This paper reviews the data and methodological difficulties in applying conventional models of constructing asset-class indices to hedge funds and argues against the conventional approach. Extending the work of Fung and Hsieh (2002a) on asset-based style (ABS) factors, an APT-like model of hedge fund returns with dynamic risk factor coefficients is proposed. For diversified hedge fund portfolios, the seven ABS style factors explain up to 90% of monthly return variations. As ABS factors are directly observable using market prices, our model provides a standardized framework for identifying differences among major hedge fund indices free of biases inherent in hedge fund databases. An ABS factor model distinguishes between hedge fund alphas (alternative alphas) from returns that are derived from bearing systematic, albeit alternative sources of, risks (alternative betas). Time-varying behavior of alternative alphas and betas reveals important insight on how funds-of-hedge funds alter their bets over time.

This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, which when added to Sharpe's (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies. Sharpe (1992) proposed an asset class factor model for performance attribution and style analysis of mutual fund managers. The elegance of Sharpe's (1992) intuition was demonstrated empirically by showing that only a limited number of major asset classes was required to successfully replicate the performance of an extensive universe of U.S. mutual funds. Based on this pioneering work, commercial software packages are now widely available for investors to analyze their asset allocation decisions and the "style mix" of their portfolios.

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We use a comprehensive data set of funds-of-funds to investigate performance, risk, and capital formation in the hedge fund industry from 1995 to 2004. While the average fund-of-funds delivers alpha only in the period between October 1998 and March 2000, a subset of funds-of-funds consistently delivers alpha. The alpha-producing funds are not as likely to liquidate as those that do not deliver alpha, and experience far greater and steadier capital inflows than their less fortunate counterparts. These capital inflows attenuate the ability of the alpha producers to continue to deliver alpha in the future. Copyright (c) 2008 The American Finance Association.