In Search of Quality Benchmarks for Hedge Fund Strategies

Over the last few years, alternative investment strategies have dramatically gained in popularity. Initially reserved for High Net Worth Individuals (HNWI), they progressively drew the attention of individual and institutional investors, to reach approximately 1 trillion dollars in assets under management today.

Author(s) :

Mathieu Vaissie

EDHEC Risk and Asset Management Research Centre

However, while HNWI were looking for absolute returns, private and institutional investors are more focused on capital preservation and/or risk-adjusted performance. This evolution of the hedge fund investor profile naturally gave rise in the alternative arena to new requirements, especially with regard to the performance measurement process. As a matter of fact, traditional performance measures such as the Sharpe ratio do not account for hedge fund risks (e.g. exposure to multiple risk factors, extreme risks, etc.). In other words, traditional performance indicators cannot inform investors about hedge funds’ risk-adjusted performance. For this reason, investors turned to multi-factor models to measure hedge fund alphas. Unfortunately, traditional multi-factor models also fail to properly account for the specific characteristics of hedge funds (e.g. dynamic and non-linear exposure to risk factors). Building on Glosten and Jagannathan’s (1994)1 contingent-claim-approach, some attempts have been made to capture hedge funds’ non-linear exposure to risk factors through the use of options. However, though theoretically robust, these models are characterised by high model risk (i.e. problem of misspecification). A practical alternative to this approach consists of using factors embedding hedge funds’ original risk characteristics. Hedge fund indices therefore appeared to be ideal candidates to serve as pseudo-risk factors. Such models must however be handled with care. Investors have to bear in mind that the relevance of the results strongly depends on the quality of inputs. This paper seeks to determine whether investable and/or noninvestable hedge fund indices provide investors with useful tools for performance measurement.
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In Search of Quality Benchmarks for Hedge Fund Strategies...
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Type : Working paper
Date : le 01/06/2004
Extra information : For more information, please contact EDHEC Research and Development Department [ research@drd.edhec.edu ]
Research Cluster : Finance

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