“Alpha or beta in the eye of the beholder: What drives hedge fund flows?” Agarwal, Vikas, Clifton T. Green, and Honglin Ren Flashcards
What is the main idea?
Capital Asset Pricing Model (CAPM) alpha explains hedge fund flows better than alphas from more sophisticated models.
Why do the authors research how investors evaluate performance?
Hedge funds engage in more exotic investment strategies, and their investors are viewed as more sophisticated than for mutual funds (or ETF); they also pay substantial fees to the managers of the fund.
Despite large literature on hedge fund performance, it remains unclear how investors evaluate performance.
How do authors decompose fund performance into components?
o Manager skill
o Returns associated with traditional risk exposures
o Returns associated with exotic risk exposures
Which risk model do investors use to evaluate hedge fund performance?
CAPM
Do investors respond differently to the returns due to traditional risks and the returns attributable to exotic risks?
While investor flows respond to all three return components, they place greater relative emphasis on the returns arising from exotic rather than traditional risk exposures.
Investors credit hedge fund managers not only for their skill to produce alpha (strong preference for alpha), but also for their ability to deliver returns through taking opportune exposures to exotic risk factors and to a lesser extent traditional risk factors – Investors know why they want to invest in hedge funds
Are investors’ capital allocation decisions justified by funds’ future alphas and returns due to traditional and exotic risks?
◦ They find no persistence, but that could also be because returns to those factors are not persistent
◦ They check if exposures to risks are persistent, and find evidence of risk exposure (beta) persistence. This means hedge funds follow certain strategies for risk exposures, but future returns to those exposures are not predictable from the recent returns to those exposures
◦ This does not rule out that these factors, on average, deliver a risk premium
What is the impact of higher performance fee?
Investors that pay high performance fees are relatively more sensitive to returns associated with exotic risk exposures
Higher-fee funds deliver significantly higher alphas, but traditional and exotic risk components do not differ much across funds with different fees (so it is skill that they earn with, not exposures to exotic risks)
What does investor’s emphasis on CAPM reflect?
Emphasis on CAPM does not reflect a lack of awareness of untraditional risks.
Reflects a specific tendency to chase recent returns associated with both traditional and exotic risk exposures (As the returns to factors do not persist, this is not an optimal practice).
How should investors allocate their capital?
Instead of looking at how much exotic risks contributed to recent returns (exotic beta is alpha), investors should employ more sophisticated models and separate traditional and exotic risks.
This would help them allocate capital between cheap mutual funds or ETFs (where they can get exposed to traditional factors) and hedge funds with exotic exposures
Which models did authors use to explain investor fund flows (to determine which is most popular)?
o CAPM
o 4-factor model
o Carhart model
o Trend-following 7-factor model
o 12-factor combined model
What do investors credit hedge fund managers for?
Investors credit hedge fund managers not only for their skill to produce alpha (strong preference for alpha), but also for their ability to deliver returns through taking opportune exposures to exotic risk factors and to a lesser extent traditional risk factors.
Do investors earn with skill or exposure to exotic risk?
Higher-fee funds deliver significantly higher alphas, but traditional and exotic risk components do not differ much across funds with different fees (so it is skill that they earn with, not exposures to exotic risks).
