The Nature of Alpha

TL;DR

This paper introduces an empirical model highlighting the significance of non-Gaussian features like volatility and fat tails in investment returns, revealing that many strategies are effectively 'short volatility' and impacting hedge fund portfolio design.

Contribution

It provides an empirical framework demonstrating the role of non-Gaussian features in expected returns and offers insights into hedge fund strategy construction.

Findings

Volatility compensation is key to most strategy returns.

Many strategies function as 'short vol' strategies.

Exceptions exhibit 'long vol' characteristics.

Abstract

We suggest an empirical model of investment strategy returns which elucidates the importance of non-Gaussian features, such as time-varying volatility, asymmetry and fat tails, in explaining the level of expected returns. Estimating the model on the (former) Lehman Brothers Hedge Fund Index data, we demonstrate that the volatility compensation is a significant component of the expected returns for most strategy styles, suggesting that many of these strategies should be thought of as being `short vol'. We present some fundamental and technical reasons why this should indeed be the case, and suggest explanation for exception cases exhibiting `long vol' characteristics. We conclude by drawing some lessons for hedge fund portfolio construction.