Macroeconomic Risk and Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper estimates hedge funds' exposures to alternative measures of economic uncertainty and examines the performance of these uncertainty betas in predicting the cross-sectional variation in hedge fund returns. The results indicate a positive and significant link between uncertainty beta and future hedge fund returns. Funds in the highest uncertainty beta quintile generate 5.5% to 7.5% more average annual returns compared to funds in the lowest uncertainty beta quintile. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty beta and future returns remains economically and statistically significant. We also use a novel statistical approach to construct a hedge fund related economic uncertainty index and find a significantly positive link between funds' exposures to the broad uncertainty index and future fund returns. Hence, economic uncertainty is a powerful determinant of the cross-sectional differences in hedge fund returns.

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Global Macro hedge funds (GMHFs) show the ability to profit from market changes caused by global politics and economics events. GMHFs mainly use short and long positions to conduct arbitrage. The concentration of this paper is to discover the relation between GMHFs indexes among macroeconomics variable factors, especially the relation between interest rates, GDP growth. The researchers analyzed the monthly GDP index aimed at the United States and the Bureau of Labor Statistics' (BLS) Consumer Price Index (CPI) through multiple regressions and appeals the subsequent conclusions: There is a dynamic relationship between GMHFs and macroeconomic factors such as real interest rate and GDP. The relationship between different macroeconomic factors and GMHFS is also diverse in distinctive degrees. The fund manager's individual ability is additionally a vital variable affecting GMHFs.

Little can be done to eliminate the limitations of historical hedge fund data. Time remains the only solution for documenting hedge fund performance over a broader range of economic cycles. In order to overcome this problem, we develop rule-based models of hedge fund strategies to help us relate the sources of hedge fund returns to directly observable market prices. A key output of such models is the risk factors that drive hedge fund performance. We call these ABS (short for Asset-Based Style) factors. We show that simple models with only a limited number of ABS factors can capture both cross-sectional variations of hedge fund returns as well as the return dynamics of hedge fund portfolios over time. Similar conclusions were reached in Jaeger and Safvenbald (2003). Models of ABS factors can also be used to integrate the construction of hedge fund portfolios in a unifying framework consistent with conventional asset allocation models. Finally, ABS factors are key variables for asses...

Journal of Financial Economics, 2011

This paper investigates hedge funds' exposures to various financial and macroeconomic risk factors through alternative measures of factor betas and examines the performance of these factor betas in predicting the cross-sectional variation in hedge fund returns. The results indicate a positive and significant link between default premium beta (DEF beta) and future hedge fund returns as well as a negative and significant link between inflation beta (INF beta) and future hedge fund returns. Hedge funds in the highest DEF beta quintile generate 5.8% more annual raw and risk-adjusted returns compared to funds in the lowest DEF beta quintile. Similarly, the annual average raw and riskadjusted returns of funds in the lowest INF beta quintile are 5% higher than the annual average returns of funds in the highest INF beta quintile. After controlling for Fama-French-Carhart's four factors of market, size, book-to-market, and momentum as well as Fung-Hsieh's five trend-following factors in stocks, short-term interest rates, currencies, bonds, and commodities, the positive relation between DEF beta and future hedge fund returns, as well as the negative relation between INF beta and future hedge fund returns remain economically and statistically significant.

Journal of Financial Economics, 2012

This paper investigates the extent to which market risk, residual risk, and tail risk explain the cross sectional dispersion in hedge fund returns. The paper introduces a comprehensive measure of systematic risk (SR) for individual hedge funds by breaking up total risk into systematic and fund specific or residual risk components. Contrary to the popular understanding that hedge funds are 'market neutral' we find that systematic risk is a highly significant factor explaining the dispersion of cross-sectional returns while at the same time measures of residual risk and tail risk seem to have little explanatory power. Funds in the highest SR quintile generate 6% more average annual returns compared to funds in the lowest SR quintile. After controlling for a large set of fund characteristics and risk factors, systematic risk remains positive and highly significant, whereas the relation between residual risk and future fund returns continues to be insignificant. Hence, systematic risk is a powerful determinant of the cross-sectional differences in hedge fund returns.

Computational Statistics & Data Analysis, 2007

We measure dynamic risk exposure of hedge funds to various risk factors during different market volatility conditions using the regime-switching beta model. We find that in the high-volatility regime (when the market is rolling-down) most of the strategies are negatively and significantly exposed to the Large-Small and Credit Spread risk factors. This suggests that liquidity risk and credit risk are potentially common factors for different hedge fund strategies in the down-state of the market, when volatility is high and returns are very low. We further explore the possibility that all hedge fund strategies exhibit idiosyncratic risk in a high volatility regime and find that the joint probability jumps from approximately 0% to almost 100% only during the Long-Term Capital Management (LTCM) crisis. Out-of-sample forecasting tests confirm the economic importance of accounting for the presence of market volatility regimes in determining hedge funds risk exposure.

SSRN Electronic Journal, 2014

This study compares the risk-adjusted performance of traditional and alternative investments. Instrumental to this design, we introduce a specific metric for assessing hedge fund performance, comprising both the relative advantage and the extra-risk of an alternative investment over a traditional one. We are concerned with the impact of the crisis. Common wisdom tells us that during phases of market euphoria, investors' wishful thinking can make them overconfident of the high returns promised by the leveraged structures and the aggressive investment policies typical of this asset class; conversely, when the downturns hit, the "big bets", taken by hedge fund managers, in risky and illiquid investments, can trigger severe losses in their investors' portfolios. We found evidence that regime switches in stock returns emphasise the performance gap among the different fund investment policies; furthermore, some styles can effectively capitalise on managerial skill, outperforming traditional equity investment in terms of adjusted performance.

Financial Assets and Investing, 2016

This study compares the risk-adjusted performance of traditional and alternative investments. Instrumental to this design, we introduce a specific metric for assessing hedge fund performance, comprising both the relative advantage and the extra-risk of an alternative investment over a traditional one. We are concerned with the impact of the crisis. Common wisdom tells us that during phases of market euphoria, investors' wishful thinking can make them overconfident of the high returns promised by the leveraged structures and the aggressive investment policies typical of this asset class; conversely, when the downturns hit, the "big bets", taken by hedge fund managers, in risky and illiquid investments, can trigger severe losses in their investors' portfolios. We found evidence that regime switches in stock returns emphasise the performance gap among the different fund investment policies; furthermore, some styles can effectively capitalise on managerial skill, outperforming traditional equity investment in terms of adjusted performance.

SSRN Electronic Journal, 2013

This paper examines the cross-sectional relation between hedge fund returns and systemic risk. Measuring the systemic risk of an individual hedge fund by using the marginal expected shortfall (MES), we find evidence for a positive and statistically significant relation between systemic risk and hedge fund returns. The risk-adjusted return of a hedge fund portfolio with a high systemic risk is 0.64% per month higher than for one with a low systemic risk during 1994-2012, while negative performance is observed during crisis periods. The relation between systemic risk and hedge fund returns holds for both live and defunct funds. Moreover, the relation holds even after controlling for a large set of fund characteristics. Hence, systemic risk is a powerful determinant of cross-sectional variations in hedge fund returns. Our results imply that the positive relation between hedge fund returns and systemic risk is due to compensation for the realized losses during systemic events.

Journal of Applied Business Research (JABR), 2014

This paper implements two types of framework to investigate the outperformance, selectivity, and market timing skills in hedge funds: uncertainty and probability. Using the uncertainty framework, the paper develops an uncertain fuzzy credibility regression model in the form of a linear and quadratic CAPM in order to estimate these performance skills. Using the probability framework the paper implements frequentist and Bayesian CAPMs (linear and quadratic) to estimate the same performance skills. We consider a data set of monthly investment style indices published by Hedge Fund Research group. The data set extends from January 1995 to June 2010. We divide this sample period into four overlapping sub-sample periods that contain different market trends. Using the probability framework, our results show that bounded rationality triggers inefficiencies in the market that fund managers can utilise to outperform the market. This market outperformance is due to selectivity and market timing skill during periods of economic recovery only. We admit that these results contradict the rational expectations model. However, with the uncertainty framework this effect disappears on behalf of the rational expectations model and the efficient market hypothesis. This disappearance may be a result of the increased amount of high frequency trading witnessed recently that has made market inefficiencies, which are the main source of hedge fund performance, rarer.