Benchmarking Hedge Funds: The Choice of the Factor Model
23 Pages Posted: 7 Sep 2010 Last revised: 29 May 2013
Date Written: August 28, 2011
Abstract
There is still no consensus regarding a generally accepted factor model to assess risk-adjusted hedge fund performance. In this paper, 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 based on a forward stepwise regression approach. Over a fairly long time period from 1994 to 2009, the differences in alphas resulting from the three alternative factor models are small. However, during crisis periods, such as the recent credit crisis, we find a substantial difference in alphas resulting from the Fung and Hsieh (2004) seven-factor model as compared to the other two models. The emerging markets factor, which is included in the eight-factor model and is chosen by the stepwise-based model for 7 out of 11 hedge fund strategies, seems to capture a large part of hedge fund return volatility during crisis periods. Both the stepwise and the eight-factor model generate qualitatively similar results even on the strategy level. Unlike the stepwise-based factor model, the eight-factor model uses the same set of risk factors for all hedge fund strategies. Given its much easier implementation, the eight-factor model seems to be a good choice for a broadly used factor model and a suitable successor for the widely used seven- factor model.
Keywords: Hedge Funds, Performance Measurement, Alpha, Factor Models, Crisis
JEL Classification: G11, G12, G23
Suggested Citation: Suggested Citation
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