LO 71.5: Explain the relationship between risk and alpha in hedge funds.

LO 71.5: Explain the relationship between risk and alpha in hedge funds.
Alpha is a risk-adjusted measure of return often used to assess the performance of active managers. It is the return in excess of the compensation for risk. It is important to identify how much of a strategys return results from risk (i.e., beta) and how much results from active management (i.e., alpha). This is known as distinguishing alpha and beta. A manager who uses statistical techniques, quantitative tools, and benchmarking to discern whether high returns are the result of the superior performance of an active manager or a function of bearing high levels of systematic risk is attempting to distinguish alpha from beta.
A hedge fund may attempt to independently manage alpha and beta. The firm may manage beta exposure while separately managing the portfolios alpha. This is known as separating alpha and beta. Managers can use investment tools to pursue alpha while sustaining a target
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2018 Kaplan, Inc.
Topic 71 Cross Reference to GARP Assigned Reading – Constantinides, Harris, and Stulz, Chapter 17
beta for the portfolio. Managers typically seek to limit beta while trying to optimize alpha. Derivatives are often used to minimize or eliminate undesired systematic risk.
For example, assume a managers benchmark is the S&P 500. He would like to pursue opportunities that increase alpha, but the result is beta exposure different from the benchmark. He can use futures contracts to hedge all systematic risks other than exposure to the S&P 500 such that the portfolios beta relative to the S&P 500 is 1.0. He does this while simultaneously pursuing an alpha optimizing strategy. In this way, he is independently managing, or separating, alpha from beta.
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