Abstract

We consider two distinct styles of active portfolio management: alpha active, wherein managers’ positions are uncorrelated with particular benchmarks, and beta active, wherein managers take positions that are correlated with identifiable benchmark factors. We construct a measure of overall beta activity of fund managers, and find ample evidence that top beta active managers deliver superior out-of-sample performance compared to top alpha active managers. Furthermore, our measure of beta activity successfully captures the time varying nature of beta exposures that could be interpreted as a common factor driving the long term predictive power of both SR (systematic risk) and R2 measures.

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1. Introduction

Hedge funds are considered the apex of professionally actively managed investment funds. Hedge fund researchers commonly consider alpha, the constant in a regression specified by an asset pricing model, as a proxy for fund performance due to active portfolio management. In essence, alpha is the performance of a fund that cannot be explained by the model, and therefore positive alpha is a proxy for superior performance relative to the factor returns. Alpha is firmly entrenched in the common investment lexicon as a sophisticated measure of performance; fund managers, investment advisors, and investors all are “seeking alpha”.1

It is questionable, however, whether alpha reliably encompasses all relevant information about hedge fund performance. Extant literature documents that relatively few funds produce significant alpha. Rather, funds exhibit exposure to systematic risk factors such that returns are driven by beta activity.2 However, there is no consensus in the literature as to the efficacy of beta activity on a risk adjusted basis. For example, Titman and Tiu (2011) argue that successful managers hedge away systematic risk exposure and thus exhibit low R2 in multifactor regressions. In contrast, Bali, Brown, and Caglayan (2012) find that hedge funds with greater exposure to systematic risk demonstrate higher risk adjusted performance. It is therefore important for investors to better understand the nature of beta management in addition to alpha production.

In this paper we attempt to provide a comprehensive view of hedge fund managerial activity by defining two styles of active management, “alpha active” and “beta active”. We define alpha activity as…