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.
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?