Assessing Hedge Fund Strategies through a Conditional Factor Risk Model

Different hedge fund strategies exhibit unique risk factor exposures and vulnerabilities. Linear factor models, like the conditional factor model used in this analysis, offer valuable insights into hedge fund investments' inherent characteristics and risks. These models help assess whether hedge fund strategies are exposed to specific risks under abnormal market conditions, highlighting their dynamic nature.

The importance of such models is evident in the hedge fund industry's response to the global financial crisis, where many funds faced unexpected risk exposures and substantial performance declines, resulting in numerous fund closures and asset declines.

Conditional Factor Risk Model

A basic conditional linear factor model used to analyze the returns of a hedge fund strategy can be expressed as:

$$ \begin{align*}
[\text{Return on HF}_i ]_t& =a_i+ \beta_{i,1} (\text{Factor } 1)_t+\beta_{i,2} (\text{Factor } 2)_t+\cdots +\beta_{i,k} (\text{Factor } k)_t \\ & +D_t \beta_{i,1} (\text{Factor } 1)_t+D_t \beta_{i,2} (\text{Factor } 2)_t+\cdots \\ & +D_t \beta_{i,k} (\text{Factor } k)_t +(\text{error})_{i,t} \end{align*} $$

Where:

• \([\text{Return on HF}_i ]_t\) is the return of hedge fund i in period t.
• \(\beta_{i,1} (\text{Factor } 1)_t\) represents the exposure to risk factor 1 (up to risk factor K) for hedge fund i in period t during normal times.
• \(D_t \beta_{i,1} (\text{Factor } 1)_t\) represents the incremental exposure to risk factor 1 (up to risk factor K) for hedge fund i in period t during financial crisis periods, where \(D_t\) is a dummy variable that equals 1 during financial crisis periods and 0 otherwise.
• \(a_i\) is the intercept for hedge fund i.
• \((\text{error})_{i,t}\) is a random error with zero mean and standard deviation of \(\sigma_i\).

Each beta factor signifies the expected impact on hedge fund returns when a specific risk factor increases by one unit while keeping all other factors constant. Unexplained portions of hedge fund returns are attributed to three factors:

1. Alpha, reflecting the manager's unique investment skills.
2. Omitted factors.
3. Random errors.

To construct this model, the initial step involves identifying a comprehensive array of asset class and macro-related market risks, encompassing stocks, bonds, currencies, commodities, credit spreads, and volatility. Following the methodology of Hasanhodzic and Lo (2007) and industry standards, the model incorporates six primary factors.

1. Equity risk (SNP500): The monthly cumulative performance of the S&P 500 Index, which includes dividends.
2. Interest rate risk (BOND): The monthly performance of the Bloomberg Barclays Corporate AA Intermediate Bond Index.
3. Currency risk (USD): Monthly return of the US Dollar Index.
4. Commodity risk (CMDTY): monthly total return of the Goldman Sachs Commodity Index (GSCI).
5. Credit risk (CREDIT): The variance in monthly yields between seasoned Baa and Aaa corporate bonds as reported by Moody's.
6. Volatility risk (VIX): The change in the month-end value of the CBOE Volatility Index (VIX).

Question

What can be concluded about the risk exposures of different hedge fund strategies?

1. Opportunistic managers often count on mean reversion in their strategies.
2. Relative value managers rely on market directionality for their returns.
3. Different hedge fund strategies exhibit unique factor exposures and vulnerabilities.

Solution

The correct answer is C.

Different hedge fund strategies exhibit unique factor exposures and vulnerabilities. This is a correct statement based on the information in the passage, as it highlights that each hedge fund strategy has specific risk exposures and vulnerabilities.

A is incorrect. Relative value managers typically count on mean reversion, and it does not specify the strategy of opportunistic managers.

B is incorrect. Relative value managers do not expect trendiness but typically count on mean reversion.

Reading 38: Hedge Fund Strategies

LOS 38 (h) Describe how factor models may be used to understand hedge fund risk exposures.