Asset-Based Style Factors for Hedge Funds

Abstract

Asset-based style factors link returns of hedge fund strategies to observed market prices. They provide explicit and unambiguous descriptions of hedge fund strategies that reveal the nature and quantity of risk. Asset-based style factors are key inputs for portfolio construction and for benchmarking hedge fund performance on a risk-adjusted basis. We used previously developed models to construct asset-based style factors and demonstrate that one model correctly predicted the return behavior of trend-following strategies during out-of-sample periods—in particular, during stressful market conditions like those of September 2001.

Hedge fund returns differ from the returns of traditional asset classes. But investors looking for alternative return characteristics in hedge funds must be concerned about the consistency between historical and future hedge fund returns. To go beyond relying on historical hedge fund performance repeating itself, one needs to answer the key question on hedge fund performance: What is the wind behind this sail? Attempts to answer this question have to contend with unconventional hedge fund strategies and limited informational disclosure from the hedge fund managers.

We propose a new method called “asset-based style factors” to provide an explicit description of hedge fund strategies. Asset-based style factors model hedge fund strategies by linking their returns to observed market prices. Through these links, the myriad of hedge fund styles may eventually be expressed as a simple, unifying model of familiar asset classes in the spirit of Sharpe's style model for mutual funds. Generally, asset-based style factors help qualify the nature of the risk a hedge fund investment is exposed to beyond a mere quantitative risk measure that conventional statistical tools provide. Constructed from market prices, asset-based style factors are directly observable and have long histories of returns. These characteristics are particularly helpful in risk management applications. Asset-based style factors are transparent and unambiguous. They provide key inputs for constructing diversified portfolios and can also be used to benchmark hedge fund performance on a risk-adjusted basis.

We illustrate this approach by using a model we developed for constructing asset-based style factors for trend-following strategies, update the results we previously found for the 1983–97 period with data up to September 2001, and show that trend-following funds have continued to perform as predicted for their style factor: They returned positive profits during four periods of extreme market volatility, particularly in the fall of 1998 and September 2001.

This article benefited from responses of the participants at a presentation at the centre for Hedge Fund Research and Education at the London Business School and a forum discussion at Albourne Village (village.albourne.com). We thank Joe Sweeney for helpful comments.