Event-driven Hedge Funds: How Much Alpha Do They Deliver?

Laurent Favre, CEO AlternativeSoft, London

August 2007

In this article, we computed the average alpha of 190 event-driven hedge funds. We found that the average annualised alpha per event-driven hedge fund is 7.3% and the average annualised alternative beta premium per event-driven hedge fund is 7.3%, as well. This means, on average, the alpha and alternative beta for event-driven hedge funds are the same.

Some hedge funds market themselves as alpha providers, whilst others as alternative beta providers. Alpha and beta are important for investors as they provide them with what they are looking for – returns. By definition, alpha is the part of the asset return unrelated to any risk premium and beta measures the exposure to risk premia. The difficult part is to separate alpha from beta in a hedge fund. We use a 12-month rolling window regression model:

Where

α : monthly alpha
β : exposure to the economic factor F
F : economic factor values
ε : unexplained value
N : number of economic factors

The regression technique is an enhanced Sharpe-based-style analysis with rolling stepwise regression and beta significant at 10%. This rolling regression allows us to measure the significant exposure between the hedge funds and 11 economic factors:

AIGCI Commodity Index

JPM Global Bond Index

MSCI EM Asia

MSCI Small Caps EMU

Oil spot west texas

Russel 1000 Value

Russel 1000 Growth

Russel 2000

CS High Yield Index (CSHY Index)

BXM Index (BXM Index, covered call on S&P500)

Merger fund (ERFX US Equity)

The event-driven hedge funds were taken from the Eurekahedge and HedgeFund.net databases, with returns available at least from January 2006 until January 2007. Wrongly classified hedge funds (approximately 20) and hedge funds from the same company but with different currencies in the event-driven strategy have been eliminated. In order to account for hedge funds which have produced extreme returns, the two hedge funds with the lowest and highest annualised alpha and beta premia (ie eight hedge funds in total) have also been excluded from the sample. After this screening, 190 event-driven hedge funds were left.

Figure 1 below shows that the annualised alpha distribution is positively skewed. This means there are more alphas to the right of the mean (which is 7.3% per annum) than to the left. In other words, some hedge funds have delivered extreme positive alphas. Figure 1 presents the average alpha for each hedge fund. Some of these alphas are volatile and not statistically different from 0%.

On average, the rolling regression model explains 42% of the 190 event-driven hedge funds (ie adjusted R2 equals 0.42, on average for each hedge fund for each rolling regression).

Figure 1: Annualised Alpha Distribution for 190 Event-Driven Hedge Funds

Figure 2 below presents the annualised alternative beta premium for 190 event-driven hedge funds. It represents the portion of the hedge fund annualised return that can be explained by the 11 factors. The beta premium is positively skewed, which means some hedge funds have delivered high annual returns due to exposure to long-only risk premiums (30% of the hedge funds have significant exposure to MSCI Small Cap EMU Index, 24% to Russell 2000 small caps, 21% to Russell 1000 Growth, 15% to CS High Yield Index and 12% to Covered call S&P500 Index). The average annualised beta premium is 7.3%.

Figure 2: Annualised Beta Premium for 190 Event-Driven Hedge Funds

Among the 190 event-driven hedge funds with at least 13 monthly returns, on average, the alpha equals the beta premium. The beta premium is mainly generated by exposure to small-cap indices or to growth or high yield index. On average, the performance of 42% of the 190 event-driven hedge funds can be explained with a 12 month-rolling combination of long-only indices.

Average for 190 Event-Driven Hedge Funds

Annualised beta premium

7.3%

Annualised alpha

7.3%

Annualised return

15.3%

Note: The HFOptimizer software platform from www.AlternativeSoft.com is able to measure alpha and alternative beta, as presented in this article. With this and many other features, HFOptimizer platform is well suited for hedge funds selection.

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