Time-Varying Coecient Model for Hedge Funds

Gilles CRITON

and Olivier SCAILLET

Second version, September 2009

Abstract
We propose a time-varying coecient model in order to analyze the dynamic in estimated
alpha and betas. We showed that the proportion of skilledfunds are higher with our model
than with a static linear factor model. Indeed, our time-varying coecient model captures the
dynamic part of alpha that reects the dynamic strategy that we can nd within Hedge Funds.
Furthermore this model is not only capable of looking into anticipation for Hedge Fund managers
but is equally well suited for the analysis of beta exposure. We show that whatever the strategy,
the increase in risk behavior is mainly concentrated on the credit spread risk factor and bond
risk factor.

We thank Jer ome Teiletche as well as seminar participants at Pictet, Unigestion, SoFiE (2009).

1
1 Introduction
Nowadays, it is well known that investing in Mutual Funds, on average, underperform passive
investment strategies. One class commonly called Hedge Funds are dened as pooled invest-
ment vehicles that are privately organized, and not widely available to the general investing
public. Hedge Funds are private partnerships that use advanced investment strategies and can
use derivatives, leverage and short selling. Over the last few years, Hedge Funds have become
the favorites of many private as well as institutional investors. Hedge Funds follow investment
strategies that are substantially dierent from the non-leveraged, long-only strategies conven-
tionally followed by investors. During alternative investment seminars and conferences, Hedge
Fund managers boast about their ability to produce something they refer to as alphaor ab-
solute returnin the sense that performance is not due to primary asset classes performance.
They do not aim to track and try to beat a certain benchmark, but instead are focused on
pure return generation. Hence Hedge Funds generate alpha, as opposed to depending on beta
and performance should normally result from active management decisions combined with the
skills of their advisors. However statistical analysis shows that many of them retain signicant
exposure to dierent types of market risk factors.
Consequently, it is essential for qualied investors to determine whether or not these strategies
are sensitive to the market and whether they can nd alpha through the managers skill. For
these reasons, an increasing focus has been directed to the performance of Hedge Funds and
their factor exposures.
Mostly, owing to the theory of CAPM or APT, fund performances are assessed by a parametric
model with the hypothesis of normality and linearity of coecients, as well as, the non-dynamic
behavior of beta. Some researchers expanded the parametric model to the world of Hedge
Funds. Fung and Hsieh (2001, 2004a) developed factors used to replicate trend-following
strategies. Agarwal and Naik (2000) suggested an approach using option-based returns in
order to capture the non-linearity in beta. Recently, Bollen and Whaley (2008) tested for
structural change and used two econometric models in order to capture the dynamic in beta.
In this paper, we attempt to go a step further than the previous research.
First, by developing the result from Bollen and Whaley (2008) by testing up to ve multiple
structural changes. We showed that the relative number of breaks by fund has increased over
the last few years, resulting in the increase of the use of leverage.
2
Secondly, by developing a new model
1
for Hedge Funds which can take into consideration their
distinctly non-normal characteristics, the dynamic in manager skill, as well as, the dynamic
trading represented respectively by alpha and beta. This model allows us to relax traditional
parametric models and to exploit possible hidden structure. For example, what manager skill
is the most important? Is it the skill to pick and choose the right stocks, bonds, any other
nancial products, or is it the skill to anticipate market events? If we consider that alpha
estimated from a linear model contains the two skills, how can we separate and study them?
Can we nd a dierent proportion of positive-alpha funds? This model specically allows us to
look into how managers behave in relation to strong events and whether or not they succeed
to generate alpha. Moreover, Hedge Fund managers are likely to change trading strategies
in order to obtain absolute return
2
. Therefore, the exposure to a risk factor can change
during special events and can have some deep implications for a Fund of Funds or a portfolio.
Often it has been merely stated that during an event, risk to a specic factor can increase or
decrease. Our study also portrays how the beta exposure or risk behaves in relation to market
reaction, as well as, alpha during two agitated periods; the equity bubble crisis (the Equity
Bubble hereafter)
3
and LTCM crisis (LTCM hereafter)
4
.
Thirdly, with the methodology used for mutual Funds by Barras, Scaillet and Wermers (2008)
called False Discovery Rate, we look into the proportion of the funds population which has
an increase in dierent market exposures, as well as, the proportion of skilled, unskilled and
zero-alpha funds.
We showed that the proportion of skilledfunds are higher with our model than with a static
linear factor model. We explained such a dierence by our models ability to capture the
dynamic part of alpha that reects Hedge Fund managers market timing ability. We found
that the quantity of new alpha substantially increased the proportion of positive and negative
alpha funds. Nevertheless, we showed that the majority of Hedge Funds are zero-alpha funds
as Barras, Scaillet and Wermers (2008) portrayed for Mutual Funds. Furthermore, we look
into the possibility for a strategy to have a common increasing trend to a market exposure
during a crisis. For all strategies, the main result was a common trend to an increase in the
credit spread risk factor.
1
This time-varying coecient model has been fully explored by the seminal work of Cleveland, Grosse and Shyu
(1991).
2
positive returns in all market conditions, up or down.
3
February, March 2000
4
July, Auguste, and September 1998
3
To the best of our knowledge, this is the rst paper which tries to look into how the risk of
Hedge Funds and CTAs exposure changes. This paper also looks into the skill of manager
anticipation, part of alpha.
The rest of our paper is organized as follows; Section 2 reviews related literature about Hedge
Funds modeling, and the dynamic in beta
5
. The data is described in section 3. Section 4
summarizes the risk factors dened in Fung and Hsiehs paper (2001, 2004). Section 5 tests
for structural change by applying the method of Bai and Perron (1998). Section 6 denes
our time-varying coecient model. Our methodology in which we apply our model is dened
in section 7. Section 8 provides results of our time-varying coecient model, as well as, the
application of the False discovery Rate (FDR hereafter) to alpha and beta bringing, in this
way, a new tool for Hedge Fund analysis. Section 9 presents our conclusion.
2 Literature review
It is well-known that there are some drawbacks to model Hedge Funds. Various fundamental
and statistical multifactor models for Hedge Funds have been analyzed by Agarwal and Naik
(2000), Edwards and Caglayan (2001), Fung and Hsieh (1997, 2001, 2004a), Lhabitant (2001),
Liang (2001), Schneeweis and Spurgin (1998), among others.
Research has specically been focused on identifying dynamic trading strategies in order to
mimic the actual trades of Hedge Funds (for example: Fung and Hsieh (1997), Agarwal and
Naik (2000)). Contrary to mutual funds, performance analyzes of Hedge Funds are completely
dierent. One reason for this, concerns the returns of Hedge Funds which usually have low
correlations with market indices, and therefore a traditional CAPM analysis using the Jensen
measure is typically non-appropriate. Another reason concerns the linear regression which
works well for mutual funds because its strategies tend to follow a buy-and-hold pattern.
Brown, Goetzmann and Ibbotson (1999) have shown that Hedge Funds pursue many dierent
styles which are completely dierent to the buy and hold strategy followed by Mutual Funds
and therefore can put the hypothesis of linearity to question. Liang (2001) also documents
that Hedge Fund investment strategies are dramatically dierent from those of Mutual Funds.
To the best of our knowledge, the rst paper which suggested another approach in order to bet-
ter analyze the returns of Hedge Funds was written by Fung and Hsieh (1997). They attempted
5
the readers can nd a detailed literature review into the book from Agarwal and Naik (2005).
4
to analyze the returns to Hedge Funds by applying the factor or style analysis conducted by
William Sharpe with respect to Mutual funds. As we will be using their methodology in this
paper we will introduce and develop it further later on in our work. In their paper, they found
that the amount of variation in Hedge Fund returns that is explained by asset class return is
low
6
. Schneeweis and Spurgin (1998) conrm this result by conducting a regression analysis
of the returns of stocks, bonds, commodities, and currency returns. They found that R-square
measures that range from near zero for relative value Hedge Funds to 0.67 for Hedge Funds
that pursue primarily a long equity investment strategy, which concludes that Hedge Fund
return patterns do not map as well to the nancial asset as do mutual fund returns. In order
to ameliorate the explanation of Hedge Fund returns by asset class, Fung and Hsieh (1997)
applied a factor analysis based on a Hedge Funds trading style. They found that ve dif-
ferent trading style (system/opportunistic, global/macro, value, systems/trend following and
distressed) explain about 45 percent of the cross-sectional variation in Hedge Fund returns.
Following Fung and Hsieh (1997), a lot of articles have been developed which seek to under-
stand the trading strategies and characteristics of Hedge Funds by regressing their returns
on explanatory factors (Agarwal and Naik (2000), Brown and al. (2001), Mitchell and Pul-
vino (2001)). Agarwal and Naik (2000) extended this analysis of Hedge Fund performance by
recognizing that funds may follow dynamic non-linear trading strategies. They used stepwise
regression to identify the independent variables, and found that a put or a call option on
an underlying variable is the most signicant factor in the case of 54 percent of their funds.
Also, Fung and Hsieh (2002) incorporated option strategies into a Sharpe style model, but
they focused on exploring the risk of xed income Hedge Fund styles and did not consider
performance explicitly. In contrary to Agarwal and Naiks (2000) discoverers, Fung and Hsieh
found that in most cases their option strategies only played a marginal role. One reason
given by the authors for the varied results mentioned above is due to the fact that Fung and
Hsieh (2002) used active and advanced straddle strategies. The paper written by Mitchell and
Pulvino (2001) on merger-arbitrage strategies are also begun to produce useful explicit links
between Hedge-Fund strategies and observable asset returns. Mitchell and Pulvino (2001) sim-
ulated the returns of a merger arbitrage strategy applied to announced takeover transactions
from 1968 until 1998. In summary, Fung and Hsieh (1999,2000,2001), Mitchell and Pulvino
(2001) and Agarwal and Naik (2004) show that Hedge Fund returns relate to conventional
6
R-Square measures were less than twenty ve percent for almost half of the Hedge Fund studied
5
asset class returns and option-based strategy returns. They relate another strong dierence
between Mutual Funds and Hedge Funds which concerns the problem of managers changing
their investment style over time. This problem is less acute for Mutual Funds than for Hedge-
Funds. Brealey and Kaplanis (2001) presented evidence that within each category funds tend
to make similar changes to their factor exposures. Their interest is in the broader issue of how
well data on Fund returns can be used to measure changesin factor exposure. Indeed they
found that their CUSUMs tests of the stability of factor loadings rejected the null hypothesis
of stable coecients at the 5 percent level in the case of three quarters of the funds. In a
similar way, Fung et al.(2006) paper was concerned with estimating factor exposures at the
time of particular crises. They study vendor-provided fund-of-fund indices, and performed
a modied-CUSUM test to nd structural break points in fund factor loadings. They found
that the break points coincide with extreme market events
7
. Recently, the paper from Bollen
and Whaley
8
studied 2 econometric techniques that accommodate changes in risk exposure.
The primer methodology was developed by Andrews, Lee, and Ploberger (1996). They stud-
ied a class of optimal tests
9
for multiple changes. The latter, uses maximum likelihood and
a Kalman lter under an AR(1) model. They found signicant changes in the risk factor
parameters in about 40 percent of their sample of Hedge Funds.
Nevertheless the 2 precedent methodologies use a hypothesis of normality which is not adapted
to the world of Hedge Funds. With strong evidence of non normality (Agarwal and Naik, 2001;
Amin and Kat, 2003; Fung and Hsieh, 1999; Lo, 2001), the mean and standard deviations are
not sucient to describe the return distribution, and higher moments need to be considered.
Kat and Lu (2002), Brooks and Kat (2002) show that although Hedge Funds oer high mean
returns and low standard deviations, the returns also exhibit third and fourth moment at-
tributes
10
as well as positive rst-order serial correlation
11
.
Furthermore these results about the distribution of Hedge Funds could be dierent depending
on their strategies (Anson, 2006).
7
the collapse of Long-Term Capital Management in September 1998, and the peak of the technology bubble in
March 2000
8
At the moment where we write this article, we do not know when this paper will be publish in Journal of Finance.
9
In the sense that they maximize a weighted average power, namely the Avg-W and Exp-W.
10
Skewness and kurtosis.
11
They showed (as Lo & al. (2004)) that monthly Hedge Fund returns may exhibit high levels of autocorrelation.
6
3 Database
For this study, we use the Center for International Securities and Derivatives Markets (CISDM)
and HedgeFund.Net database. The primer covers the period from January 1994 through to
July 2007 with the advantage of the inclusion of dead funds. One of the main studies in this
article is to analyze whether or not Hedge Funds and CTA were able to generate alpha during
market events or on the contrary, whether they generated negative alpha. In order not to
create a bias we have included all funds in our analysis even though dead funds mean that
they did not necessarily generate alpha or worst, generate negative alpha. The sample with
all funds contains approximately 9800 funds (Hedge Funds, CTA and Fund of Funds), and
approximately 3000 live funds. The latter is the largest commercial database of active Hedge
Fund, Fund of Fund and CTA products with over 8500. It covers the period from May 1975
through to October 2008 but we are only concerned with the period from January 1991 until
October 2008. It has approximately 3000 Funds of Funds, 4900 Hedge Funds, and 600 CTAs.
For every fund, we have collected the returns, the strategy and fund type
12
. Returns are net
of management and performance based fees. We select funds for a minimum of 30 months
covering the period May 1998 until June 2000. We have created 2 groups in order to analyze
them separately; one for Hedge Funds and the other for CTAs. Nevertheless, it is more
pertinent to study Hedge Funds and CTAs depending on their strategies. There is a vast
selection of academic literature on how to classify Hedge Funds. Fung and Hsieh (1997)
and Brown and Goetzmann (2003) have identied between ve and eight investment styles,
whereas, Bianchi Drew, Veeraraghavan, and Whelan (2005) have found the presence of only
three dierent Hedge Fund styles. In contrast, Hedge Fund database providers classify Hedge
Funds into between 11 and 31 investment styles. Therefore choosing a number of strategies is
not an easy task, especially because we are not persuaded by the precedent results.
13
. Thus,
it seems better for this study to follow the 23 strategies dened by the provider plus the CTA
as another strategy as well as Fund of Funds.
{please insert Table I here}
HedgeFund.net uses 31 strategies that we have grouped in order to obtain the same 23 strate-
gies from the CISDM.
12
This database combines four main group, Hedge Funds, Funds of Funds, CTA, and CPO.
13
it will be the topic we are going to turn to next.
7
{please insert Table II here}
The main analyzes consider the merge database
14
due to the specicity of these products that
they tend to avoid direct regulation (by the SEC or any regulatory authorities).
4 Factors
Hedge Funds can be divided into four main groups, market directional, corporate restructuring
fund, convergence trading fund and opportunistic funds. We can add to each of them a major
risk factor. The exposure to the stock market is the major risk aecting market directional
funds
15
. The major risk aecting corporate restructuring funds
16
is exposure to the event
risk
17
which is the same for the convergence trading fund
18
. Into every group, each strategy
can also have a specic exposure to another risk factors and therefore risk exposure can change
drastically in regards to the strategy.
Consequently, dening factors is not an easy task. Precedent articles have shown that the
relation between Hedge Fund returns and market returns are nonlinear. Moreover, Hedge
Funds have a systematic risk but it is not possible to capture this risk with standard asset
benchmarks. Therefore many researchers have suggested factors in order to explain Hedge
Fund returns (Fung and Hsieh (1999, 2000, 2001, 2004), Mitchell and Pulvino (2001) and
Agarwal and Naik (2004)). Nevertheless, it is not the only problem that we have with factors.
Indeed, knowing the right number of factors is major in order to capture risk correctly. If
some risk factors are missing, the model is misspecied and we can question whether alpha
corresponds to the manager skill. If there are too many factor, we can have a problem of
multicollinearity.
To the best of our knowledge, the most accomplished article about Hedge Fund factors was
written by Fung and Hsieh (2004). They showed that their seven factor model strongly explains
variation in Hedge Fund returns and at the same time avoid multicollinearity
19
. Moreover,
they managed to obtain similar results using the Agarwal and Naik (2004) option-based factor
14
We merged the HedgeFund.Net database to the CISDM and found that they are 925 funds in common.
15
equity Long/Short, Short selling and equity market timing.
16
distressed securities, merger arbitrage and event driven.
17
failure of the proposed transaction.
18
xed income arbitrage, convertible bond arbitrage, equity market neutral, statistical arbitrage, and relative value
arbitrage.
19
We use the diagnostic technique presented in chap 3 of Regression Diagnostic by Belsley, Kuh, and Welsh (1980).
The diagnostic is capable of determining the number of near linear dependencies in a given data matrix X, and the
diagnostic identies which variable are involved in each linear dependency. We do not detect any multicollinearity
with these eight factors.
8
model.
Their paper included seven factors and they added an eighth factor on their website
20
that we
have also added.
Therefore we will follow the eight Hedge Fund risk factors dened in Fung and Hsiehs paper
(2004)
21
.
These factors are :
Three Trend-Following Factors: Bond, Currency and Commodity
22
which capture a non linear
exposure.
2 Equity-oriented Risk Factors: S&P500 minus risk free rate
23
and Size Spread Factors dened
by the Russell 2000 index monthly total return less S&P500 monthly total return.
2 Bond-oriented Risk Factors: a Bond Market Factor represented by the monthly change in the
10-year treasury constant maturity yield, and a Credit Spread Factor formed by the monthly
change in the Moodys Baa yield less 10-year treasury constant maturity yield.
One Emerging Market Risk Factor, the MSCI Emerging market minus the risk free rate.
5 Structural Change
Few researchers have tested if there has been a structural change. The tests used considered
only one structural change and most of them needed to know when the break point should
happened. Indeed, the classical test for structural change is typically attributed to Chow
(1960) with the weakness that the breakdate must be known `a priori. Quandt (1960) treated
the breakdate as unknown but, in this case, the chi-square critical values are inappropriate.
The problem of critical values was solved simultaneously in the early 1990s by several sets of
authors. Nevertheless, the best known solution was provided by Andrews (1993), and Andrews
and Plobergers (1994). Andrews, Lee and Ploberger (1996) developed the precedent results
into a class of optimal tests for linear models with known variance. This class of optimal
tests allows an arbitrary number of changepoints. However, Bolley and Whaley implemented
this test using just one changepoint. The problem with these tests in the case of multiple
structural change is practical implementation. According to Perron, the Avg-W and Exp-W
20
http://faculty.fuqua.duke.edu/ dah7/.
21
For more details about the construction of these factors see Fung and Hsieh, 1997, 2001, 2004a.
22
These factors are downloadable on http://faculty.fuqua.duke.edu/ dah7/DataLibrary/TF-FAC.xls .
23
3-month USD LIBOR
9
tests require the computation of the W-test over all permissible partitions of the sample. Bai
and Perron (1998, 2004) solved this problem with a very ecient algorithm which is available
on their website
24
. Although Bai and Perron (1998, 2004) proposed three dierent tests
25
, we
have applied just one of them which is, in our opinion, the most signicant for this analysis.
This is the second test provided by Bai and Perron, called Double Maximum Test. It is a
test of no structural breaks against an unknown number of breaks given some upper bound
(M = 5 in our application). In this category, there are two tests, the UDmax and the WDmax
which dier by their weight methodology
26
.
The results are conclusive.
{please insert Table III here}
The majority of Hedge Funds present structural breaks. By strategy, the minimum percentage
of Hedge Funds with breaks is 31 percent (Other Relative Value) and the maximum is 70
percent for Event Driven Multi Strategy. If we consider the most representative strategy
(Equity Long/Short, 2142 Hedge Funds), 62 percent present some structural changes. All
these precedent results took into consideration track records with more than 30 months. Bai
and Perrons tests also give the breaks date. Therefore another interesting view is to look at
the frequency of breaks dates in the Hedge Funds universe by considering the number of the
breaks at time t; relative to one fund. Indeed, the increase in the amount of Hedge Funds is
considerable and we must take this huge growth into consideration within our analysis. For
this reason, we have suggested to create a ratio called R
breaks
, which is dened as the number
of breaks at time t divided by the number of funds at time t.
{please insert Graph I,II,III,IV here}
Once again, the results are conclusive. Whatever the strategy, we have noted an increase in
the ratio over the period 2002-2007 as well as an increase in the frequency of breaks.
There are two interesting things to say about the two crisis. In August 1998, the Russian gov-
ernment defaulted on the payment of its outstanding bonds. This default caused a worldwide
liquidity crisis with credit spreads expanding rapidly all around the globe. The Russian debt
24
http://people.bu.edu/perron/. This code is a companion to the paper: Estimating and testing structural changes
in multivariate regressions (Econometrica, 2007) (developed by Zhongjun Qu).
25
The primer test considers no break versus xed number of breaks (up to 5 breaks)This test considers the sup F
type test of no structural break (m = 0) versus the alternative hypothesis that there are m = 1, ..., 5 breaks. It is a
generalization of the sup F test considered by Andrews (1993). The latter is a test of the null hypothesis of l breaks
against the alternative that an additional break exists. This sequential procedure estimates each break one at a time.
It stops when the sup F(l + 1|l) test is not signicant.
26
See Bai and Perron (1998) for a full explanation on the dierent weights.
10
crisis (LTCM) was a crisis that materially aected Hedge Fund returns that was conrmed by
the results from R
breaks
. Furthermore, the precedent results for a majority of strategies were
conrmed.
Surprisingly, we noticed the opposite for the equity bubble crisis which corroborated the con-
clusions of Brunnermeier and Nagel (2002).
The conditions for nancial markets in 1999 were very good, especially for riskier assets.
During this period a bubble developed. According to Brunnermeier and Nagel (2002) most
Hedge Funds, despite irrational levels of valuation, decided to ride the bubble rather than
clear their positions. They explained that Hedge Funds heavily tilted their portfolios towards
technology stocks without osetting this long exposure by short or derivatives. They concluded
that Hedge Funds deliberately held technology stocks and were able to exploit this opportunity.
These arguments are conrmed by the fact that R
breaks
is very low, for the majority of the
strategies, showing fewer structural changes.
This section has shown that it is not enough to purely take into consideration dierent dis-
tributions but also that alpha and beta could be dynamic and consequently depend on time.
Furthermore, we showed that the risk in Hedge Funds increased over the last few years es-
sentially due to the use of leverage in order to reach the investors desired return target. The
next section presents an answer to the problem of dynamic for alpha and beta. We suggest a
time-varying coecient model with the Fung and Hsieh factors which are, in this way, better
suited for Hedge Funds.
6 Our Model
Stone (1977) introduced local linear least squares kernel estimators as a regression estimator
which has been generalized by Cleveland (1979)
27
.
Stone (1980, 1982) used local linear least squares kernel and its generalization to higher-order
polynomials to show the achievement of his bounds on rates of convergence of estimators of a
function m and its derivatives. Fan (1992, 1993) showed in the univariate case that another
important advantage of local linear least squares kernel estimators is that the asymptotic bias
and variance expressions are particularly interesting and appear to be superior to those of
the Nadaraya-Watson or Gasser-M uller kernel estimators. Furthermore, Kernel estimators
27
The robust local regression estimators.
11
have the advantage of being simple to understand and globally used by researchers. The
mathematical analyze and the implement into a computer is easy, and they are consistent for
any smooth m, provided the density f of X

i
s satises certain assumptions.
The varying coecient model assumes the following conditional linear structure:
Y
t
=
p

j=1

j
(t)X
jt
+
t
= (t) +X(t) +
t
for a given covariates (t, X
1
, ..., X
p
)

and variable Y . See appendix for more details on the

Time-Varying Coecient Model.
Thus
i
(t) depend on t, this hypothesis can signicantly reduce the modeling bias and espe-
cially avoid the curseof dimensionality
28
.
To practice statistical inferences such as the construction of condence interval for
i
(t) dif-
ferent methods have been suggested. Coling and Chiang (2000)
29
suggest a naive bootstrap
procedure that we have applied in this article.
The main advantage of this naive bootstrap procedure is that it does not rely on the asymp-
totic distributions of

i
(t). Coling and Chiang (2000) recommend another alternative boot-
strap procedure suggested by Hoover et al. (1998), which relies on normal approximations
of the critical values
30
. According to the authors, both bootstrap procedures may lead to
good approximations of the actual (1 ) condence intervals when the biases of

i
(t) are
negligible
31
.
It is well-known in kernel regression that the selection of bandwidths is more important than
the selection of kernel function. In practice, bandwidth may be selected by examining the plots
of the tted curves. Moreover, for this study we need an automatic bandwidth selection. Colin,
Wu and Chiang (2000) suggest that we apply the choice of bandwidth leave-one-subject-
outcross-validation
32
. We illustrated the performance of our estimator by a simulation study.
We used the bandwidth dened above and a number of data equal to 50 in order to respect
28
Kernel depends, in this context, only on t.
29
Another paper of Galindo, Kauermann, and Carroll (2000) suggest another bootstrap method based on the wild-
bootstrap of Hardle and Marron (1991)
30
Construct pointwise intervals of the form

i
(t) z
(1/2)
se

B
(t),
where se

B
(t) is the estimated standard error of

i
(t) from the B bootstrap estimators and z
(1/2)
is the (1 /2
th
)
percentile of the standard Gaussian distribution.
31
They point out that theoretical properties of these bootstrap procedures have not yet been developed.
32
Appendix I gives a summary to the algorithm.
12
the average size of Hedge Fund tracks (see appendix).
We regress the net-of-fee monthly excess return (in excess of the risk-free rate) of a Hedge
Fund on the excess returns earned by traditional buy and hold and primitive trend following
strategies dened above
33
. We have grouped the estimates together into the 23 strategies
dened by the CISDM. In each group obtained, we have formed 2 groups. The rst is composed
by all tracks record which is superior to 30 months. The second has the rst requirement (more
than 30 months) but only has funds which were available during the 2 crisis.
{please insert Table I here}
Indeed, we are concerned with the 2 dierent aspects. The rst focusses on the security
selection ability ( (t)). The second aspect treats the ability to anticipate market events or
to cope with them (i.e. robust ability). In order to capture anticipation in alpha, we are
going to look at 2 strong market events: the LTCM crisis and the Equity Bubble crisis. To
properly cover these periods, we have selected 3 consecutive months. For the LTCM period we
will focus on July, August, and September 1998, and for the Equity Bubble period, February,
March and April 2000
35
. Using these 3 months data, we have built 2 indicators for
36
and
2 indicators for
i
, (i = 1, ..., 8). The 2 primers are the dierence between the second month
and the rst month and the dierence between the last month and the second month.
37
The 2
indicators for beta
38
have the same dierences but are augmented by 10 percent
39
. By doing
this, we were able to determine whether or not managers were able to react quickly and also
if we can capture change exposure superior to 10%. In each case, we have used the t-statistic,

t
i,
=
i
/

i
and

t
i,
=

i
/

i
for every
j
(t) and

ij
(t), i = 1, ..., 8. For every indicator
33
Kat and Lu (2002), Brooks and Kat (2002) show that the net-of-fees monthly returns of the average individual
Hedge Funds exhibit positive rst-order serial correlation which is due, according to the authors, to marking-to-market
problems. We have removed serial correlation by applying the same methodology as used in Brooks and Kats paper
(2001), called the simple Blundell-ward lter
34
.
The observed (or smoothed) value V

t
of a Hedge Fund at time t could be expressed as a weighted average of the true
value at time t, V
t
and the smoothed value at time t 1, V

t1
:
V

t
= V
t
+ (1 )V

t1
,
r
t
=
r

t
r

t1
1
.
35
End of month of July, Auguste, and September and end of month of February, March, and April.
36

t

t1
37
These two indicators were created in order to show a new methodology that this model bring to the analysis of
Hedge Funds. Nevertheless, some others indicators could be more appropriate for a specic analysis of these market
events.
38

t
(1.1)

t1
39
This methodology is simply a linear relation between 2 independent variables which, under the condition of
normality for

jt
j = 1, ...N
j
; N
j
being the number of funds, assure that the linear relation follows also a normal
distribution.
13
covering the 2 periods i.e. 4 indicators by fund for

j
(t) and 32 indicators by fund for

ij
(t).
Once it was done, we calculated the p-value for every indicator and the precedent means.
40
If we examine just 1 fund, we only have to test a null hypothesis H
0
versus an alternative H
1
based on a statistic (lets say X). We have 2 possibilities for a given rejection region . Either
we reject H
0
when X or we accept H
0
when X . Nevertheless, there is the possibility
that there is an error in the test. On the one hand, the test can reject H
0
whereas H
0
is true,
called type I error. On the other hand, the test can accept H
0
whereas it is H
1
which is true.
This error is called a type II error. Now, if we want to test for numerous Hedge Funds this
problem becomes much more complicated. Testing numerous Hedge Funds is to do, in fact, a
multiple-hypothesis testing.
A rst approach was suggested by Kosowski, Naik and Teo (2005), using a bootstrap proce-
dure; They analyzed whether or not Hedge Fund performance can be explained by luck and if
Hedge Fund performance persists at annual horizons. Their methodology tested the skills of
a single fund that was chosen from the universe of alpha-ranked funds. Barras, Scaillet, and
Wermers (2008) suggested another approach which is notably informative with regards to the
prevalence of outstanding managers in the whole fund population. Their approach simultane-
ously estimated the prevalence and location of multiple outperforming fund within a group;
examining fund performance, in this manner, from a more general perspective. Therefore we
have used their methodology called False Discovery Rate (FDR hereafter) in our multiple-
hypothesis test.
Step 1, for each strategy, we have applied the FDR on (security selection ability) in order to
determine the proportion of zero-alpha funds and skilled and unskilled funds; but also for the
indicator dened above
t

t1
(timing ability) for the 2 crisis. In this way, we were able
to determine, for each strategy, the proportion of the security selection ability as well as the
proportion of the timing ability.
Step 2, we applied the FDR on the beta indicators dened above during the 2 crisis in order
to determine if we could observe a common increasing trend for change in market exposure i.e.
a common increase in beta value of more than 10%. Moreover, we calculated the median of the
percentage change for each beta of each strategy in order to give an I.D. of the possibility
change in market exposure.
40
The t-statistic distributions for individual Hedge Funds are generally non-normal. In order to overcome the non-
normality, we use the same approach as Barras, Scaillet, and Wermers (2008), consisting of the use of a bootstrap to
more accurately estimate the distribution of t-statistics for each Hedge Funds (and their associated p-values).
14
With these results, we brought 2 dierent views about exposure change. Firstly, a view about
common trend change and secondly about what are the highest impacted beta.
7 Results
Generally speaking, Mutual Fund managers use a buy and hold strategy consisting of buying
a range of nancial products according to their investment strategy and then they hold them
according to the time horizon (or investment horizon)
41
. Therefore Mutual Funds are often
associated with Funds that have a relative performance. Unsurprisingly, Barras, Scaillet and
Wermers (2008) have shown that only 0.6 percent of Mutual Funds generate positive alpha
and a majority of them can also be considered as zero-alpha funds. So the legitimate question
is: Are the results relatively the same for Hedge Funds or are they completely dierent?
On the one hand, if we apply a static linear factor model such as the Newey-West (1987)
heteroscedasticity and autocorrelation consistent estimator, we determine a staticalpha that
does not capture the particularities of Hedge Fund Strategies. And therefore we have showed
that, whatever the strategies, the majority of Hedge Funds are zero-alpha funds.
On the other hand, when we applied our time-varying coecient model, we were able to
capture other skills from Hedge Fund managers, resulting in obtaining us a non negligible
increase of positive alpha funds.
{please insert Table V here}
Concerning the risk behavior, we showed that the majority of Hedge Funds have a tendency
to get an increase in credit spread as well as bond market risk factors. We are going to look
into the results for seven out of the twenty four strategies in the following part of this paper
42
.
Results for the CTA
We observed a strong dierence for estimated alpha between the static factors model (SFM
hereafter) and our time-varying coecient model (TVCM hereafter). The SFM gave a very
small percentage of positive and negative alpha funds with two percent and one percent respec-
tively. Whereas the TVCM roughly gave nineteen and twenty eight percent. The estimated
alpha from the two dierent crisis are interesting to point out. Although The CTA coped
41
refer to the time between making an investment and needing the funds.
42
The results and the graphs for the seventeen remaining strategies are available upon request.
15
during the two crisis it obtained a strong percentage of positive alpha funds during the Equity
Bubble Crisis where approximately twenty seven percent were positive alpha funds.
During the Summer of 1998, CTAs had one of its best performances
43
while all other Hedge
Fund strategies were struggling.
Unsurprisingly, during the two events, the CTA had a tendency to show a slight increase in
the credit spread risk factor and the emerging market risk factor. Nevertheless this sensitivity
concerned only a small percentage of our population. The majority of CTAs had a relatively
stable exposure.
{please insert Graph XI here}
Emerging Markets
The emerging market strategy showed a good proportion of stock-picker skilled funds where
approximately twelve percent generated positive-alpha which pointed out that the majority of
managers were fundamental bottom-up stock-pickers. We obtained the same results using the
SFM. It indicated that the estimated alpha was more staticthan with other strategies. The
proportion of dynamic skilled funds was very good during the two crisis with a huge number of
roughly forty percent, of positive alpha funds. These results conrmed that emerging market
equity hedge fund managers perceived the high volatility of emerging markets as an asset.
During the Equity Bubble and LTCM we noticed a greater dynamic strategy than previously
seen where approximately twenty-ve and fty percent of our population showed an increase
in two risk factors: the credit spread risk factor and the bond market risk factor. The credit
spread risk factor was the most sensitive factor during LTCM, whereas, four out of the eight
factors showed a sensitivity during the Equity Bubble crisis.
{please insert Graph V here}
Equity Long/Short
Equity Long/Short obtained approximately the same results as the CTA apart from the Equity
Bubble crisis. It obtained a better percentage with twenty four percent using the TVCM. The
SFM gave a small four percent and three percent of negative alpha funds. Certain Equity
Long/Short specialize in a specic sector like technology, and, unsurprisingly, the timer ability
had been more impact during the Equity Bubble than during LTCM. Generally speaking, the
43
Approximately 10 percent in August and 7.5 percent in September according to CSFB/Tremont Managed Futures
16
proportion stayed relatively consistent pointing-out their ability to switch from the short to
the long position and visa versa.
A small percentage of the population showed an increase or a decrease in exposure during the
two crisis. We still noticed a sensitivity to the credit spread risk factor and to the commodities
factors during LTCM. Whereas emerging risk factor was the most sensitive during the Equity
Bubble crisis.
{please insert Graph VI here}
Equity Market Neutral
This strategy produced a very interesting result where the proportion of stock-picker skilled
funds was three percent higher than the estimated proportion using the SFM. Therefore the
two results were relatively closer than with the other strategies. Furthermore this result was
conrmed by the obtained percentage of estimated alpha during LTCM with zero percent. It
didnt cope as well during the equity bubble. We noticed a tiny four percent during the rst
period which reached a strong sixteen percent in the second period.
{please insert Graph VII here}
It was the most robust strategy in terms of change in exposure. Nevertheless, for a minority
of the population we noticed that the credit spread and the commodity showed the biggest
sensitivity during LTCM and the emerging market factor during the Equity Bubble.
Event Driven Multi Strategy
Event Driven Multi Strategy obtained the worst percentage of skilled-funds with zero percent
for the SFM and a small two point ve percent for the TVCM. The result was conrmed
during the two crisis with zero percent during LTCM. This was surprising because the two
crisis created several opportunities
44
, and only the second crisis was more protable. On the
other hand it was the strategy which obtained the smallest proportion of unskilled funds.
Therefore we can dene it as a zero-alpha fund strategy.
{please insert Graph VIII here}
Another strength, for this strategy, concerned the percentage of the population to show a
variation in factor exposure. A negligible part showed an instability during the crisis. The
44
Invests in mergers, spin-os, reorganizations, and other announced events.
17
factors concerned were the credit spread the emerging market factor and the commodity factor
for LTCM and the emerging risk factor for the equity bubble.
Global Macro
Global Macro showed a proportion of stock-picker skilled funds equal to ve percent using
TVCM and one percent using the SFM. It obtained one of the bigger groups of unskilled
funds with roughly twenty eight percent. Unsurprisingly, the percentage of positive alpha
during LTCM increased up to twenty six percent. These results conrmed that global macro
managers have the most extensive investment universe and that they were able to nd some
arbitrages. The Equity Bubble crisis also gave a good percentage of positive alpha funds with
eighteen percent.
Less than ten percent of our population showed an increase or decrease in our general expo-
sure. Credit Spread risk factor stayed the most sensitive during LTCM. Whereas, the size
spread factor, the emerging market risk factor and the credit spread risk factor (slightly) were
concerned about the change in exposure.
{please insert Graph IX here}
Short Bias
Step one, it is important to say that the number of Hedge Funds following this strategy was
relatively small, so the result, in our opinion, could be debatable.
The SFM gave ve percent of skilled funds whereas the TVCM gave thirty ve percent.
Furthermore, this strong percentage was less than the seventy one percent of positive alpha
funds found during LTCM. The Equity Bubble obtained a tiny twenty seven percent: This
impressive result conrmed the strong dynamic within the strategy.
Moreover, the short bias produced the best percentage of variation exposure in. More than
sixty percent of our population showed an increase in dierent market risk factors. Credit
spread was still present during LTCM while Size-spread risk factor had an non negligible
sensitivity to bond, commodity and emerging market risk factors during the Equity Bubble.
{please insert Graph X here}
18
Robustness
The goal of this section is to demonstrate that our model is robust to structural change and
that we succeeded to capture a jump in estimated alpha or beta. For this, we created a track
of return where the two betas had a structural change. We allowed for three dierent sizes:
fty, one hundred and one hundred and fty months which akin the size of Hedge Funds that
we can nd in dierent databases.
The main problem with structural change concerns some technical conditions. Mainly that the
second derivative is required to be continuous in a neighborhood of t. As showed in appendix
I, we managed to obtain some very good results; even in the short sample.
Furthermore, in order to show that our results were independent to our model we created
another time-varying coecient model which was also based on the work of Fan and Zhang
(1999). Nevertheless in second step to our estimator we used a B-spline smoothing instead of
a local regression. We retested the ability to capture a structural break (see appendix I). The
results were also very good.
We used one of the same example as in Zhang, Lee and Song (2002). Our result are less
accurate than Zhang, Lee and Song due to three reasons.
Firstly, our sample contains between 50 and 150 values in opposite to the range in 250-1000.
Secondly, we did not apply a monte carlo study in order to nd the optimal bandwidth (or
knot for the second model). Because of the size of our database, the use of a second bootstrap
algorithm for each fund (the rst algorithm calculates the p-value) would have made the
estimation process too costly.
Thirdly, we used the S&P500 and the monthly change in the 10-year treasury constant maturity
yield as factors which are not a perfect factors set. And therefore these dierences slightly
alter the performance of our estimator. For these reasons the dierent graphics truly represent
the obtained result for each fund.
In a second step, we applied the false discovery rate to the estimated alpha and betas obtained
by B-spline. The results gave approximately the same percentage of unskilled, zero and skilled
funds for our population.
19
8 Conclusion
Hedge Funds cover many dierent strategies which radically vary in terms of market exposure
and risk. However there are some common characteristics. Hedge Fund managers try to focus
on positive return (whatever the market conditions), the use of leverage and their structural
fees. If we want to model Hedge Funds, these characteristics imply a model which takes
some new assumptions into consideration. No assumption about statistical distribution, the
dynamic in beta as well as non linearity exposure to the market.
In order to overcome these drawbacks, we used a time-varying coecient model as well as
the whole factors; dened in Fung and Hsiehs paper (1997, 2001, 2004). The model allowed
us to postulate that alpha and beta are a function which depended on time and avoided
parametric distribution. The use of the factors from Fung and Hsieh allowed us to capture
the non-linearity in beta and therefore gave the best overall risk factors.
This model allowed us to separate manager skill into two components pointed-out by the (stock
or bond or funds)-picking and the ability to anticipate market events. It also allowed us to see
what were the changes in beta exposure or the managers reactions according to the markets
conditions.
Whereas Barras, Scaillet and Wermers (2008) showed us that only 0.6 percent of Mutual
Funds generated positive alpha and therefore a majority of them can be considered as zero-
alpha funds. We found a dierent result for Hedge Funds. Hedge Fund managers seek absolute
returns and try to outperform the market whatever the market conditions are. We showed
that this dynamic was not well-captured by a static factor model where the results considered
Hedge Funds as zero-alpha funds. Whereas our model found a better proportion of positive
alpha funds but also, unfortunately, a proportion of negative alpha funds.
Another advantage of this model was its capacity to analyze change in factorial exposure. We
saw three main results. Firstly, that a majority of Hedge Funds with a track record superior
to 30 months had a minimum of one structural break. Furthermore we noticed that the
frequency of breaks has increased over the last few years. Secondly, by strategy, we examined
the percentage change between our eight factors and saw if there was a persistent for beta
parameters. Our results suggest that the common increasing percentage change of dierent
Hedge Funds in the down-state of the market is strongly represented by one exposure. it
was the credit spread risk factor. Last but not least, we applied the FDR to determine the
20
proportion of the funds population which had an increase, a decrease, or stayed constant
in the markets exposure during the two crisis (LTCM and the Equity Bubble). We show
that within a strategy, Hedge funds have a tendency to have an increase in market exposure.
The changes in factorial exposure and the proportion of funds give us a strong tool for risk
managers and specically for stress-testing.
21
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annals of Statistics, 22(3):13461370, 1994.
[96] Schneeweis T. and Spurgin R. Multifactor Analysis of Hedge Fund and Managed Futures,
Return and Risk Characteristics. Journal of Alternative Investments, 1:124, 1998.
[97] Severini Thomas A. and H. W. Wong. Prole Likelihood and Conditionally Parametric
Models. The Annals of Statistics, 20(4):17681802, Dec., 1992.
[98] Stone C. J. optimal Global Rates of Convergence for Nonparametric Regression. Ann. Statist,
10:10401053.
[99] Stone C. J. Consistent Nonparametric Regression. Ann. Statist, 5:595620, 1977.
[100] Stone C. J. Optimal Rates of Convergence for Nonparametric Estimator. Ann. Statist,
8:13481360, 1980.
26
[101] Swamy P. A. V. and Mehta J. S. Estimation of Linear Models with Time and Cross-
Sectionally Varying Coecients. Journal of the American Statistical Association, 72(360):890
898, Dec., 1977.
[102] zhang W., Lee S.-Y., and Song X. Local Polynomial Fitting in Semivarying Coecent
Model. journal of Multivariate Analysis, 82:166188, jan. 2002.
27
Table I
See Appendix I for denitions of fund types. The funds used at minimum cover the LTCM and bubble period which
represent a track record of a minimum of 30 months. Certain of the funds used are considered as dead funds i.e. they
stopped their activities. The database marked by a asterisk give the number of funds covering the 2 specic periods
i.e, LTCM period (July, Auguste, and September 1998) and the Equity Bubble years (February, March, and April 2000)
Strategies Number of Hedge Funds
CISDM merge CISDM* merge*
Equity Long/Short 2141 3519 1561 2525
Multi Strategy 251 734 142 462
Emerging Markets 445 635 331 461
Sector 387 630 296 468
Equity Market Neutral 322 698 227 519
Event Driven Multi Strategy 224 384 168 293
Global Macro 303 534 205 377
Equity Long Only 148 276 99 174
Single Strategy 114 112 50 50
Fixed Income 153 326 109 260
Distressed Securities 162 268 131 232
Fixed Income Arbitrage 190 314 143 237
Convertible Arbitrage 207 271 181 227
Relative Value Multi Strategy 89 179 74 137
Fixed Income - MBS 74 98 59 69
Option Arbitrage 29 126 17 76
Merger Arbitrage 126 139 111 122
Other relative Value 16 32 7 17
Short bias 51 74 32 56
Regulation D 16 56 13 44
Capital Structure Arbitrage 21 30 13 21
Market Timing 2 3 1 1
Unclassied 58 521 37 369
CTAs (systematic) 1003 759
CTAs (discretionary) 283 1915 202 1394
FoHFs (multi strategy) 1837 1390
28
Table II
See Appendix I for denitions of fund types. This table shows how we have grouped the 31 strategies from Hedge-
Fund.Net and the 23 strategies from CISDM .
CISDM database HedgeFund.Net database
23 Strategies 31 Strategies
Multi Strategy
Multi Strategy
Statistical Arbitrage
Equity Long/Short Equity Long/Short
Short bias Short bias
Event Driven Multi Strategy Event Driven
Emerging Markets Emerging Markets
Merger Arbitrage Merger (risk) Arbitrage
Fixed Income Fixed Income (non arbitrage)
Equity Market Neutral Market Neutral Equity
Global Macro Macro
Relative Value Multi Strategy Value
Sector
Small/Micro Cap
Finance Sector
Technology Sector
Energy Sector
Healthare Sector
Equity Long Only Long Only
Distressed Securities Distressed
Single Strategy FoF Market Neutral
Unclassied
Asset Based Lending
country specic
Special situations
short-term trading
Fixed Income - MBS Mortgage
Convertible Arbitrage Convertible Arbitrage
Fixed Income Arbitrage Fixed Income Arbitrage
Other relative Value Other Arbitrage
Market Timing Market Timer
Option Arbitrage Option Strategies
Regulation D Regulation D
Capital Structure Arbitrage Capital Structure Arbitrage
29
Table III: Test of Multiple Structural Changes
See Appendix I for denitions of fund types. The funds used at minimum cover the LTCM and bubble period which
represent a track record a minimum of 30 months. Listed is a test provided by Bai and Perron (1998) to analyze
whether Hedge Funds have some structural. We note the percentage of Hedge Funds signicant to the test after
applying the False Discovery Rate methodology . The test considers tests of no structural break against an unknown
number of breaks given some upper bound (m = 5).
Strategy Double Maximum test
UDmax WDmax
Equity Long/Short 38% 38%
Multi Strategy 46% 46%
Emerging Markets 34% 34%
Sector 41% 41%
Equity Market Neutral 49% 49%
Event Driven Multi Strategy 35% 35%
Global Macro 42% 42%
Equity Long Only 53% 53%
Single Strategy 71% 71%
Fixed Income 40% 40%
Distressed Securities 20% 20%
Fixed Income Arbitrage 41% 41%
Convertible Arbitrage 41% 41%
Relative Value Multi Strategy 30% 30%
Fixed Income - MBS 58% 58%
Option Arbitrage 57% 57%
Merger Arbitrage 27% 27%
Other relative Value 75% 75%
Short bias 51% 51%
Regulation D 29% 29%
Capital Structure Arbitrage 53% 53%
Market Timing 100% 100%
Unclassied 38% 38%
Fund of Hedge Funds 65% 66%
CTA Systematic 70% 70%
CTA Discretionary 66% 66%
30
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31
Figure I:
31Mar1997 30Nov1998 31Jul2000 31Mar2002 30Nov2003 31Jul2005 31Mar2007
0
0.2
0.4
0.6
0.8
1
LTCM Equity Bubble
R
breaks
Capital Structure Arbitrage
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
Convertible Arbitrage
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
CTA
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
Distressed Securities
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
0.25
LTCM Equity Bubble
R
breaks
Emerging Markets
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
LTCM Equity Bubble
R
breaks
Equity Long Only
See Appendix I for denitions of fund types. The number of hedge Funds has increased drastically since 2000 therefore
the number of breaks in 1995, for instance, has not the same signicance as the number of breaks in 2002. In order
to overcome this problem and to study correctly the dynamic in beta we dene a ratio: R
breaks
which is equal to
the number of funds at time t divided by the number of break at time t. In this way, we are able to study how the
dynamic in hedge Funds behaves during a long period.
The bar gures illustrate the number of breakdates relative to one fund.
32
Figure II:
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
Equity Long/Short
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
Equity Market Neutral
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
0.25
LTCM Equity Bubble
R
breaks
Event Driven Multi Strategy
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
0.5
LTCM Equity Bubble
R
breaks
Fixed Income MBS
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
LTCM Equity Bubble
R
breaks
Fixed Income Arbitrage
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
0.25
LTCM Equity Bubble
R
breaks
Fixed Income
See Appendix I for denitions of fund types. The number of hedge Funds has increased drastically since 2000 therefore
the number of breaks in 1995, for instance, has not the same signicance as the number of breaks in 2002. In order
to overcome this problem and to study correctly the dynamic in beta we dene a ratio: R
breaks
which is equal to
the number of funds at time t divided by the number of break at time t. In this way, we are able to study how the
dynamic in hedge Funds behaves during a long period.
The bar gures illustrate the number of breakdates relative to one fund.
33
Figure III:
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
Global Macro
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
LTCM Equity Bubble
R
breaks
Merger Arbitrage
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
0.5
LTCM Equity Bubble
R
breaks
Multi Strategy
31Dec1993 30Nov1995 30Sep1997 31Aug1999 30Jun2001 31May2003 31Mar2005 28Feb2007 31Dec1993
LTCM Equity Bubble
Option Arbitrage
31Dec1993 30Nov1995 30Sep1997 31Aug1999 30Jun2001 31May2003 31Mar2005 28Feb2007 31Dec1993
LTCM Equity Bubble
Other Relative Value
31Dec1993 30Nov1995 30Sep1997 31Aug1999 30Jun2001 31May2003 31Mar2005 28Feb2007 31Dec1993
LTCM Equity Bubble
Regulation D
See Appendix I for denitions of fund types. The number of hedge Funds has increased drastically since 2000 therefore
the number of breaks in 1995, for instance, has not the same signicance as the number of breaks in 2002. In order
to overcome this problem and to study correctly the dynamic in beta we dene a ratio: R
breaks
which is equal to
the number of funds at time t divided by the number of break at time t. In this way, we are able to study how the
dynamic in hedge Funds behaves during a long period.
The bar gures illustrate the number of breakdates relative to one fund.
34
Figure IV:
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
0.25
LTCM Equity Bubble
R
breaks
Relative Value Multi Strategy
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
0.25
LTCM Equity Bubble
R
breaks
Sector
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.1
0.2
0.3
0.4
0.5
LTCM Equity Bubble
R
breaks
Short Bias
28Feb1994 31Jan1996 31Dec1997 30Nov1999 30Sep2001 31Aug2003 31Jul2005 30Jun2007 28Feb1994
0
0.2
0.4
0.6
0.8
1
LTCM Equity Bubble
R
breaks
Single Strategy
31Dec1993 31Aug1995 30Apr1997 31Dec1998 31Aug2000 30Apr2002 31Dec2003 31Aug2005 30Apr2007
0
0.05
0.1
0.15
0.2
LTCM Equity Bubble
R
breaks
unclassified
See Appendix I for denitions of fund types. The number of hedge Funds has increased drastically since 2000 therefore
the number of breaks in 1995, for instance, has not the same signicance as the number of breaks in 2002. In order
to overcome this problem and to study correctly the dynamic in beta we dene a ratio: R
breaks
which is equal to
the number of funds at time t divided by the number of break at time t. In this way, we are able to study how the
dynamic in hedge Funds behaves during a long period.
The bar gures illustrate the number of breakdates relative to one fund.
35
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+ A
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)
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s
.
42
Appendix I
Denition of Strategies
The emerging markets strategy attempts to capture gains from ineciencies in emerging
markets.
The Equity Long/Short strategy refers to taking both long and short positions in equities.
The Market Timer focus on securities associated with companies that will soon experience
a signicant event.
The Distressed Securities Strategy focuses on asset of distressed companies. Buys equity,
debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization.
The Merger Arbitrage Strategy also called risk arbitrage strategy exploit pricing inef-
ciencies associated with a merger or acquisition.
The event driven multi-strategy can use both the distressed securities style and/or the
merger arbitrage style.
The Relative Value arbitrage style take positions in 2 securities that are mispriced relative
to each other, with the expectation that their prices will converge to appropriate values in the
future(Arbitrage, Market neutral.
The arbitrage involves simultaneously purchasing and selling related securities that are mis-
priced relative to each other.
Convertible Arbitrage Strategy can be described by taking a long position in a convertible
bond and sells short the associated stock. Convertible arbitrage - exploit pricing ineciencies
between convertible securities and the corresponding stocks.
Fixed Income Arbitrage Strategies encompass a wide range of strategies in both domestic
and global xed-income markets. Fixed income arbitrage - exploit pricing ineciencies between
related xed income securities.
Equity Market Neutral style creates a position that attempts to hedge out most market
risk by taking osetting positions. This strategy exploits the mispricing between a stock
which is overvalued and one that is undervalued such that beta of the combined position is
zero. Statistical arbitrage - equity market neutral strategy using statistical models.
Index arbitrage style generally attempts to exploit mispricing between an index and deriva-
tives on that index.
Mortgage-backed securities arbitrage style exploit the mispricing of mortgage-backed
assets relative to Treasury securities.
multi-strategy style uses dierent styles and may change exposures to dierent styles based
upon changing market conditions.Multi strategy in Macro strategy - combination of discre-
tionary and systematic macro. Multi strategy in FoHF - a hedge fund exploiting a combination
of dierent hedge fund strategies to reduce market risk.
dedicated short selling style only takes short equity positions.
Global Macro Discretionary macro - trading is done by investment managers instead of
generated by software.
Systematic macro (Systematic diversied) - trading is done mathematically, generated by
software without human intervention.
43
Sector funds - expertise in niche areas such as technology, health care, biotechnology, phar-
maceuticals, energy, basic materials.
Fundamental value - invest in undervalued companies.
Fundamental growth - invest in companies with more earnings growth than the broad equity
market.
Quantitative Directional, statistical arbitrage - equity trading using quantitative tech-
niques.
Multi manager - a hedge fund where the investment is spread along separate sub managers
investing in their own strategy.
Trend following - long-term or short-term. Non-trend following (Counter trend) - prot
from trend reversals.
Regulation D - specialized in private equities.
Credit arbitrage or xed income arbitrage strategy - specialized in corporate xed
income securities.
Fixed Income asset backed - xed income arbitrage strategy using asset-backed securities.
Volatility arbitrage - exploit the change in implied volatility instead of the change in price.
Yield alternatives - non xed income arbitrage strategies based on the yield instead of the
price.
Capital Structure Arbitrage - involves taking long and short positions in dierent nancial
instruments of a companys capital structure, particularly between a companys debt and
equity product.
44
Two-step Time-Varying Coecient Model
The varying coecient model assumes the following conditional linear structure:
Y
t
=
p

j=1

j
(t)X
jt
+
t
= (t) +X(t) +
t
for a given covariates (t, X
1
, ..., X
p
)

and variable Y with

E[|t, X
1
, ..., X
p
] = 0,
V ar[|t, X
1
, ..., X
p
] =
2
(t),
In this study, we took X
1
= 1 as the intercept term and t = time.
if we consider that
i
depends on t: (
i
(t)), we can approximate the function locally as

i
(t) a
i
+b
i
(t t
0
). This leads to the following local least-squares problem:
minimize
n

i=1
_
_
Y
i

p

j=1
{a
j
+b
j
(T
i
t
0
)}X
ij
_
_
2
K
h
(T
i
t
0
)
for a given kernel function K and bandwidth h, where K
h
(.) = K(./h)/h.
In matrix notation:
Let
X
0
=
_
_
_
X
11
X
11
(T
1
t
0
) . . . X
1p
X
1p
(T
1
t
0
)
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
X
n1
X
n1
(T
n
t
0
) . . . X
np
X
np
(T
p
t
0
)
_
_
_
Y = (Y
1
, ..., Y
n
)

and W
0
= diag(K
h
0
(T
1
t
0
), ..., K
h
0
(T
n
t
0
))
Then the solution to the least-squares problem can be expressed as:
a
j,0
= e

2j1,2p
(X

0
W
0
X
0
)
1
X

0
W
0
Y
With these estimates, a
j,0
, a local least-square regression is tted again via substituting the
initial estimate into the local least-squares problem:
n

i=1
_
_
Y
i

p1

j=1
a
j,0
(T
i
)X
ij

_
a
p
+b
p
(T
i
t
0
) +c
p
(T
i
t
0
)
2
+d
p
(T
i
t
0
)
3
_
X
ip
_
_
2
K
h
2
(T
i
t
0
)
where h
2
is the bandwidth in the second step. In this way, a two-step estimator is obtained.
Fan and Zhang showed that the bias of the two-step estimator is of O(h
4
2
) and the variance
O
_
(nh
2
)
1
_
45
Two-step Time-Varying Coecient Model using B-splines
As mentioned by Fan and Zhang (1999), other techniques such as smoothing splines can also
be used in the second stage of tting. Therefore we built the second two-step estimator based
on the same article but we used during the second step a smoothing splines instead of local
regression.
From the rst step, we obtained the estimates:
a
j,0
= e

2j1,2p
(X

0
W
0
X
0
)
1
X

0
W
0
Y
In a second step, knowing that we can approximate each
p
(t) by a basis function expansion

p
(t)
K

k=0

pk
B
pk
(t),
We can now minimized in order to estimate

kp
:
n

i=1
w
i
_
_
Y
i

p1

j=1
a
j,0
(T
i
)X
ij

_
K

k=0

kp
B
kp
_
X
ip
_
_
2
then it is natural to estimate
p
(t) by

p
(t) =
K

k=1

kp
B
kp
(t).
46
Robustness: local and B-spline Time-Varying Coecient Model
The following example will be used to illustrate the performance of our estimator. We created two betas
(called
i
created
) which represent a possible structural change for a Hedge Fund. We put up a simulated Hedge
Fund track (R
HF
) in this manner:
R
HF
=
1
created
X
1
+
2
created
X2 +
where X
1
, X
2
are the S&P500 and the monthly change in the 10-year treasury constant maturity yield respec-
tively. The random variable follows a normal distribution with mean zero and variance 1.
We called the local time-varying coecient model: L-TVCM and the B-spline time varying coecient model:
B-TVCM.
Short sample: 50 months
0 20 40 60
2
1
0
1
2

1
and true
1
using L-TVCM
months
0 20 40 60
5
0
5
10

2
and true
2
using L-TVCM
months
0 20 40 60
2
0
2
4

2
and true
2
using B-TVCM
months
0 20 40 60
2
0
2
4
6

2
and true
2
using B-TVCM
months
FIG.: Comparison of the performance between the one-step estimator (long-dashed curve) and the true coe-
cient function (the solid curve).
47
Medium sample: 100 months
0 50 100
2
1
0
1

1
and true
1
using L-TVCM
months
0 50 100
2
0
2
4

2
and true
2
using L-TVCM
months
0 50 100
1
0.5
0
0.5
1

2
and true
2
using B-TVCM
months
0 50 100
2
0
2
4
6

2
and true
2
using B-TVCM
months
FIG.: Comparison of the performance between the one-step estimator (long-dashed curve) and the true coe-
cient function (the solid curve).
Long sample: 150 months
0 50 100 150
2
1
0
1

1
and true
1
using L-TVCM
months
0 50 100 150
2
0
2
4

2
and true
2
using L-TVCM
months
0 50 100 150
1
0.5
0
0.5
1

2
and true
2
using B-TVCM
months
0 50 100 150
2
1
0
1
2

2
and true
2
using B-TVCM
months


true

FIG.: Comparison of the performance between the one-step estimator (long-dashed curve) and the true coe-
cient function (the solid curve).
48
Bootstrap Condence intervals
We summarize the methodology from Colin and Chiang (2000) in order to create condence
regions.
According to the author this following naive bootstrap procedure can be used to construct
approximate pointwise percentile condence intervals for
i
(t):
1) Randomly sample n subjects with replacement from the original data set, and let
{(t

ij
, X

i
), Y

ij
; 1 = i = n, 1 = j = n
i
} be the longitudinal bootstrap sample.
2) Compute the kernel estimator

boot
i
(t)
3) Repeat the above 2 steps B times, so that B bootstrap estimators

boot
i
(t) of
i
(t) are
obtained.
4) Let L
/2
(t) and U
(/2)
(t) be the (/2)
th
and (1 )
th
i.e. lower and upper (/2
th
) per-
centiles, respectively, calculated on the B bootstrap estimators. An approximate (1 )
bootstrap condence interval for
i
(t) is given by (L
(/2)
(t), U
(/2)
(t)).
bandwidth leave-one-subject-out cross-validation methodology
The leave-out method is based on regression smoothers in which one, say the jth, observation
is left out. So, for N values,
1) Compute the leave-out estimate m
h,j
(X
j
) = n
1

i=j
W
hi
(X
j
)Y
i
.
2) Construct the cross validation function CV (h) = n
1
n

j=1
(Y
j
m
h,j
(X
j
))
2
w(X
j
). where w
denotes a weight function.
3) With this N CV(h), we can, now, dene the automatic bandwidth as

h = arg min
hH
n
[CV (h)]
49