Investigating Hedge Fund Performance

Huber, Otto
October 2010
University of St. Gallen, Business Dissertations;10/26/2010, p1
Driven by tremendous historical growth and the recent credit crisis, the hedge fund industry has come to an interesting turning point. This thesis presents three studies on risk-adjusted hedge fund performance to shed some more light on this issue. A probable consequence of this changed environment is that hedge fund alpha has diminished. The results of the first topic in this thesis indicate that hedge fund alpha has been positive on average, even after accounting for fees and potential biases in reported returns. In addition, and unlike previous research, neither do we find a systematically decreasing hedge fund alpha over time, nor empirical evidence pointing to capacity constraints in the industry. The second empirical study concludes that the knowledge about historical alpha and other fund characteristics enables investors to form hedge fund portfolios that outperform their peers. Out-performance turns out to be both statistically and economically highly significant. Specifically, we investigate the performance persistence of two-way sorted portfolios, for which the sorting is based on past performance and several additional fund characteristics. Besides a strong alpha persistence, we find only one fund characteristic, a 'Strategy Distinctiveness Index' (SDI), to have the ability to systematically improve alpha performance persistence. The SDI attempts to measure manager skills and the uniqueness of the hedge funds' trading strategies. Finally, we compare three alternative factor models: The widely used Fung and Hsieh (2004) seven-factor model, a recently proposed extension to an eight-factor model, and a model that selects the relevant risk factors for each strategy based on a stepwise regression approach. The alphas resulting from the three alternative factor models are qualitatively similar over a fairly long period of time. However, during crisis periods, we find substantial differences in alphas (and r-squares) resulting from the Fung and Hsieh (2004) seven-factor model compared to the other two models. Given its much simpler implementation, the eight-factor model seems to be a suitable successor for the widely used seven-factor model.


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