Alpha, Alpha… Who's Got the Alpha?

Abstract

Hedge funds have also been called “Absolute Return” strategies given their supposed ability to achieve positive returns in a wide range of market environments. In addition, performance is often based on their ability to obtain a return in excess of the risk free rate. However, the ability to obtain alpha (i.e., return above the risk free rate) is not indicative of managerial ability. In fact, any strategy that has volatility should use a benchmark return above the risk free rate. In this article, various forms of alpha determination are discussed. Moreover, the article emphasizes the problem of using Sharpe ratios to compare return/risk performance of two dissimilar strategies, especially when these strategies would be added to a predetermined portfolio.