Not surprisingly, the strong gains made by ChinaÆs equity indices over the last 18 months have been reflected in the performance of China-oriented hedge funds.

Similar spectacular returns have also been recorded by exchange-traded funds and mutual funds, which raises the question: is it worth paying base and performance fees of up to 22% to a hedge fund manager? Are hedge funds in China delivering alpha and decent risk-adjusted returns, or are they a bunch of closet index trackers?

Melvyn Teo at the Singapore Management University was commissioned to conduct research on Chinese hedge funds, and released his findings at an AIMA investor briefing in Singapore on Tuesday.

Upon starting his task, Teo expected that the betas would be high, at around 0.8, given the lack of short selling in China. But what he found was that the Greater China equity long/short sector had a beta of 0.37 (measured between 2000 and 2006) compared to the MSCI China Index.

Many market participants casually toss off the terms æalphaÆ and æbetaÆ, but letÆs just refresh our understanding of the definition of beta. Beta is the tendency for a securityÆs returns to respond to movements in the markets. A beta of 1 means that the security moves in line with the market, a beta of less than 1 means it is less volatile than the market, a beta of greater than 1 means the stock price is more volatile than the market.

Remember, beta measures volatility, not returns. So a beta of 0.37 does not mean that hedge funds have only managed 37% of market returns. Their returns have, in fact, exceeded the performance of the broader market during the last decade. But this outperformance is accounted for by alpha not beta. In other words, it has been derived from manager skill.

Teo put together a regression analysis to determine the alpha and the beta. This was done by plotting hedge fund returns on the Y axis, and the China market on the X axis, and drawing a line through the dots. Where the line bisected the Y axis was the alpha, and the slope of the line was the beta.

ôManagers like to have low beta in a bear market, and around 0.5 at other times,ö says Teo in Singapore. ôIf ChinaÆs market goes into depression, I do not think betas will change significantly with the absence of short selling. If Chinese companies continue to list offshore, then the absence of short selling in China is less of a problem, as other mechanisms exist.ö