Panagiotis Ballis-PapanastasiouTesting Asset Pricing Models with Hedge Fund Data and Hedge Fund Performance

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Hedge funds are now established investment instruments in the asset management world. A hedge fund can be thought of as a fund which is subject to very little or no regulatory requirements. Because of that reason access to hedge funds is usually only possible for accredited investors, who do not have any specific legal protection and are fully responsible for their actions. That is why today for high net worth individuals and institutional investors hedge funds represent an indispensable investment instrument.

The attractiveness of hedge funds stems from the loose regulatory requirements they are subject to. The hedge fund manager has more freedom in the way he invests compared to an ordinary mutual fund manager and is thus able to take positions and risk which are not accessible to mutual fund managers. For sophisticated investors hedge funds are therefore particularly interesting, since many studies confirm their superior performance compared to ordinary mutual funds. Although the risks are high and the possibility of total loss of capital is present, hedge funds seem, on average, to be an attractive investment alternative.

Since countless hedge funds exist today which offer different investment strategies, one is faced with a selection problem. Typically, investors choose hedge funds based on their performance achieved in the past. This means that hedge funds which have exhibited an above average performance in the past will attract capital, whereas hedge funds which have performed poorly will experience capital outflows or even liquidation.

This typical behaviour pattern requires two conditions. Firstly, hedge funds should exhibit a superior risk adjusted performance. Secondly, this superior risk adjusted performance, if present, should be a good indicator of future returns, i.e. we should have signs of performance persistence

The author identifies three main questions: i) What kind of asset pricing models are adequate to measure the performance of hedge funds, what kind of properties do they possess ii) if we are able to identify suitable asset pricing models to measure the performance of hedge funds, what kind of performance we are actually detecting? Do hedge funds exhibit higher abnormal returns as it is usually stated iii) if we are able to detect a superior risk adjusted performance, is this performance persistent? Or stated differently, is the past risk adjusted over performance helpful for future performance?

In an extensive theoretical and empirical analysis the authors shows that the consistent measure of the performance of hedge funds fails already in the first step, since no asset pricing model is statistically significant and hence, according to the strict conditions of capital market theory, they are unsuitable for measuring performance.

Although these performance models, strictly according to the capital market theory, are not suitable for measuring performance, one can still ask the question as to whether hedge funds exhibit a superior performance against some common benchmark or performance attribution models. This excess returns is then, strictly speaking, not an alpha in terms of capital market theory, rather a relative outperformance compared to this benchmark or performance attribution model. The author shows that a small excess return, measured against such factor models is prevalent. However, the persistence of the excess returns is weak and most probably not economically exploitable. The results are robust against alternative factor models, both linear and regime-switching model and against parametric and non-parametric methods.

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