Hedge Fund Benchmarks: A Risk-Based Approach

William Fung, David A. Hsieh
2004 Financial analysts journal  
This paper reviews the data and methodological difficulties in applying conventional models of constructing asset-class indices to hedge funds and argues against the conventional approach. Extending the work of Fung and Hsieh (2002a) on asset-based style (ABS) factors, an APT-like model of hedge fund returns with dynamic risk factor coefficients is proposed. For diversified hedge fund portfolios, the seven ABS style factors explain up to 90% of monthly return variations. As ABS factors are
more » ... BS factors are directly observable using market prices, our model provides a standardized framework for identifying differences among major hedge fund indices free of biases inherent in hedge fund databases. An ABS factor model distinguishes between hedge fund alphas (alternative alphas) from returns that are derived from bearing systematic, albeit alternative sources of, risks (alternative betas). Time-varying behavior of alternative alphas and betas reveals important insight on how funds-of-hedge funds alter their bets over time.
doi:10.2469/faj.v60.n5.2657 fatcat:sijdy5azpnfpjhxfz5tai2u5iy