpha?

Out performance measures the return in excess of some index with no regard for risks taken. Alpha is a risk adjusted measure of out performance.

What exactly am I looking for?

Any fund that does not generate positive alpha does not warrant an investment simply because their performance is replicable by simple, passive beta exposures. Hence, at the very least, you are looking for positive alpha. Furthermore, you want to confirm that the beta exposures your fund has are consistent with what they say they are doing and are consistent with your investment objectives.

For example, a “market neutral” hedge fund should have all betas close to zero.

The fund I wish to investigate invests globally. Are these factors still appropriate?

Technically no. However, because of the strong correlation of global markets, the Alpha Gauge factors can still be quite telling. In fact, often the performance of a “global” hedge fund is explained completely by Alpha Gauge’s US factors. Technically though, iluka’s full global factor model would be needed to definitively measure the fund.

This fund doesn’t even invest in bonds, yet it has bond beta? This fund doesn’t invest in stocks, yet it has stock beta?

The risk factors that drive global markets do not promise to isolate themselves. Stocks are affected by credit markets, bonds by stock markets, etc. Alpha Gauge measures the underlying source of risks in a fund, irrespective of the instruments the fund employs.

Surely my hedge fund’s strategy is too complex to be simplified to stocks and bonds.

Many of the most obfuscated hedge fund strategies reduce quite simply to basic stock and bond exposure. If the fund’s complexity is truly beneficial, it will precipitate alpha.

Why is this the correct way to measure alpha?

There is no debate as to the correct way to measure alpha. The only subjective aspect is the choice of beta benchmarks. Our market factors are simple, understandable, and investable. A fund generating alpha against these factors is at least achieving something that can not be easily replicated.

Mathematically, what does Alpha Gauge actually do?

Alpha Gauge regresses the monthly return (as uploaded by a user) minus the riskless return for the month on 7 factors. These factors are effectively Fama and French’s three stock market factors, two Treasury factors, a credit factor and a commodity trend factor.

The financial science behind Alpha Gauge is well documented in, (and indeed based on) papers like:

Can Hedge Fund Returns Be Replicated? The Linear Case, by Jasmina Hasanhodzic and Andrew Lo

Risk and Return in Fixed Income Arbitrage: Nickels in front of a Steamroller?, by Jefferson Duarte and Francis Longstaff

My fund has exceptionally high alpha, so its good right?

It could well be. You can certainly conclude that the manager is sourcing returns from somewhere other than US stocks and bonds—which is extremely desirable. There are two caveats:

1.       Alpha Gauge does not include a full set of global risk factors in its analysis. The fund might be taking beta risk from a market that Alpha Gauge does not consider.

2.       The fund’s track record might be too short to draw bold conclusions from.

My manager generated 30% last year. Why do I care if its alpha or beta?

Unless some fraction of the 30% is alpha, you didn’t need the manager. You could have got the same return without bearing the operational risks incurred by giving money to a hedge fund. If the alpha is in fact negative, you would have achieved higher risk adjusted returns by avoiding the hedge fund.

How should I interpret positive alpha?

Positive alpha indicates that a fund generated returns not attributable to simple investments. Positive alpha indicates that a manager is adding value. Positive alpha is returns which an investor could not have achieved without the manager’s help.

How should I interpret negative alpha?

Negative alpha implies that the investing with the manager was inferior to simply making a passive investment into stocks and bonds at the same risk level over the same period.

Is beta bad?

Beta is most certainly not bad. But beta is available extremely cheaply and investors should avoid paying hedge fund fees for it.

Can one not argue that a hedge fund manager is taking certain beta risks by design. After all, he may be good at getting the right beta exposures at the right time.

If the manager is good at selecting the right beta exposures at the right time, it translates directly into alpha.

Is alpha better than beta?

Yes. Alpha is scarce and uncorrelated to global markets. As such it is an extremely desirable addition to any portfolio. Beta is ubiquitous.

What is a good alpha level?

Alpha should be judged against the its volatility. An alpha information ratio above 1.0, is very good. The alpha information ratio is the ratio of alpha to alpha volatility. Mathematically, that is (alpha p.a.) / (std_err p.a.)

So a fund generating 6% of alpha per annum with a alpha volatility of 6% is impressive. 6% alpha per annum with 12% alpha volatility is less impressive.

What is a good beta level?

The beta level doesn’t matter, because you can easily adjust it to what you want with index futures, tracking funds or other hedge funds. But the most useful hedge funds are mostly alpha and minimal beta. That allows you to add them to your portfolio with ease.

What is false alpha and when might I get a false alpha.

False alpha is when the mathematics indicates positive alpha, but in reality the returns are not really alpha. There are many routes to false alphas. Illiquid funds (Private Equity for example) would look exceptionally good when analyzed by Alpha Gauge because the NAV at any time is rather arbitrary. As such, correlations are muted. A fund taking a very specific beta risk (Japanese railroads stocks for example) would look like pure alpha against our factors. This is why we suggest that positive alpha is just the beginning of the evaluation process. Negative alpha, on the other hand, is a good reason to be done with the particular hedge fund immediately.

Where can I learn more?

On this site, see our article titled The Tao of Alpha.

Elsewhere on the web, see All About Alpha

Consult almost any textbook on corporate finance for a mathematical introduction to the subject.

Why was Alpha Gauge created?

Alpha Gauge is actually a “lite” version of iluka’s complete factor analysis tool. We published it for several reasons:

1. To introduce prospective clients to our tools.
2. To attempt to narrow the (unfortunately) wide ranging definitions of alpha in the hedge fund industry.
3. To gain insight on the methodology from others via feedback.
4. To help investors evaluate hedge funds.

Can Alpha Gauge be used for hedge fund replication

The beta factors from Alpha Gauge are the replicating portfolio. See Can Hedge Fund Returns Be Replicated? The Linear Case.

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