CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

33.4 THE CASE FOR HEDGE FUND REPLICATION

Prior to the bear market that began in 2000, there was a widely held market belief that the returns to actively managed alternative investment funds were composed primarily of alpha (excess return above that available in an equally risky passive investment product) and small amounts of beta (return due to a fund strategy's exposure to investable market factors). Since then, the return streams associated with passive investable indices, active managers, and other alternative or structured products have severely challenged this belief system. In the traditional mutual fund arena, research continues to question the existence of manager alpha (Bodie, Kane, and Marcus 2010). Even in the alternative investment area, where greater amounts of informational inefficiencies may be expected, studies have shown that the alpha of many hedge fund strategies has declined since 2000 (Fung and Hsieh 2007). Similarly, Fung et al. (2008) document that hedge fund of funds products did not deliver any alpha between 2000 and 2004, and Naik et al. (2007) have shown that the levels of alpha associated with various investment strategies have substantially declined over the period 1995 to 2004.

Exhibit 33.1 displays a one-factor estimate of the rolling beta and rolling alpha of the Hedge Fund Research (HFR) Funds of Funds index, where the S&P 500 index is used as the benchmark. Both the beta and the alpha are estimated using a 24-month rolling window. The alpha is ...