Traders take positions in pairs of similar stocks, longing the “undervalued” one and shorting the “overvalued one”, thereby placing a bet on the ultimate outperformance of the long position.
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If you have been following our recent blogs, you are by now familiar with the concepts of alpha, beta, and the Efficient Market Hypothesis. Our final goal is to evaluate the role of alpha in hedge fund investing, and to look at trading strategies that do not rely on alpha. Before we can discuss these topics, we need to better understand financial asset pricing models, the role of alpha and beta within these models, and how the models apply specifically to hedge funds. In this installment, we’ll review the concept of rate of return (ROR).
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In previous blogs, we discussed the concepts of alpha and beta in the context of hedge fund investment returns. Recall that alpha refers to that portion of total return attributable to an investment manager’s skill; beta is simply the return due to an investment’s exposure to market risks. A third component, random fluctuations, essentially goes to zero over time and is usually ignored in this discussion. One of the biggest questions in the hedge fund industry today is the role, if any, of alpha in investment returns, and how much is the alpha contribution worth?
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