*We are reposting an earlier analysis of a paper selected as one of the best financial research papers of 2011. Over the summer, we will post analyses of all of our top 10 papers of 2011, as well as others who didn’t quite merit a top 10 selection but were intriguing in their own right.

This is an admirably careful study of hedge fund performance from January 1995 through December 2009.  Using the Lipper TASS database of some 13,000 funds living and dead, and eliminating non-dollar funds, funds of funds, and funds that reported gross, pre-fee returns, Ibbotson and  colleagues were left with some 6,000 funds. Correcting for survivorship bias and backfill bias (the tendency for funds to start reporting returns after a hot year) the team found that hedge funds in the sample on average yielded…… positive alpha every year except1998 and that annual alpha averaged about 3%. Though estimated fees exceeded alpha, fees net of alpha averaged about 43 bps, less than the fees charged by most mutual funds. Moreover the hedge funds “provided excellent diversification benefits to stock, bond and cash portfolios. The results also show that hedge funds exhibit tactical asset allocation skills, especially in reducing beta exposures during bear markets.”

All very gratifying, but what most interested us was the authors’ discussion of hedge fund beta. We have long been skeptics of the alpha/beta distinction, in part because the most powerful of all investment decisions is whether and when to expose one’s portfolio to market betas. More fundamentally, alpha and beta, like idiosyncratic and systemic risk, are necessarily relative terms. “Beta” by definition refers to the return on any predefined group of securities that contains the alpha-generating group selected from it. Alpha is simply the difference between the returns of set and subset. Or, as we have often said, “all alpha is simply the beta of a creatively defined asset class.”

So imagine how pleased we were to find these perceptive comments embedded about halfway through the Ibbotson et al paper [Emphasis added]:

“Although we believe that a portion of the hedge fund returns can be explained by non-traditional betas (or hedge fund betas), these non-traditional beta exposures are neither well specified nor agreed upon and are not readily available to individual or institutional investors. A substantial portion of alpha can always be thought of as betas waiting to be discovered or implemented. Nevertheless, because hedge funds are the primary way to gain exposure to these non-traditional betas, the latter should be viewed as part of the added value that hedge funds provide as compared with traditional long-only managers.”

Couldn’t have said it better ourselves.