re: Getting Past the Gate: Capital Introduction at Prime Brokerage Firms

III-A. Hedge Funds and Hidden Beta

There were a few links I remember reading about this online that I haven't been able to find this week, and although that's been really aggravating, it's not really a big deal, because the basic idea here is pretty simple--hedge funds tend to hide their true level of investment risk (producing hidden beta, or "alternative beta"), thus making their alpha (i.e., their returns generated by investment skill over and above what an efficient return should be for the same level of investment risk) seem much higher than it really is.

Google "hedge fund clone/cloning" and you'll see lots of interesting links about how many academic researchers think it may be possible to replicate hedge fund returns, which are more due to hidden beta rather than true alpha. (There is also a Wikipedia entry on " hedge fund replication," although it is rather minimal.)

One of the most cited papers in this field is by Jasminah Hasanhodzic & Andrew W. Lo. Of note is that Lo published a book back in 1999, " A Non-Random Walk Down Wall Street," which was a sort of very technical rebuttal to Burton Malkiel's more famous book.


Jasminah Hasanhodzic

In any case, it is now a well established truth that hedge funds tend to produce most of their eye-popping returns through various methods of hiding their true level of risk. Jaeger & Pease seem to have the most popular book on this subject at the moment on Amazon, although other academics like Jens Jackwerth have also studied the issue in depth.

Without going into any detail (which I must admit to having not studied up on myself), these are the categories of hidden risk listed by Jaeger & Pease:

-- roll yield risk
-- commodity hedging risk
-- volatility risk
-- convergence risk
-- complexity/efficiency risk
-- momentum risk
-- value risk
-- FX carry risk
-- term risk
-- credit risk
-- EmMa risk
-- duration (bond) risk
-- equity risk

So please don't ask me what any of that means right now (the author claims that only the last 2 categories typically apply to common investors), but you know... I think you can get the gist of what's going on here.