In Chapter 5, we looked at a range of risk-adjusted return metrics which were both absolute and relative to a benchmark. As such we were trying to answer the question which? In this chapter we will try to answer the question why? Asset pricing models allow us to delve deeper into the structure of hedge fund returns in an attempt to explain them as a complex mix of various exposure factors. In doing so, we look beyond the superficial gloss of the beauty contest associated with the array of risk-adjusted return metrics already described. For sophisticated investors, asset pricing models are very useful in the hedge fund selection process since they allow them to figure out if a hedge fund is really producing skill-based returns worth paying for, or whether the hedge fund could easily be replicated at low cost.
In Section 5.3.4, we introduced Sharpe's CAPM market model, given by
On rearranging, the alpha term can be written as
Where αP is Jensen's alpha. Equation (6.2) can be broken down into two terms
Equation (6.3) has until recently been widely used for the calculation of alpha within the asset ...