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.
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 what is driving their returns.
Systematic equity market neutral performance stripped
We are using a proprietary data set of equity market neutral hedge funds (EMN) that are classified as either discretionary or systematic based on the funds’ descriptions. A significant number of these funds either stopped existing or are no longer reporting returns, which means the data set features survivorship bias.
For this analysis, we conducted a two-stage return decomposition. First, we regressed the systematic EMN index’s returns against the returns of the S&P 500 and removed the market beta; we call this the net of market beta index. We then ran a multiple linear regression using common equity factors, namely value, momentum, quality, size, and low volatility against this index. This then leaves us with what we call the Alpha Index and represents the unexplained returns. Stated differently, it is the alpha generated by the hedge fund managers’ net of market beta and equity factors.
Intuitively, we would expect the equity market neutral index to have no relationship with market beta given their objective of offering uncorrelated returns. Capital allocators would hope to find the majority of returns coming from equity factors given that these are systematic funds, or better, represent true alpha.
As shown in previous research notes we have published, the EMN index has generated a significant portion of its returns from simply providing exposure to the stock market. At its peak in 2018, alpha accounted for a little under a third of the EMN index’s returns. However, the alpha generation turned negative thereafter and essentially was zero over the entire period between 2011 and 2020.
