Alpha Generation: The Search for the Unexplainable

Equity Market Neutral Strategies Stripped

February 2021. Reading Time: 10 Minutes. Author: Karl Rogers & Nicolas Rabener.

This research note is a joint effort of ACE Capital Investments & Finominal.

SUMMARY

  • The performance of equity market neutral hedge funds, both discretionary and systematic, can be fully explained by market beta and equity factors
  • At their peak, systematic managers brought in twice as much unexplained returns  versus their discretionary counterparts, however, their factor loadings explain this difference
  • Given that we understand their performance drivers, these can be replicated efficiently

INTRODUCTION

We began this research effort on the hypothesis that one can use an equity market neutral strategy to either a) isolate exposure on idiosyncratic risks or b) isolate exposure to equity factors like Value or Momentum. The latter is steeped with academic research and readily available as long-short risk premia products from investment banks.  The former is filled with the unknown and is highly desirable for portfolio diversification, but as one can imagine, is difficult to generate for hedge fund managers.

A relatively simple definition of alpha is the return driven in an unrelated fashion to one’s benchmark. Capital allocators have greater access to cheap strategies, markets, and risk types due to the boom in passive investing products. Although these make reducing returns down to the bare bones much easier as we can strip out more risk exposures, the transparency makes the active manager’s job significantly more challenging. The goal of all active managers is to provide, from a quantitative perspective, alpha. This represents the unexplainable returns once stripped of various loadings (try Finominal’s Alpha Analyzer for alpha and contribution analysis).

Allocators look for a large portion of a fund’s return to be alpha. Otherwise, why pay high active management fees?

In this short research note, we analyse the returns of equity market neutral hedge fund managers, both systematic and discretionary, to study how much alpha they are generating and whether we can explain