Market neutral hedge fund returns 2010, returns, generate, absolute

karoliukas

According to the CAPM, a zero beta portfolio should earn a risk free rate of return. However market neutral hedge funds are able to generate superior absolute returns. How does that work? Is it due to leverage?



Edited 1 time(s). Last edit at Wednesday, September 29, 2010 at 11:53PM by oz001.

johnnyBuz

Thanks for all your responses! the leverage contribution is clear.

Wasteoftime

it may earn the risk free rate, but when you buy on a margin you measure the returns on your original investment, not your total portfolio value.

example

I run a hedge fund worth 100. I take out 300 of debt. total value is 400. I earn 5% over the course of 1 year. my total value is 420. pay back the 300 of debt and I have 20 left over (maybe a little less for interest payments, etc). thats a 20% return on my original 100 investment, not bad.

ramzes

oz001 Wrote:
-------------------------------------------------------
> According to the CAPM, a zero beta portfolio
> should earn a risk free rate of return. However
> market neutral hedge funds are able to generate
> superior absolute returns. How does that work? Is
> it due to leverage?

There could be other risk factors besides the market. For example, HL or BL (look at Fama-French model). A market-neutral portfolio can collect premiums that are different from the market premium. Then leverage controls exposure to those other risk factors. Does that help?

nitoha

That should read "Unfortunately it also means you can generate extraordinarily large negative returns."

rkapoor

If you lever up you can indeed generate extraordinarily large returns. That's the nature of leverage.

Unfortunately it also means you can generate extraordinarily large returns. And if you have enough political clout then Uncle Sam will bail you out too (witness the recent financial crisis).

NC

agulani

Actually my query was in relation to a particular example 7 in the CFA I 2010 curriculum (page 222 alternative investments). I've noticed that the example has since been deleted per the errata. Still curious to know if / how such market neutral long/short strategies can generate extraordinary returns of that magnitude (50% pa) in the real world.

Penny-wenny

If CAPM is correct, then market neutral hedge funds at an average should earn the riskless rate. Leverage for a market-neutral portfolio does not matter in a CAPM world. All it does is to increase idiosyncratic risk, for which there should be no extra return according to CAPM.

So at least one of the following two statements is incorrect:

1) CAPM is true
2) Market-neutral hedge funds earn an average return greater than the riskless rate.

If I were to guess, I would say that 1) is definitely incorrect, and 2) is also likely incorrect.

NC