“Alpha” Risk misManagement

The biggest “CIO” Risk: “Alpha” Risk misManagement

by Leslie Rahl, Richard Horwitz, Erin Simpson

Despite “beta” risk being the dominant source of systematic behavior in the hedge fund industry, the greatest source of market-driven hedge fund blow-ups is “alpha” risk. A significant percent of alpha risk results from hedge funds’ tendency to be net-long Complex, Illiquid, and Opaque (“CIO”) securities. The hedge fund industry does an inadequate job of managing alpha risk. Finally, this article defines a risk-adjusted measure of alpha, naturally called the “Alpha Ratio”. What are Alpha and Beta Risk? Let’s first define alpha and beta risk. To do that we must first define alpha and beta. Beta is the return enjoyed by hedge funds driven by their exposure to the underlying markets. Over a long period of time, markets reward investors for accepting the inherent risk. For example, the equity market has, over a long period of time, returned an average 11% and long-term bonds have returned 8%, both in excess of the risk free rate that averaged 5%. However, these beta exposures can be gained through ETFs or futures, and do not justify the significant fees hedge funds charge. Alpha is the additional return generated in excess of that which comes from market betas.

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