Is it Alpha or Beta? Decomposing Hedge Fund Returns When Models are Misspecified

The decomposition of hedge fund returns is hampered by model misspecification. To address this issue, we develop a novel approach to compare models in a large population of funds. This comparison, which accounts for misspecification-driven estimation errors, sharpens the separation between alpha and beta. Our analysis reveals that: (i) prominent models are as misspecified as the CAPM, (ii) several factors—primarily time-series momentum, variance, carry—capture hedge fund strategies and lower performance, (iii) alpha and beta components correlate negatively and vary substantially across funds, consistent with equilibrium models featuring search costs, and (iv) fund valuation is sensitive to investor sophistication.