The role that hedge funds play in institutional investor portfolios is changing. For many years, they have typically been regarded as homogeneous, high risk/high return investments directly comparable with risky asset classes such as equities. But this view is being challenged as some institutions are once again seeking to use hedge funds as sources of both differentiated risk exposure and returns that are uncorrelated to traditional markets. Underpinning this shift is the growing understanding of the need to dig deeper into portfolio performance in order to understand more clearly the types of risks taken to generate returns.

The overall performance of two investments may be broadly similar, but there could be significant differences in the risk factor exposures that each provides. This is important because risk factor exposures are a key determinant of the “quality” of an investment’s returns over the long term. An investment with significant primary market (or beta) risk exposures will typically be highly correlated with equity or fixed income market movements, whereas one with a differentiated risk exposure may be more likely to deliver uncorrelated returns.

Idiosyncratic risk exposures can be a key source of alpha. For example, the decision of a ratings agency to downgrade or upgrade a company’s credit rating due to a small change in its fundamentals is likely to disproportionately impact the price of that company’s bonds. Such a dislocation of asset prices from fundamentals or broader bond market movements can be a source of idiosyncratic risk. Many hedge funds focus on opportunities arising from just such market complexity, lopsided incentives or other inefficiencies, while hedging other risks.

Do hedge funds actually generate alpha, in practice? To answer this question, BlackRock decomposed the 2013 returns of the HFRI Fund Weighted Index and its component sub-strategy indices. We discovered that approximately one third of the 9.1% total returns of the hedge funds in the index appear to be derived from alpha.

In Search of the Unexplained

We also analyzed the 1,548 hedge funds that make up the index and decomposed their returns as well. We uncovered a significant degree of dispersion in both alpha generation and overall performance within and across hedge fund strategies. The median hedge fund might have offered 3.1% of alpha during 2013, but the top 25% generated at least 10.4% over the same period. This means that investors with the time, resources and ability to identify top quartile managers could gain a significant advantage over a “scattershot” approach.

Successful investment programs treat risk as an input when making asset allocation decisions, with returns as the output. For this reason, an active risk management approach can help to identify valuable idiosyncratic risk factors, the most reliable sources of alpha returns. Adding alpha to portfolios dominated by beta-type sources of risk is an effective approach to diversification that does not rely on equating often-incomparable return streams.