Relative Value Hedge Funds: A Behavioral Modeling of Hedge Fund Risk and Return Factors

ABSTRACT

This study has 4 contributions to the literature. First, the authors analyze the risk characteristics for 11 Relative Value hedge fund strategies. Second, the authors introduce 3 families of behavioral factors, the D family, the L family, and the R family. In contrast to previous hedge fund studies, these new factors assume investors use historical and behavioral data such as average drawdown, run up, and liquidity from each hedge fund category to assess the risk. Third, additional macroeconomic variables, such as the CRB, Copper, and Oil are found to be statistically significant in some strategies. This economic and historical information, when included with asset pricing models, is more powerful in explaining hedge fund returns than previous models. Fourth, unlike the previous literature, these generated models are corrected for time-series assumptions violations and heteroskedasticity. To more fully understand the timing of risks and returns associated with investing in relative value hedge funds, pension funds and other investors should incorporate more economic factors and behavioral factors.

KEYWORDS:

• Relative value
• Hedge fund
• Factor models
• Risk factors
• Macroeconomic indicators

Acknowledgments

The authors would like to thank Kenneth Ahern, Mikhail Chernov, Mike Cooper, Harry DeAngelo, Wayne Ferson, Gerard Hoberg, and Gordon Philips for their insightful comments and suggestions. They would also like to thank the participants of the Shanghai National Futures Exchange Conference and China Derivatives Market Conference of their comments and suggestions.

Notes

1. The Fung & Hsieh factors data can be reached at: http://faculty.fuqua.duke.edu/∼dah7/DataLibrary/TF-FAC.xls

2. The Fung & Hsieh factors data can be reached at: http://faculty.fuqua.duke.edu/∼dah7/DataLibrary/TF-FAC.xls