The main reason to put money into hedge funds">hedge funds is for EXCESS, RISK-ADJUSTED performance. If you are SURE of a bull market there is no need to put money in hedge funds">hedge funds. The beta from passive index funds are all that an investor would require assuming they can stomach the volatility which I certainly can't. Isolating and measuring alpha can also be difficult. Past betas and alphas are unstable and do not necessarily carry predictive information on FUTURE betas and alphas.
Not all hedge fund absolute returns can be considered alpha. In fact many alphas are negative after looking at the risks and factor exposures taken to generate that performance. Identifying the alpha dogs in the financial world is hard but not impossible. But true alpha is what the 2% and 20% fees are for. Some investors choose to pay intermediary allocators an extra layer of 1% and 10% to source and locate that alpha and conduct expensive and time consuming manager due diligence.
Alpha is a measure of value added performance but alpha is often evaluated incorrectly, especially with hedge funds">hedge funds. For example, take a USA equity long/short hedge fund. The closest security universe might be the Russell 3000 and typical long-biased exposure is 130/30 long and short. So it has 100% NET exposure like the index and the fund generated alpha if it made MORE than 17% after fees last year. Yet the manager will often claim all the absolute return is alpha. Nonsense.
An added complication is that if its longs were high beta and shorts were low beta, the hedge fund would have needed to make an even higher absolute return for ANY alpha. Alpha is the return AFTER allowing for dependence on beta risk factors. If the hypothetical fund's individual longs had an average beta of 1.5 and the shorts a beta of 0.5, then hedge fund alpha is only ABOVE a 30.6% return.
Suppose you set up a hedge fund that only invests in countries starting with "T"- the T-fund. Last year Turkey, Thailand, Tunisia and Trinidad were mostly difficult markets which is somewhat at odds with the conventional notion that "every" emerging market performed well. If the T-fund returned higher than risk free rates last year then that fund is an alpha dog.
Conversely take the C-fund, investing in China, Czech Republic, Chile and Canada. Those stock markets went up a lot so there was plenty of beta. The way to assess the C-fund for alpha is to look at its long/short gross and net exposures throughout the year on a daily basis, DEDUCT the net beta contribution of the closest stock indices to their universe, and then see what alpha is left. Many funds with "good" performance last year actually generated NEGATIVE alpha. Portable alpha is not even possible in many cases where the underlying market is not liquid or hedgeable.
In the connected world we now live in, there are no exotic countries so there can be no exotic beta; there is just plain old beta. Alpha however is ALWAYS exotic since it takes exotic feats of exploration and discovery to generate. Suppose a multistrategy "do anything, go anywhere" hedge fund increased the capital allocated to India 12 months ago. That is an alpha decision. An increased risk budget to Indian trading and investment opportunities.
If the fund then hedged its India longs with shorts, Nifty index put options, single stock futures and credit default protection, then that is an alpha dog decision. The best due diligence question to ask all these India focused "hedge funds">hedge funds": "How would you have done if the BSE Sensex had been NEGATIVE for the year?" Some funds who completely missed China and India rallies are now herding in on the long side. They will lose badly in the coming bear market. Those markets are sources of alpha NOT beta.
by Veryan Allen. Copyright 
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