Predictability in Hedge Fund Index Returns and Implications For FoF Style Allocation

Predictability in Hedge Fund Index Returns and its application in Fund of Hedge Funds style allocation
By Philippe Pillonel Laurent Solanet
Masters Thesis November 2004
Keywords: Hedge funds. Return predictability. Portfolio optimization. JEL Classification: G23, G14, G11.
Both Philippe Pillonel and Laurent Solanet are students in Masters in Banking and Finance (MBF) at the Ecole des HEC of the University of Lausanne. We are responsible for any error. We are grateful to Mr. Nils Tuchschmid for his continuous help and close supervision. His insightful comments and suggestions have laid the foundation for this work. We would also like to address a special thank to Mr. Franois-Serge Lhabitant, our thesis Director.
Predictability in Hedge Fund Index Returns and its application in Fund of Hedge Funds style allocation
ABSTRACT
In this paper, we search for evidence in return predictability of hedge fund indexes. We assume that the expected future returns can be characterized by a factor model, at first linear single-factor and subsequently multi-factor and non-linear. Based on these forecasts, we perform different portfolio optimization problems. The performance of these optimum portfolios is then compared with that of two benchmarks (equally- and buy-and-hold) made of the same hedge fund indexes. In a first part, we find that evidence of predictability in hedge fund index return is mainly due to the persistence in hedge fund style performance. Then, in a second part, we observe that the benefits for a fund of hedge funds manager in performing tactical style allocation strategies via our predictive models is jeopardized by numerous operational/investment constraints.
Introduction ................................................................................................................................ 4 1 Evidence of Predictability in Hedge Fund Index Returns ................................................... 5 1.1 Review of Literature and Background Theory ............................................................. 6 1.2 Data ............................................................................................................................. 10 1.3 Predictive Variables .................................................................................................... 13 1.4 Methodology ............................................................................................................... 16 1.5 The Predictive Models ................................................................................................ 21 1.5.1 Linear Single-factor Predictive Models ............................................................... 22 1.5.2 Linear Multi-factor Predictive Models................................................................. 31 1.5.3 Non-linear Multi-factor Predictive Models.......................................................... 42 A Practical Application: TSA in Fund of Hedge Funds.................................................... 52 2.1 Operational Constraint: Redemption Notification ...................................................... 53 2.2 Investment Constraint: Turnover and Diversification ................................................ 56 Conclusion ......................................................................................................................... 59
Appendix A. Hedge Fund Index Data ...................................................................................... 60 A.1 Hedge Fund Classification.......................................................................................... 60 A.2 Summary Statistics of Hedge Fund Index Returns ..................................................... 65 Appendix B. Predictive Variable Data.................................................................................... 69 B.1 Summary Statistics of Predictive Variables................................................................ 69 Appendix C. Others................................................................................................................. 71 C.1 Methodology Scheme ................................................................................................. 71 C.2 Optimal portfolio weights (without any upper weight constraint).............................. 72 C.3 Optimal portfolio weights (with upper weight constraints of 20%) ........................... 73 References ................................................................................................................................ 74
Introduction
In this paper, we focus on the predictability of hedge fund index returns and its eventual application in a fund of hedge funds. There is now a consensus in empirical finance that expected asset returns are, to some extent, predictable, at least for traditional asset classes. However, literature on evidence on return predictability of hedge fund is still in its infancy. Amenc, El Bied and Martellini (2002) were the first to report both statistical and economic significance of predictability in hedge funds returns. Like Amenc et al. (2002), we use factor models to find evidence of predictability in various hedge fund index returns. Given that the true set of predictive variables is virtually unknown, we extend Amenc et al. (2002) empirical analysis using various forecasting models to analyze hedge fund index returns predictability and its impact to tactical style allocation (TSA)1 strategies. We take into account a larger number of predictive variables reflecting the stage of the economic cycle, the interest rate environment, and the dynamic trading strategies applied by hedge funds. These variables are able to predict changes in hedge fund index returns. We finally expand the sample period until December 2003. In order to provide some evidence of the economic significance of these predictive models, we analyze their out-of-sample performance in terms of tactical style allocation. Three portfolio construction models are performed, all based on traditional optimization (i.e. meanvariance framework). Traditional portfolio optimization models require forecasts of the portfolio expected returns and an estimate of their covariance matrix. In this paper, we estimate the expected returns using different factor models. The difficulty arise when there is no consensus on the most appropriate factor model, that is why we attempt in this paper to compare an extensive number of different factor models beginning with the simplest form of the fund returns (linear single-factor models) and ending with more complex representation (non-linear multi-factor models).
Amenc et al. (2002) introduce the term "tactical style allocation" (TSA) rather than "tactical asset allocation" (TAA) because hedge funds may be better regarded as new investment styles than investment classes. Moreover, in this paper, we precisely look at evidence of predictability in hedge fund index returns and, accordingly, at its implications to tactical allocation across hedge fund styles.
The paper is organized as follows: the first section provides evidence of return predictability in hedge fund indexes. The second section explores the practical application of our predictive models, i.e. their uses in tactical style allocation by fund of hedge funds managers. The third section concludes.
1 Evidence of Predictability in Hedge Fund Index Returns

There are many studies that show that stock returns at time t can be forecasted with information based at time t-1. For example, Harvey (1989) shows that up to 18% of the variation in U.S. stock portfolios can be forecasted on a monthly basis. Harvey (1991) finds similar results with international data [see also Ferson and Harvey (1991a) and (1991b)]. More recently, Amenc, El Bied and Martellini (2002) provide strong evidence of predictability in hedge fund index returns. To remove any ambiguity, Amenc et al. (2002) and this paper as well focus on evidence of predictability in hedge fund returns at the index level and not in individual hedge fund returns. As each index relates more or less to a particular hedge fund investment style, the return predictability should be applied to hedge fund styles and not to specific hedge funds (see Appendix A.1 for a description of the different hedge fund styles).
1.1 Review of Literature and Background Theory

Over the last few decades, there has been a growing interest in the modeling and forecasting of economic and financial variables, such as GDP, exchange rates, stock prices or returns. Most of these earlier works used structural models, trying to explain the fluctuations in the variable under study with some exogenous macroeconomic variables as the explanatory variables. Lately, with the advancement of time series econometric techniques, many researchers resort to time series models in their forecasting endeavor. This approach gain further popularity when data of higher frequency are becoming available from the equity, foreign exchange and derivatives markets, which is particularly useful to those with shortterm horizons.
Equivalently, Brooks (2002) makes the distinction between two types of forecasting: Time series forecasting involves trying to forecast the future values of a series given its previous values and/or previous values of an error term. Econometric (structural) forecasting relates a dependent variable to one or more independent variables. Such models often work well in the long run, since a long-run relationship between variables often arises from no-arbitrage or market efficiency. Return prediction derived from arbitrage pricing models is an example of the second type.2 Time series models have been widely applied in forecasting financial time series for several reasons. The most important reason is that time series models enjoy greater simplicity as compared to the econometric structural models without loosing their forecastability. In other words, the forecasting performance of time series models are at least comparable to structural models disregarding the fact that the former requires minimum information set. Unlike a structural model, a time series model demands nothing more than the historical records of the variable under investigation. It is assumed that the movements of a time series are solely explained in terms of its own past and therefore forecasts can be made by extrapolation of the past (Harvey, 1993).
2 In this paper, our forecasting model will be derived from arbitrage pricing models, yet we will use autoregressive terms as well. Ttherefore we are dealing with a mix of these both types of forecasting.
Econometric (structural) forecasting Forecasting economic variables is a difficult art. There are actually two ways of considering this task. 1. One approach consists in forecasting returns by first forecasting the values of economic variables (scenarios on the contemporaneous variables). E(yt | t-1) = Et-1(yt) = 1 + 2 Et-1(x2t) + 3 Et-1(x3t) + + k Et-1(xkt)
2. The other approach to forecasting returns is based on anticipating market reactions to known economic variables (econometric model with lagged variables). E(yt | t-1) = Et-1(yt) = 1 + 2 Et-1(x2,t-1) + 3 Et-1(x3,t-1) + + k Et-1(xk,t-1) = 1 + 2 x2,t-1 + 3 x3,t-1 + + k xk,t-1 Amenc et al. (2003) write that a number of academic studies (e.g., de Bondt and Thaler [1985], Thomas and Bernard [1989]) suggest that the reaction of market participants to known variables is easier to predict than financial and economic factors. The performance of timing decisions based on an econometric model with lagged variables results from a better ability to process available information, as opposed to privileged access to private information.
1.1.1 Asset Return Predictive Models

For the review of the asset return predictability and its background theory, we extensively refer to Ferson (2003), who says : "Virtually all asset pricing models are special cases of the fundamental equation: Pt = Et{mt+1 (Pt+1 + Dt+1 )} (1)
where Pt is the price of the asset at time t and Dt+1 is the amount of any dividends, interest or other payments received at time t + 1. The market-wide random variable mt+1 is the stochastic discount factor (SDF) 1. The prices are obtained by
discounting the payoffs using the SDF, or multiplying by mt+1, so that the expected present value of the payoff is equal to the price. Assuming nonzero prices, Equation (1) is equivalent to: E (mt+1 Rt+1 1 | t ) = 0 (2)
where Rt+1 is the N-vector of primitive asset gross returns and 1 is an N-vector of ones. The gross return Ri,t+1 is defined as (Pi,t+t + Di,t+1) / Pi,t. We say that a SDF prices the assets if Equations (1) and (2) are satisfied. Empirical tests of assetpricing models often work directly with Equation (2) and the relevant definition of mt+1. Return predictability Rational expectation implies that the difference between return realizations and the expectations in the model should be unrelated to the information that the expectations in the model are conditioned on. For example, Equation (2) says that the conditional expectation of the product of mt+1 and Ri,t+1 is the constant 1. Therefore, 1 mt+1 Ri,t+1 should not be predictably different from zero using any information available at time t. If we run a regression of 1 mt+1 Ri,t+1 on any lagged variable, Zt , the regression coefficients should be zero. Conditional asset pricing presumes the existence of some return predictability. There should be instruments Zt for which E(Rt+1 | Zt) or E(mt+1 | Zt ) vary over time, in order for the equation E(mt+1 Rt+1 1 | Zt ) = 0 to have empirical bite. Interest in predicting security-market returns is about as old as the security markets themselves. Fama (1970) reviews the early evidence."
1.1.2 Hedge Fund Return Predictive Models

What about evidence of predictability in hedge fund returns? Is actively managed portfolios may be as predictable as buy-and-hold portfolios? Due to the myriad of strategies employed by hedge funds, their highly dynamic and the extensive use of derivatives and leverage, models for hedge fund returns are inherently complex. In a recent paper, Amenc, El Bied, and Martellini (2002) provide evidence of predictability in hedge fund index returns, and discuss its implications in terms of tactical style allocation decisions. See the section 1.5.2.1 for a presentation of their methodology. As for individual hedge fund return predictability, Martin (1999) writes that there are difficulties in systematically determining and representing the sources of individual fund returns3. He adds two important remarks. 1. All the evidence can be taken as a justification for the creation of index-based product designed to efficiently deliver the returns to particular hedge fund styles. 2. The evidence also provides a rationale for the development of models for the dynamic allocation of capital across hedge fund styles (tactical style allocation - TSA) The first remark can be related to the recent emergence of investable hedge fund indices by several hedge fund index providers (CSFB/Tremont, HFR, ). The second remark is also backed by a multitude of academic papers [see Amenc and Martellini (2001), Agarwal and Naik (2003), Alexander and Dimitriu (2004) to cite a few of them]. This last remark is also a rationale for the use of TSA portfolios as an evaluation tool for our numerous predictive models.
3 If we really want to predict the returns of an individual hedge fund and disregard the previous remark made by Martin, we can proceed as follows: 1. perform a style analysis of the hedge fund (see Lhabitant, 2004) and 2. forecast the returns of this particular hedge fund based on : the fund's exposures to the investment styles (point 1) the forecasted returns of the investment styles
In brief, the forecasted returns of an individual hedge fund are the weighted averages of the investment styles' forecasted returns with weights being the fund's exposures to the investment styles. We assume there will be no style drift.
1.2 Data
To represent the alternative investment universe, we chose to use the data from Credit Suisse First Boston/Tremont (CSFB/Tremont). The CSFB/Tremont Hedge Fund indexes have been used in a variety of studies on hedge fund performance and order several advantages with respect to their competitors: They are transparent both in their calculation and composition, and constructed in a disciplined and objective manner. Starting from the TASS+ database, which tracks over 2,600 US and offshore hedge funds, the indexes only retain hedge funds that have at 5 least US $10 million under management and provide audited financial statements. Only about 300 funds pass the screening process. They are computed on a monthly basis and are currently the industrys only asset weighted hedge fund indexes.3 Funds are re-selected quarterly, as necessary, and in order to minimize the survivorship bias, they are not excluded until they liquidate or fail to meet the financial reporting requirements. This makes these indexes representative of the various hedge fund investment styles (see in the annex for more style information) and useful for tracking and comparing hedge fund performance against other major asset classes. The CSFB/Tremont sub-indexes were launched in 1999 with data going back to 1994. They cover nine strategies: convertible arbitrage (HF1), dedicated short bias (HF2), emerging markets (HF3), equity market neutral (HF4), event driven (HF5), fixed-income arbitrage (HF6), global macro (HF7), long/short equity (HF8) and managed futures (HF9). See Appendix A.1 for a description of the hedge fund strategies. In this paper, we select the nine CSFB/Tremont Hedge Fund Indexes based on monthly data over the period January 1994 to December 2003. This period includes the Asian and Russian crisis along with the LTCM debacle and the Internet bubble burst. For the nine hedge fund indexes and the various risk factors, monthly data are used throughout, spanning 120 months from January 1994 to December 2003. We use arithmetic return for all our result.
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As far as the hedge fund indexes are concerned, we denote by NAVt the net asset value of a hedge fund at time t. From the funds net asset values, (arithmetic) returns are derived as follows: Rt =
NAVt - NAVt -1 NAVt -1
Table 1 reports the nine Tremont Hedge Fund Indexes performances and statistics over this period. It is followed by a graph showing the evolution of $100 invested in each of these indexes.
Table 1. Performances and summary statistics of Tremont hedge fund indexes

This table shows the performance and some summary statistics for the nine CSFB/Tremont hedge funds indexes during the period 1994-2003. The figures come from the monthly return time series and have been annualized.
ANNUAL RETURN CONV. ARBITRAGE SHORT BIAS EMERG. MARKETS EQUITY MKT.NTRL EVENT DRIVEN FIXED INC. ARB. GLOBAL MACRO LONG SHORT MANAGED FUTURES
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Mean St. Dev. Skewness Kurtosis % Up Month Avg Gain Avg Loss
-8,07% 16,57% 17,87% 14,48% -4,41% 16,04% 25,64% 14,58% 4,05% 12,90% 10.49% 4,78% -1,57 4,05 81,67% 13,23% -3,23%
14,91% -7,35% -5,48% 0,42% -6,00% -14,22% 15,76% -3,58% 18,14% -32,59% -3.17% 18,02% 0,92 2,15 45,00% 23,31% -23,33%
12,51% -16,91% 34,50% 26,59% -37,66% 44,82% -5,52% 5,84% 7,36% 28,75% 7.10% 17,76% -0,58 3,71 59,17% 27,40% -20,97%
-2,00% 11,04% 16,60% 14,83% 13,31% 15,33% 14,99% 9,31% 7,42% 7,07% 10,65% 3,07% 0,21 0,24 84,17% 11,09% -0,97%
0,75% 18,34% 23,06% 19,96% -4,87% 22,26% 7,26% 11,50% 0,16% 20,02% 11,40% 6,04% -3,46 22,98 80,00% 14,24% -3,56%
0,31% 12,50% 15,93% 9,34% -8,16% 12,11% 6,29% 8,04% 5,75% 7,97% 6,80% 3,95% -3,25 16,61 81,67% 9,34% -2,85%
-5,72% 30,67% 25,58% 37,11% -3,64% 5,81% 11,67% 18,38% 14,66% 17,99% 14,49% 12,12% -0,04 1,98 70,83% 23,64% -10,26%
-8,10% 23,03% 17,12% 21,46% 17,18% 47,23% 2,08% -3,65% -1,60% 17,27% 12,16% 11,00% 0,22 3,35 66,67% 20,39% -9,16%
11,95% -7,10% 11,97% 3,12% 20,64% -4,69% 4,24% 1,90% 18,33% 14,13% 7,08% 12,14% 0,03 0,58 55,83% 19,79% -12,16%
There is more descriptive statistics about CSFB/Tremont Hedge Fund Indexes in the Appendix A.2
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The above table and plot confirm that the hedge fund universe is very heterogeneous: some hedge fund strategies have relatively high volatility (e.g., dedicated short bias, emerging markets, global macro, long/short equity and managed futures); they act as return enhancers and can be used as a substitute for some fraction of the equity holdings in an investors portfolio. On the other hand, some other hedge fund strategies have lower volatility (e.g., convertible arbitrage, equity market neutral, fixed-income arbitrage and event driven); they can be regarded as a substitute for some fraction of the fixed-income holdings in an investors portfolio. The above statistics show also that most hedge funds returns exhibit negative skewness and positive excess kurtosis; these two characteristics are not welcome for a risk averse investor.
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1.3 Predictive Variables

We consider hedge funds as investments that provide exposure to several types of risk. Some of these risk factors come from the traditional part (equity, interest rates, credit), but the main of them come from the non-traditional part (spreads, volatility, markets trends) of these alternative investments.
We have selected the following risk factors on the basis of previous evidence of their ability to predict hedge fund returns and/or their natural influence on them.

US equity market (proxied by the return on the S&P500 index) World equity market (proxied by the return on the MSCI World index ex US) Emerging equity market (proxied by the return on the MSCI Emerging market index) Small capitalization equity market (proxied by the return on the Russel 2000 index) Dividend yield (proxied by the dividend yield on the S&P500 index).
It has been shown to be associated with slow mean reversion in stock returns across several economic cycles [Keim and Stambaugh (1986), Campbell and Shiller (1998), Fama and French (1998)]. It serves as a proxy for time variation in the unobservable risk premium since a high dividend yield indicates that dividends have been discounted at a higher rate.
Equity market volume (proxied by the change in the volume on the NYSE) Implicit volatility (proxied by changes in the average of intra-month values of the
VIX).
Short term interest rate (proxied by the yield on 3-month T-Bill )

Fama (1981) and Fama and Schwert (1977) show that this variable is negatively correlated with future stock market returns. It serves as a proxy for expectations of future economic activity.
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Term spread (proxied by the difference between the yield on 3-month T-Bill and 10-
year Treasuries)
Default spread (proxied by the difference between the yield on Moody's long term
BAA bonds and the yield on Moody's long term AAA bonds)
This captures the effect of default premiums, which track long-term business cycle conditions; higher during recessions, lower during expansions [Fama and French (1998)].

AAA yield (proxied by the yield on Moody's long term AAA bonds) US bond market (proxied by the return on the Lehman Aggregate Bond index) US high-yield bond market (proxied by the return on the Merrill Lynch High Yield) Currency (proxied by the return on the FED trade-weighted US Dollar index) Gold (proxied by the return on the gold price)
It is a proxy of inflation
Commodities (proxied by the return on the Goldman Sachs Commodity Index GSCI) Oil (proxied by the return on the refiner acquisition cost of imported crude oil)
It is closely related to short-term business cycles
By using all these variable, our single- and multi-factor models covering equities, bonds, currencies and commodities provide a good depiction of the different hedge fund styles. We will also try to take into account the specific characteristics of the hedge fund return distributions (due to the use of derivatives and dynamic trading strategies) by introducing non-linear functions of the above predictive variables. All the data concerning the risk factors (proxies) have been extracted from DataStream, except for the VIX (CBOE website) and the oil prices data (EIA website).
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Table 2. Summary statistics for the predictive variables

This table shows some summary statistics for all the predictive variables during the period 1994-2003. The figures come from the monthly return time series and have been annualized.
Mean US equity mkt World equity mkt Emerging equity mkt Small cap equity mkt Dividend yield Implied volatility Short term interest rate Term spread Default spread US bond mkt High-yield bond mkt Currency Gold Commodities Oil 12.47% 5.92% 3.15% 11.62% 1.79% 21.38% 4.20% 1.48% 0.81% -0.07% 7.33% -0.46% 1.39% 5.40% 12.22% Std. Dev. 15.84% 15.49% 23.76% 19.74% 0.55% 6.37% 1.68% 1.14% 0.23% 4.07% 7.29% 5.44% 12.24% 19.37% 25.87% Skewness -0.60 -0.50 -0.77 -0.49 0.70 0.49 -0.91 0.23 1.06 -0.45 -0.76 -0.54 1.28 0.18 -0.01 Kurtosis 0.29 0.49 1.98 1.01 -0.69 -0.12 -0.65 -0.99 0.01 0.73 3.45 0.17 4.57 0.31 0.40
See Annex B.1 for more detailed descriptive statistics of the predictive variables and the correlation matrix. In comparison to the returns of the hedge fund indexes seen previously, we can say that our equity-related indexes show in average lower returns and higher volatility. Yet, they are also characterized with lower negative skewness and lower excess kurtosis, which make their return distributions more normal.
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1.4 Methodology
Hereafter are the different steps of our methodology:
Step 1: For each hedge fund index, we select a sub list of explanatory variables or risk
factors. This variable selection is done on the entire sample period (1994-2003) among the predictive variables described in previous section and through one of these criteria:
statistic model: we consider all combination of these variables (k variables give 2k
combinations) and select the one that allows for a good quality of fit and robustness. The explanation power is measured in terms of (in-sample) R-squared4 for single factor models or (in-sample) adjusted R-squared5 for multi-factor models. The robustness is measured by the (in-sample) Chow test6.
economic model: we consider macroeconomic, financial variables and dynamic
trading strategies that are known to have a influence or a predictive power on the 9 hedge fund indices.
Step 2: For each hedge fund index, we analyse several models (starting with linear and
continuing to more and more non-linear models) based on risk factors (starting with one risk factor and continuing with several risk factors). We construct the linear specifications for predicting hedge fund returns that is implied by the different popular asset pricing models. The forecasts generated allow us to study the ability of different asset pricing models to explain the predictable variation in returns.
Step 3: Out-of-sample forecasting: the previous selected models are used to forecast the
future returns of the respective hedge fund indexes. This is done by dynamically calibrating them using a rolling window of 60 data to predict the 61st and the following 60 returns of the respective hedge fund indexes. We thus generate 60 out-of-sample forecasts.
A window of 60 data Yt Xt-1 We predict return in t61 (Y61)
t1
t2
t59 t60 t61
4 R-squared: is defined in terms of variance about the mean of Yt so that if a model is reparameterised and the dependent variable changes, R will change. R take value between 0 and 1: 0 means the model have no explanatory power, the closest to 1 the higher explanatory power. R will always be at least as high for regression with more regressors [Brooks (2002)]. 5 Adjusted R-squared: in order to get around the R problem with more regressors, a modification is often made which takes into account the loss of degrees of freedom associated with adding extra variables [Brooks (2002)]. 6 A Chow test consists of dividing the sample into two part of same duration and computing the error sum of squared residuals for each part. Then a Chow statistic is obtained based on the restricted error sum of squares to test the null hypothesis that there is no structural change using the F-distribution tables [Chow (1960)].
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Step 4: We perform a Tactical Style Allocation based on the forecasts of our hedge fund
index returns (step 3). We use as variances and covariances matrix input the unconditional one (i.e. estimated on the 60-month rolling window range). Practically, we solve 3 different portfolio optimisation problems in order to obtain the allocation (weights) that should be done across the hedge fund styles. Here are our three optimization programs (optimizers):
P1: Maximization of the expected return of the portfolio subject to a variance
constraint (mean-variance approach)
Max Et 1 ( R p )
w1 ,..., wn
subject to and
p = Var ( R p ) = Var ( RBench ) = Bench
w
i =1
= 1 and 0 wi 1
P2: Maximization of the Information Ratio, i.e. the excess return of the portfolio
with respect to a benchmark per unit of tracking error Max Et 1 ( R p RBench ) Var ( R p RBench ) = IRp subject to
w1 ,..., wn
w
i =1
= 1 and 0 wi 1
P3: Maximization of the excess return of the portfolio with respect to a
benchmark, subject to a tracking error constraint of 2%

w1 ,..., wn
Max Et 1 ( R p RBench )
subject to
and
Var ( R p RBench ) TE
w
i =1
= 1 and 0 wi 1
where
Ri wi Rp p RBench Bench
is the return of the ith hedge fund index return is the amount invested in the ith hedge fund index, no short selling allowed
=
w R
i =1 i
is the return of a portfolio invested in each of the
nine hedge fund indexes is the standard deviation of a portfolio invested in the nine hedge fund indexes is the return of a benchmark portfolio defined as an equallyweighted portfolio invested in the nine hedge fund index return is the standard deviation of a benchmark portfolio
Note that we use only mean-variance optimizers in this paper. Another measure of risk would have been more appropriate, especially as we deal with hedge fund returns. However, these
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other measures are either not coherent (Value-at-Risk) or our sample size is too small to give robust results (conditional VaR). Once these optimizations performed, we end up with several optimal TSA portfolios, each of them resulting from the joint use of a particular predictive model (i.e. a particular set of forecasted returns) and a particular portfolio optimizer. For each of optimizer, we use only the historical covariance covariance model. as forecasting we expect Indeed,
Figure 1. Convertible Arbitrage correlation and covariance with respect to other CSFB Hedge Fund indices (rolling windows of 36 months)
covariance to be more stable in the case of hedge funds compared to unmanaged assets (see Figure 1), This stability comes from funds manager who typically have a target level of volatility: dynamic hedge fund strategies adapt to changes in the market environment. For example, Fixed Income Arbitrage managers will reduce leverage when equity index volatility goes up, since equity index volatility is usually associated with spread widening in credit markets.
Step 5: In order to provide some evidence of the economic significance of these predictive
models, we compare the optimum TSA portfolio obtained in Step 4 (4 optimal portfolios, one for each optimization problem) with four benchmarks:
Benchmark 1: an equally-weighted benchmark made of the 9 hedge fund indices i.e.
each month you re-allocate it in order to have the same value (1/9) invested in each Hedge Fund index.
Benchmark 2: a buy-and-hold benchmark made of the 9 hedge fund indices i.e. you
invest 1/9 in each of the Hedge Fund index and do not re-allocate it any more the following periods.
Benchmark 3: a perfect timer, i.e. each month t, you allocate 100% in the Hedge
Fund index that will best perform at t+1. Benchmark 3 returns are the maximum returns you can attend from Hedge Fund indices allocation. 18
Benchmark 4: a global minimum variance portfolio. We use the covariances matrix
based on the historical observations of the entire rolling windows (60 months).
w1 ,..., wn
Min Var ( R p ) = p
subject to
w
i =1
= 1 and 0 wi 1
None of these benchmarks use a predictive model.
Step 6: We evaluate the performance of our different TSA portfolios with our benchmarks. In
doing so, we test the economic significance of our predictive models. In practice, the performance of a tactical asset (or style) allocation strategy is always measured against a (strategic) benchmark portfolio. Similar to the Sharpe ratio, which takes both total return and total risk into account, one typical measure in comparing the performance of different tactical style allocation strategies is the information ratio (see below). Tactical asset/style allocation strategies are strategies that attempt to deliver a positive information ratio by systematic asset/style allocation shifts. So, the higher the information ratio, the better.
The following is a description of the statistics we used: 1. Annualized Mean is the arithmetic mean return of the portfolio invested in the hedge fund indices.
1 Rp = nb obs
nbobs 9
w
t =1 i =1
i ,t
Ri ,t 12
2. Annualized Standard Deviation is the average dispersion of return of the portfolio around the mean. Mathematically speaking it is calculated as the squared root of the average squared deviation from the mean.
nbobs 1 2 p = nb 1 ( R p ,t R p ) 12 t =1 obs
3. Tracking Error evaluates the performance of our portfolio against a benchmark portfolio. Mathematically speaking it is the standard deviation of the returns difference between our portfolio and the benchmark.
TEp =
1 nbobs
(R 1
t =1
nbobs
portfolio
Rtbenchmark ) 2
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4. Information Ratio compares the excess return with its tracking error.
IRp = R p RBench Var ( R p RBench ) = R p RBench TE p
5. Percentage Up is number of time the strategy had a positive return. This gives an intuitive idea if the strategy is often right or not (right side of the distribution). 6. Average Gain is arithmetic mean of the periods with a gain. This gives an intuitive idea of intensity of gain when the strategy is right (size of the right tail of distribution). 7. Average Loss is arithmetic mean of the periods with a loss. This gives an intuitive idea of intensity of loss when the strategy is wrong (size of the left tail of distribution).
8.
Hit Ratio which is the percentage of time that the return on the tactical style
allocation portfolio is greater than the return on the benchmark

9.
Drawdown is the maximum uninterrupted decline in net asset value (in percentage
terms). The drawdown gives an intuitive idea of severity of loss7.
Nevertheless, it should be used with caution. For example, Drawdown will give a poor interpretation if you have big and frequent interrupted losses. That the reason why this performance measure must be used in complement of previous ones.
10. Annualized Turnover is the number of time the portfolio change (in percentage
terms)
1 Turnover = nbobs
nbobs t =1
Max(w w
t
t 1
,0) 12
For a comprehensive description of all these statistics and many more, see Lhabitant (2004)
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1.5 The Predictive Models

The development of a parsimonious factor model that adequately explains, or in our case predicts, hedge fund returns is a great challenge. Since there is no consensus on the best model we estimate different types of predictive models in order to forecast the expected future returns of the hedge fund indexes. They are the predictive versions of popular asset pricing models (conditional asset pricing models). Each of our models are estimated by least square regressions over the period Jan-94 to Dec2003 on each of the 9 CSFB/Tremont hedge fund indexs returns. In the following subsections, we present the models from the simplest form (linear singlefactor model) to a more complex representation (non-linear multi-factor model). Each description of the predictive model is directly followed by an evaluation of their out-ofsample performances in terms of tactical style allocation.
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1.5.1 Linear Single-factor Predictive Models

First of all we analyze linear single factor models. Usually used as the simplest asset-pricing model. A linear single factor model is nothing but a linear regression; with the dependent variable given by the monthly asset return (in our case, a hedge fund index return) and the independent variable is chosen to represent the market, in the classical asset pricing context; in our case, the independent variable is chosen to represent whatever could be the most influent risk factor with respect to the returns in the hedge fund indexes. This approach is justified by the fact that some hedge funds strategies have returns that look linearly related to returns of the market. For example, we found that these returns are positively linearly related to S&P 500 returns in the case of Equity Long/Short and Event-Driven strategies and negatively related to S&P 500 returns for Dedicated Short Bias strategy.
Figure 2. Relation between returns of hedge funds strategies and returns of the market.
The performance of the Short bias strategy (in % per month) vs. US equities (S&P 500, in % per month)
The performance of the Event driven strategy (in % per month) vs. US equities (S&P 500, in % per month)
The performance of the Long/short strategy (in % per month) vs. US equities (S&P 500, in % per month)
We also noticed that some hedge fund indexes display positive serial correlation or persistence (see Figure 3 next page and Appendix A.2 Statistical Summary Table). This is the case for Convertible Arbitrage (1st and 2nd lag), Emerging Market (1st lag), Equity Market Neutral (1st lag), Event-Driven (1st lag) and Fixed Income Arbitrage (1st lag) styles.
22
Figure 3. CSFB/Hedge Fund indexes serial correlation
23
In the next three sections, we study the predictive power of linear single factor models with:

each of the risk factors we have originally selected (see section 1.3) the lagged return of the hedge fund index itself as a predictive variable.
1.5.1.1 Single-factor model
We remember the risk factors we are interested in: S&P 500, MSCI ex US, MSCI Emerging markets, NYSE Volume, term spread, T-bill 3 months, AAA yield, credit spread, Oil, GSCI, Gold, Currency, Frank Russel 2000 and VIX. For each hedge fund index and each of 14 factors, we search for a relationship of the type:
Yt = + Xt-1 + t
where
Yt t
is the explained variable, given by the hedge fund index return at time t, is the error term at time t.
Xt-1 is the explanatory variables given by the risk factor return at time t-1,
In order to estimate the coefficients and , we use the Ordinary Lest Squares (OLS) method, which attempts to minimize the sum of the squared errors. We chose a confidence interval of 5%: we select models with a R of the regression bigger than 5%. In Table 3, we present all the results for the period January 1994 to December 2003: in the first column the risk factor, each column corresponds to a hedge fund index. For each selected models we measure the quality of the regression:

its explanatory power with the R, the significance of the coefficients with the p-value (smaller than 0.05 means the corresponding coefficient is statistically different from 0). It gives the probability that the t-static exceeds the observed sample under the null hypothesis of a zero population value.
For each strategy, we highlight the highest R.
24
The figures in Table 3 do confirm that for the strategies such as:

Emerging Markets, the prevailing factor is the MSCI Emerging Market index which alone explains about 10% of the one-month ahead future returns Event-Driven, the S&P500 index explains about 7.5% of the future returns.
On the other hand, these figures are surprising when it comes to predict strategies such as Convertible Arbitrage, Dedicated Short Bias or Long/short. Indeed,

Convertible Arbitrage expected returns are explained by both oil and commodity prices for about 8% each. Dedicated Short Bias and Long/short strategies do not have any significant single factor despite their known equity market exposures8
In all these cases, the coefficients are statistically different from 0. The results of Table 3 presage that the search of lagged relationships (predictive models) between the returns of hedge fund indexes and the returns of predictive variables will be a more difficult task than the search of contemporaneous relationships (explanatory models). A predictive/forecasting model has to capture the dynamics (cycle, persistence, ) of hedge fund index returns, whereas an explanatory model has only to describe the current level of hedge fund index returns.
The next step of our work is to use these results in forecasting. We proceed as follows: 1. We first select the best risk factor for each hedge fund index. 2. Then, with a rolling window of 60 months, we do an OLS for each hedge fund index and its corresponding chosen risk factor to get the best predictive models 3. We finally use the latter to construct our optimal TSA portfolios and evaluate them by comparing their performances in term of information ratio with those of our two benchmark portfolios. The results are shown and commented in section 1.5.1.4.
We noted, however, significant exposures to the equity market indexes when contemporaneous returns were used.
25
Table 3. Xt-1 Yt
R Oil R VIX R Volume MSCI ex. US R Franck Russel 2000 R T-Bill 3 months Term spread R AAA Credit Spread MSCI Emerging Market R GSCI R Gold Currency 0.0083 (0.0000) 0.1255 (0.0014) 0.0775 0.0070 (0.1228) 0.005 (0.0005) 0.0918 -0.0386 (0.0410) 0.0001 (0.0060) 0.0536 0.0124 (0.0000) -0.0025 (0.0007) 0.0880 -0.0155 (0.0172) 0.0001 (0.0004) 0.0792 0.0071 (0.0286) -0.001 (0.0076) 0.0521 -0.0362 (0.0063) 0.0151 (0.0007) 0.0868 0.0064 (0.0000) -0.0367 (0.0039) 0.0622 CONV. ARBITRAGE SHORT BIAS EMERG. MARKETS EQUITY MKT. NTRL EVENT DRIVEN 0.0082 (0.0000) 0.1085 (0.0016) 0.0750 FIXED INC. ARB GLOBAL MACRO LONG SHORT MANAGED FUTURES
S&P 500
26
1.5.1.2 Single-factor model with own lagged-return
For each hedge fund index we search for a relationship of the type:
Yt = + Yt-1 + t
where
Yt t
is the explained variable given by the hedge fund index return at time t, is the error term at time t.
Yt-1 is the explanatory variables given by the hedge fund index return at time t-1,
The reason is that some hedge fund indexes exhibit significant serial correlation. (see Figure 3). Indeed, managers can smooth portfolio returns when marking illiquid securities using historical prices or whatever they think it is reasonable. This is particularly true for Distressed Securities strategies where the instruments bought are by nature very illiquid. Another cause is that some strategies generate constant stream of cash flows, like coupon payment on bonds or interest earned on the short sale rebate. This is the case for Convertible Arbitrage and Fixed Income Arbitrage strategies. See Appendix A.2 for more on the smooth characteristic of hedge fund index return time series.
In order to approximate the coefficients and , we use the Ordinary Lest Squares (OLS) method, which attempts to minimize the sum of the squared errors.
Table 4.
This table shows all the results for the period January 1994 to December 2003: the estimated coefficients and in brackets their p-value, in all cases with a R bigger than 5%.
Yt-1
R
Yt
CONV. ARBITRAGE 0.0038 (0.0027) 0.5525 (0.0000) 0.2996
DEAD SHORT BIAS
EMERG. MARKETS 0.0042 (0.3520) 0.3004 (0.0007) 0.0852
EQUITY MKT. NTRL 0.0061 (0.0000) 0.2937 (0.0010) 0.0803
EVENT DRIVEN 0.0058 (0.0008) 0.3460 (0.0001) 0.1147
FIXED INC. ARB 0.0033 (0.0029) 0.4044 (0.0000) 0.1570
GLOBAL MACRO
LONG SHORT
MANAGED FUTURES
Our results confirm our previous remark that some strategies are positively serially correlated. In all these cases, the coefficients are statistically different from 0.
27
Like before, the next step of our work is to use these results in forecasting: With a rolling window of 60 months, we do an OLS for each hedge fund index and its own lagged return in order to get the best predictive models for the expected hedge fund index returns. We then use them to construct our optimal TSA portfolios. We finally evaluate them by comparing their performances with those of our two benchmark portfolios. In the case of the 4 indexes for which no predictive model could have been calibrated, we simply use the unconditional expected return as a forecast of the expected return. This allows regressing the return on these indexes on a constant variable (equivalent to taking the mean). The results are shown and commented in section 1.5.1.4.
1.5.1.3 Single-factor model with own lagged-return (moving average)
We now look if there is more predictive power in a moving average of their own lagged returns than just in a one-period lag return. Therefore, for each hedge fund index we search for a relationship of the type: 1 n 1 Yt = + (Yt - 1 + Yt - 2 + + Yt - n ) + = + Yt i + t n i =1 n where Yt is the explained variable given by the hedge fund index return at time t,
Yt-n is the explanatory variables given by a moving average of lagged hedge fund index
returns,
is the error term at time t.
The next step of our work is to use these results in forecasting: With a rolling window of 60 months, we regress each hedge fund index on a moving average of its lagged returns (3-month moving average, 12-month and historical mean of the rolling window) in order to get the best predictive models for the expected hedge fund index returns. We then use them to construct our optimal TSA portfolios. We finally evaluate them by comparing their performances with those of our two benchmark portfolios. In the case of the 3 indexes for which no forecasting model could be calibrated, we simply use the unconditional expected return as a forecast of the expected return. The results are shown and commented in section 1.5.1.4.
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1.5.1.4 Performance of the linear single-factor predictive models
This table gives the TSA portfolios performances resulting from the use of the previous linear single-factor models as the estimators of the expected future returns. The performances are given for a 60-month holding period starting in January 2000 and ending in December 2003.
Table 5. Linear single-factor model performance
Model \ Annualized (in%) Benchmark 1 (Equally) Benchmark 2 (Buy-and-hold) Benchmark 3 (Perfect timer) Benchmark 4 (Minimum variance) Linear model with one regressor X X X Linear model with lagged return X X X Linear model with lagged return
(3-month moving average)
Return 9.72 9.91 57.63 8.97 11.54 11.60 10.83 13.32 19.51 14.56 14.16 16.73 16.00 11.69 9.64 13.97 9.33 11.05 9.57
Standard Deviation 3.29 3.49 10.17 1.79 3.87 3.99 6.67 6.53 11.55 9.58 6.38 10.43 8.82 6.57 11.20 9.64 4.39 3.68 8.64
Track Error1 0.00 0.25 4.65 0.73 1.14 1.13 1.64 1.51 2.97 2.28 1.44 2.66 2.06 1.27 2.66 2.10 0.97 1.15 1.90
Info. Ratio1 n/a 0.75 10.31 -1.03 1.60 1.66 0.68 2.38 3.29 2.12 3.09 2.64 3.05 1.55 -0.03 2.03 -0.40 1.16 -0.08
%Up 85 81 100 95 85 85 66 81 81 73 86 81 83 78 76 73 73 85 59
Average Gain Loss 0.89 0.91 4.80 0.76 1.05 1.07 1.20 1.35 2.02 1.70 1.40 1.79 1.70 1.30 1.51 1.73 0.90 1.02 1.19 -0.08 -0.08 0.00 -0.01 -0.09 -0.10 -0.30 -0.24 -0.39 -0.49 -0.22 -0.39 -0.37 -0.33 -0.70 -0.56 -0.12 -0.10 -0.39
Hit Ratio1 0 59 100 49 61 56 47 53 63 59 69 66 63 63 63 61 39 56 39
Draw Down 2.19 2.47 0.00 0.37 2.88 3.17 5.36 3.60 6.10 5.29 4.24 6.10 5.66 5.06 11.14 9.32 2.52 3.15 8.83
Turn Over 11 10 854 37 603 822 667 679 956 771 385 687 454 216 529 231 213 691 154
Linear model with lagged return


1. with respect to the Benchmark 1 (equally-weighted) Note: This table is computed with OLS_TREMONT_RF2_V12.M program.
P1 P2 P3 X X X X X X X X X
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The above table shows that all the linear single-factor models, except for the one with the moving average on the entire window, outperform clearly our benchmarks with respect to the information ratio. For the linear single-factor models, we note that with respect to the information ratio, the model with lagged hedge fund return has more predictive power than regression on lagged risk factor returns. This again confirms that some strategies exhibit persistence. We see that the 3-month moving average model is the best of the moving average models with respect to the information ratio. Furthermore, this 3-month moving average model clearly outperforms all other linear single-factor models (IR between 2,64 and 3,09). This nave model has a very good predictive power. As we stated previously, some hedge fund managers have to some extent the ability to smooth their portfolio returns. Moreover, some strategies generate constant stream of cash flows (carry). These good results are therefore not so surprising. However, it is very difficult to estimate which part of these results are due to those practices? As far as the turnover is concerned, it is well known that the allocation of an optimal portfolio is very sensitive to inputs and more particularly to estimates of expected future returns. Although efficient frontiers that are based only on recent data will reflect current market conditions more accurately, optimal portfolios will not stay optimal for very long and will require constant rebalancing. This fact is confirmed by our results. Indeed, the longer the moving average, the lower the turnover. Still, the turnover for these 3 programs is very high. The P1 program is in average better than P2 and P3. The diversification of our portfolios is very poor as well. See Appendix C.2 In brief, we note that the 3-month moving average model is the best predictor in term of information ratio. That does not appear to be coherent with respect to the Figure 3 on CSFB/Hedge Fund indexes serial correlation. Yet, in term of predictive power, it turns out that the 3-month moving average model is the best model to capture the smooth characteristics of hedge fund index returns. Unfortunately, this model generate quite high turnover, ranging from 400 to 700% annually. 30
1.5.2 Linear Multi-factor Predictive Models

The previous section concentrated on linear single-factor models. We go now one step further to linear multi-factor models. This new approach is justified by the fact that some hedge funds strategies have returns that are linearly related to more than one risk factor (Figure 4, 5 and 6). We see that these returns are linearly related to S&P 500, MSCI ex. US and Russel 2000 index returns. Then we try to capture the different preferred habitats of hedge funds with different location factors (stocks, bonds, commodities or currencies, domestic or foreign) suggest by Fung and Hsieh (1998a, 1998b). These location factors are typically linearly related to conventional asset classes.
Figure 4. Hedge fund index returns versus S&P 500 index returns
The bars correspond to the market factor monthly returns and the lines to the hedge fund index monthly returns.
The performance of the Short Biased strategy versus S&P500.
The performance of the Event Driven strategy versus S&P500.
The performance of the Long/Short strategy versus S&P500.
Figure 5. Hedge fund index returns versus MSCI ex. US index returns
The performance of the Short Biased strategy versus MSCI ex. US.
The performance of the Event Driven strategy versus MSCI ex. US.
The performance of the long/Short strategy versus MSCI ex. US.
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Figure 6. Hedge fund index returns versus Russel 2000 index returns
The performance of the Short Biased strategy versus RUSSEL 2000.
The performance of the Event Driven strategy versus RUSSEL 2000.
The performance of the Long/Short strategy vs. RUSSEL 2000.
Based on these figures, in next sections we study:
Statistic multi-factor models suggest by Amenc, Bied and Martellini (2002) Economic multi-factor models.
As we did in the previous section about single-factor linear models, we use our results in order to compare performance with respect to our two benchmarks.
1.5.2.1 A statistic multi-factor model: Amenc, Bied and Martellini Model
In this section we use a method developed by Amenc, Bied and Martellini (2002). They built a model for predicting CSFB/Tremont index return over the period January 1994 to December 2000. In order to be able to compare their results with ours, we replicate these models for the period January 1994 to December 2003. They chose 10 risk factors: T-Bill 3-month yield, Dividend yield, Default spread, Term spread, Implicit volatility (VIX), Market volume (NYSE), Oil price, US equity factor (S&P 500), World equity factor (MSCI World Index ex US), Currency factor. From these risk factors, they selected a subset of variables that allows a good trade-off between quality of fit (allowed for at least 5 percent in-sample explanatory power) and robustness (Chow Statistic test). This based on the explanatory power of the:
raw variables : Xi,t, change in variables : Xi,t - Xi,t-1, return of raw variables: (Xi,t/Xi,t-1)-1, one month lag Xi,t-1, two months lag Xi,t-2, three months lag Xi,t-3, moving average (Xi,t-1+ Xi,t-2+Xi,t-3) 1/3.
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They have found the following set of 6 factors that most closely predict the return on hedge fund indexes: The moving average of the return on the S&P 500 over the previous 3 months, denoted as MA(S&P) t-1 Crude oil price, denoted as Oil t-1 Changes in the 3-month Treasury bill rate, denoted as 3m t-1 Changes in the VIX index, denoted as VIX t-1 Market volume, denoted as Vol t-1 The moving average of the return on the MSCI World Index ex US over the previous 3 months, denoted as MA(MSCI)t-1 Then, for each hedge fund index and these 6 factors, they ran the following Generalized Least-Squares regressions (GLS):
Yi,t = i + i,0i,0Yt-1 + i,1i,1MA(S&P)t-1 + i,1i,2Oilt-1 + i,1i,23mt-1 + i,1i,2VIXt-1 + i,1i,2Volt-1 + i,1i,2MA(MSCI)t-1+
Where the coefficient i,k (with i = 1,,9 for the nine indexes and k=1,,7 for the seven variables) take the value 0 when the variable k is not use in the model for index i or otherwise take the value 1. They look for all possible combinations of these variables and keep the model with the highest explanatory power in terms of in the sample R adjusted of regressions of the nine CSFB/Tremont hedge fund indexes.
33
Table 6 gives results of models ( and ) for each hedge fund index with respect to all possible factors and in parentheses their corresponding p-value for the period January 1994 to December 2003.
Table 6. Predictive Models (Amenc, Bied and Martellini method)

Const CONV. ARBITRAGE DEAD SHORT BIAS EMERG. MARKETS EQUITY MKT.NTRL. EVENT DRIVEN FIXED INC. ARB. GLOBAL MACRO LONG/ SHORT MANAGED FTRS -0.0180 (0.2950) 0.0060 (0.0000) -0.0039 (0.5348) -0.0045 (0.2485) -0.0206 (0.1152) 0.3314 (0.0008) 0.3114 (0.0006) 0.2524 (0.0200) 0.3036 (0.0006) 0.2551 (0.0145) 0.1120 (0.0098) 0.2079 (0.1146) 0.0004 (0.1501) 0.0004 (0.0518) 0.0022 (0.0041) -0.0072 (0.2882) -0.0003 (0.3031) -0.7588 (0.1105) 0.0011 (0.1908) 0.0016 (0.2533) 0.0003 (0.2173) -0.1726 (0.0000) -0.0086 (0.0617) Rt-1 0.4008 (0.0000) MA(S&P) t-1 0.1055 (0.0313) Oil t-1 0.0008 (0.0055) 3m t-1 -0.0065 (0.1835) VIX t-1 Vol t-1 -0.1672 (0.3054) MA(MSCI) t-1
They performed out-of-sample testing of their models using a rolling window of 60 months. The Table 7 provides information on the performance of the predictive models for the nine CSFB/Tremont Hedge Fund indexes for the period January 1994 to December 2003.
Table 7. In the sample and Out of sample performance of the predictive models
IN the sample adjusted R CONV. ARBITRAGE DEAD SHORT BIAS EMERG. MARKETS EQUITY MKT.NTRL. EVENT DRIVEN FIXED INC. ARB. GLOBAL MACRO LONG/ SHORT MANAGED FTRS 0.10 0.08 0.14 0.22 0.06 0.34 OUT of sample Hit Ratio 0.85 0.47 0.58 0.92 0.82 0.78 0.56 0.61 0.54
Then, they tested the economic significance of return predictability in terms of overperformance of style allocation models in a static mean-variance framework. They based their
34
tactical style allocation strategies on the conditional expected returns obtained from the predictive models. In the case of the 3 indexes for which no forecasting model could be calibrated (adjusted R < 5%), they simply used the unconditional expected return as a forecast of the expected return. Table 9 gives the results. We replicate the models for the period January 1994 to December 2003 and use an additional portfolio optimisation programs P1. The programs P2 and P3 are identical to those used by Amenc et al. These results are shown and commented in the section 1.5.2.3.
As we can see in these statistical models, oil price is a predictor of convertible and fixed income arbitrage strategy. Does it make sense economically? For the convertible arbitrage strategy for instance, Figure 7 shows that the expected return is mainly explain by: the constant (the non explicative part of the model) and the Oil price. We know that convertible arbitrage strategy exploit pricing anomalies between convertible securities and their underlying equity. If the Oil price has an explanatory power statistically speaking, there is none economically speaking. That is the reason why in the next section we study models based on economic significance and we compare it with these models. So in the next section we do not look for the best combination of all risk factors respect to the explanatory power (R adjusted), but we select some risk factors with respect to their economic significance.
Figure 7. Expected return decomposition for convertible arbitrage strategy.
35
1.5.2.2 An economic multi-factor model
In this section, we search for an economic significance and not statistic one. So we do not look to the best combination of all risk factors with respect to the explanatory power (adjusted R), but we select some risk factors with respect to their known economic significance for each hedge fund style. This selection is presented in the following table.
Table 8. Matrix of economically significant predictable variables for each hedge fund index
MSCI Emerging T-Bill 3-month Default Spread Term Spread GSCI Comm Russel 2000 MSCI World AAA
Gold
S&P
VIX
CONV. ARBITRAGE DEAD SHORT BIAS EMERG. MARKETS EQUITY MKT.NTRL EVENT DRIVEN FIXED INC. ARB GLOBAL MACRO LONG/ SHORT MANAGED FTRS
For each hedge fund index and each of 14 factors, we search for a relationship of the type:
Yt = + 1X1, t-1 + 2X2, t-1 + + nXn, t-1 + t

where
Yt t
is the explained variable at time t, given by the hedge fund index return, is the error term at time t.
Xt-1 is the explanatory variables at time t-1, given by the risk factor return,
Furthermore, in order to be able to compare these economic models with statistic ones seen in the previous section (predictive model of Amenc, Bied and Martellini), we create others models with the same set of risk factors as before to which we add the lagged return of the hedge fund index.
36
Cur
Vol
Oil
This second relationship is then of the type:
Yt = + 0Yt-1 + 1X1, t-1 + 2X2, t-1 + + nXn, t-1 + t

where
Yt
is the explained variable given by the hedge fund index return at time t,
Yt-1 is the explanatory variables given by the hedge fund index return at time t-1, Xt-1 is the explanatory variables given by the risk factor return at time t-1, t
is the error term at time t.
Next step of our work is to use these results in forecasting: Then with a rolling window of 60 months from January 1994 to December 2004, we do an OLS for each hedge fund index and his respective risk factors in order to get the best predictive models for the expected hedge fund index returns. We then use them to construct our optimal TSA portfolios. We finally evaluate them by comparing their performances with those of our two benchmark portfolios. These results are shown and commented in the section 1.5.2.3.
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1.5.2.3 Performance of the linear multi-factor predictive models
This table gives the TSA portfolios performances resulting from the use of the previous linear multi-factor models as the estimators of the expected future returns. The performances are given for a 60-month holding period starting in January 2000 and ending in December 2003.
Table 9. Linear multi-factor models performance
Model \ Annualized (in%) Benchmark 1 (Equally) Benchmark 2 (Buy-and-hold) Benchmark 3 (Perfect timer) Benchmark 4 (Minimum variance) Linear model with lagged return
Return 9.72 9.91 57.63 8.97
Standard Deviation 3.29 3.49 10.17 1.79 6.38 10.43 8.82 3.45 4.10 6.62 4.01 3.94 6.56 5.23 8.52 8.36 5.46 9.01 8.32
Track Error1 0.00 0.25 4.65 0.73 1.44 2.66 2.06 1.02 1.27 1.49 1.09 1.30 1.42 1.22 2.15 1.92 1.32 2.34 1.92
Info. Ratio1 n/a 0.75 10.31 -1.03 3.09 2.64 3.05 2.34 1.36 3.81 2.65 2.55 1.59 0.44 0.02 0.50 0.90 1.06 0.43
%Up 85 81 100 95 86 81 83 92 88 80 85 85 73 78 76 71 81 76 69
Average Gain Loss 0.89 0.91 4.80 0.76 1.40 1.79 1.70 1.05 1.07 1.37 1.16 1.18 1.28 1.10 1.25 1.46 1.19 1.50 1.44 -0.08 -0.08 0.00 -0.01 -0.22 -0.39 -0.37 -0.04 -0.12 -0.09 -0.11 -0.09 -0.29 -0.24 -0.44 -0.57 -0.28 -0.48 -0.56
Hit Ratio1 0 59 100 49 69 66 63 53 49 63 59 59 53 47 51 53 53 51 51
Draw Down 2.19 2.47 0.00 0.37 4.24 6.10 5.66 1.01 3.15 1.94 3.13 3.15 3.15 4.78 6.10 6.04 4.49 6.10 6.36
Turn Over 11 10 854 37 385 687 454 632 934 672 384 594 446 750 975 764 717 892 793
P1 P2 P3 X X X X X X X X X X X X
14.16 16.73 16.00 12.11 11.45 15.39 12.61 13.03 11.98 10.25 9.76 10.68 10.90 12.19 10.55
only as a reference
STATISTIC multi-factor model (Amenc, Bied and Martellini model) without lagged return STATISTIC multi-factor model (Amenc, Bied and Martellini model) with lagged return ECONOMIC multi-factor model without lagged return
ECONOMIC multi-factor model with lagged return
X X X
1.
2.
with respect to the Benchmark 1 (equally-weighted) This table is computed with OLS_TREMONT_V12.M Matlab program for STATISTIC multi-factor models. ECONOMIC multifactor models are computed with OLS_TREMONT_RF2_V12.M Matlab program.
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We find similar results as Amenc, Bied and Martellini when we replicate their models: Information ratios are around 2.5 and 1.5 for P2 and P3 respectively. The above table also shows that all our linear multi-factor models have a higher ex-post information ratio compared to benchmarks. This confirms Amenc, Bied and Martellini results that the superior performance of the Tactical Style Allocation programs relative to the benchmark (equally- and value-weighted) is clear. We see that Statistic models have better predictive power than Economic ones. It is not surprising, since statistic models are customized to be better. But the significance predictive variables are not very clear, as we saw previously. Finally, we note that the predictive power of the multi-factor models is increased when we add the lagged return as a predictive variable. These results are not very surprising when you compare Figures 8 to 12 as the TSA portfolios using these models invest mainly in nondirectional strategies and so, mimic the behaviour of single factor models with 3-month moving average in lagged returns. Non-directional strategies are preferred in the case of our allocation optimization programs, since we chose the variance as risk measure9. The following figures give the average allocation in hedge funds indices for each model (in the case of P1 optimization).
We see that the 3-month moving average model invest mainly (67%) in non-directional strategies: 30% in Convertible arbitrage, 15% in Equity market neutral, 13% in Event driven, 9% in Fixed income arbitrage.
Figure 8. Allocation of 3-month moving average model
9 If we used an alternative measure of risk like the modified VaR which take into account the third and four moments of the return distribution, the preference for this non-directional strategies would be reduced in favour of high skewness and low kurtosis strategies.
39
On another hand, we see that the Statistical model is very sensitive at adding or removing the lagged return term: Without lagged return, 49% is invested in Equity market neutral and 18% in even driven (two nondirectional strategies). With lagged return, 38% is invested in Convertible arbitrage, 34% is invested in Equity market neutral strategy (two non- directional strategies) and 12% is
Figure 9. Allocation of Statistic multifactor models with lagged return Figure 10. Allocation of Statistic multifactor models without lagged return
invested in Long/Short (a directional strategy).
On the contrary, the Economic model is not very sensitive of adding or removing the lagged return.
Figure 11. Allocation of Economic multifactor models with lagged return
Figure 12. Allocation of Economic multifactor models without lagged return
40
This predictive power of hedge fund index lagged returns confirms the results of the previous section. But which part of these multi-factor models comes from the mimic and which part comes from the predictive power of risk factors? Economical model is not very sensitive at adding or removing the lagged return. But the superior performance of this model without lagged return compared to benchmark is not very significant: Information Ratio is between 0.02 and 0.5. As for the turnover, we note again that all the optimization programs give very high value, P2 and P3 programs being the worst as their turnovers stand between 600 and 900 percent. In addition to high turnover, all the TSA portfolios we have seen display very poor diversification (see Appendix C.2). Still, we note that all the multi-factor models do not beat the 3-month moving average singlefactor model as the latter has higher information ratio and final return. On the other hand, the 3-month moving average model has higher standard deviation and tracking error. Knowing that investors are interested in return, this naive model appears to be the best predictive model so far. Also, these same investors will care more about the risk (standard deviation) during periods of bear market. In this case, we can imagine them to switch to multi-factor models in order to mitigate their downside risks.
41
1.5.3 Non-linear Multi-factor Predictive Models

So far, we have only concentrated ourselves on linear models. We go now one step further by discussing non-linear models in our quest to search for the best predictive model. This new approach is justified by the fact that some hedge funds strategies have returns that are not linearly related to returns of risk (Figure 13). We see that these returns are non linearly related to S&P 500 returns in the case of global macro and managed futures strategies and also in the case of global macro non linearly related to our currency index. We also note that the fixed income strategy is non-linearly related to MSCI ex. US (straddle shape).
Figure 13. (in % per month)
The performance of the global macro strategy vs. US equities (S&P 500)
The performance of the global macro strategy vs. currency (major currencies index)
The performance of the fixed income strategy vs. World equities index ex. US (MSCI ex US)
The performance of the managed futures vs. US equities (S&P 500)
The conclusion is that linear factor models of investment styles using standard asset benchmarks, as Sharpe (1992), are not designed to capture the non-linear return features commonly found among hedge funds.
42
Fung and Hsieh (1998a, 1998b) suggest that hedge funds returns are the result of three factors:
Location factors determine where a hedge fund invests on a long-term basis (stocks,
bonds, commodities or currencies, domestic or foreign). They are typically linearly related to conventional asset classes.
Trading strategy factors are the result of the hedge fund managers active decision and
short-term trades (buy-and-hold, long-short, trend-following). They are typically nonlinearly related to location factors and harder to identify.
Leverage decisions may differ between individual location and trading strategy
factors, so that identifying leverage decisions precisely may be quite difficult. Fung and Hsieh (2001a) search across five asset classes (stocks, government bonds, currencies, three month interest rates and commodities) spanning twenty six different markets and found that, during extreme equity market movements, trend followers can be explain by a combination of currencies (deutschemark and Japanese Yen), commodities, three month interest rates and US bonds): preferred habitats. These results are from contemporary data. Fung and Hsiehs approach does not result in a very reliable model. Since we saw the persistence of hedge fund indices returns, we go now one step further and we study in next sections:
Quadratic single factor model, Single factor model as Call or Put payoff,
As we did with the linear models, we use our results in order to compare performance with respect to our two benchmarks.
43
1.5.3.1 Quadratic multi-factor model
The aim of this section is to look for convexity, by searching for each hedge fund index and each of 14 factors a relationship of the type:
Yt = + 1 (Xt-1) + 2(Xt-1) + t
where
Yt t
is the explained variable given by the hedge fund index return at time t, is the error term at time t.
In doing so, we expect to capture the convexity effect or the ability of some Hedge Funds indices (in average, since we work on hedge fund indices), as long-short equity strategies, to time the market. In order to approximate the coefficients , 1 and 2, we use the Ordinary Lest Squares (OLS) method, which attempts to minimize the sum of the squared errors. Next, we measure the quality of the regression:
its explanatory power with the R adjusted significance of coefficients with the p-value.
The performances of these models are shown and commented in the section 1.5.3.3.
44
Table 10.
Xt-1 S&P 500 Yt 1 2 R adj. NaN 1 2 R adj. NaN . 1 2 R adj. . 1 2 R adj. . . 1 2 R adj. . 1 2 1 R adj. NaN . 1 2 R adj. 1 1 R adj. 1 2 R adj. NaN -0.0041 -0.4845 0.7938 0.0083 0.1255 NaN 0.0064 0.2203 NaN 0.0086 0.0381 NaN 0.0087 0.1605 -1.2283 NaN 0.0090 0.0227 -0.6533 NaN -0.0038 0.1774 NaN 0.0084 -0.1622 NaN CONV. ARBITRAGE DEAD SHORT BIAS EMERG. MARKETS EQUITY MKT. NTRL EVENT DRIVEN 0.0082 0.1085 FIXED INC. ARB 0.0079 0.0277 -1.0154 NaN 0.0064 -0.0367 GLOBAL MACRO LONG SHORT MANAGED FUTURES
Oil VIX
NaN 0.0100 -0.0737
NaN
NaN 0.0117 -0.0880
NaN 0.0035 0.0491 0.1150 NaN 0.0007 -0.0461 2.8386 0.0018 -0.1206 1.6431
Volume MSCI ex. US
NaN 0.0018 -0.8191 -4.6338
NaN 0.0038 0.6465
NaN
NaN
NaN
NaN
NaN 0.0088 0.4294
FR2K
0.0022 0.4847
0.0198 0.0352 -1.1127 NaN NaN NaN NaN NaN
T-Bill (3 months) Term spread
NaN
NaN
NaN
NaN 0.0071 -0.1246
AAA
0.0125 -0.2800
0.0054 -0.3197
Credit spread MSCI Emerging Market GSCI
NaN 0.0185 -0.0232 -1.1435
NaN 0.0119 0.2458 -0.4118
NaN
0.0055 0.1549
Gold Currency
NaN
NaN
NaN
NaN
NaN
NaN
NaN
NaN
NaN 0.0018 -0.5001 17.0059
45
1.5.3.2 Non-linear multi-factor model with option-like regressors
A standard mean to control for option-like return features is to add a nonlinear function of factor returns as independent regressors. Using this kind of model, Agarwal and Naik (2001) obtain R values that are dramatically higher than the ones obtained by Fung and Hsieh using Sharpes (1992) asset class factor model. These results tend to prove the importance of including trading in performance evaluation models for hedge funds. The aim of this section is to look for a relationship that incorporates a Call or Put payoff i.e. of the type:
Yt = + 3Xt-1 + 4 Max( Xt-1,0) + t Yt = + 3Xt-1 + 4 Max(-Xt-1,0) + t

where
Yt t
is the explained variable given by the hedge fund index return at time t, is the error term at time t. In doing so, we attend to capture leverage effect (Call payoff) for directional strategy and insurance effect
4
NAVt+1
Re su l
tin gp os iti on
(Put
payoff)
for
non-
directional strategy.
NAVt
In order to approximate the coefficients , 3 and 4, we perform the Ordinary Lest Squares (OLS) method, which attempts to minimize the sum of the squared errors, for each hedge fund index and each of 14 factors.
46
As usual, we measure the quality of the regression:
its explanatory power with the R adjusted significance of coefficients with the p-value.
We present all the results in Table 11 for the period January 1994 to December 2003: We report the estimated coefficients along with their p-value, where the R of the regression is bigger than 5%. For each strategy, we highlight the highest R. Next step of our work is to use these results in forecasting: Then with a rolling window of 60 months from January 1994 to December 2004, we do an OLS for each hedge fund index and his respective risk factors in order to compare the obtained performances with those of our two benchmarks. The results are shown and commented in the section 1.5.3.3.
47
Table 11.
Xt-1 S&P 500 Yt 1 2 3 4 R adj. Oil VIX NaN 1 2 3 4' R adj. Volume MSCI ex. US NaN . 1 2 3 4 FR2K R adj. . 1 2 3 4 T-Bill (3 months) R adj. . 0.2929 NaN NaN NaN NaN NaN NaN 0.0913 NaN 0.1029 (0.3887) 0.4829 0.3132 0.0022 (0.5913) 0.4847 (0.0000) -0.1250 (1.0000) -0.2656 (1.0000) 0.1608 0.0198 (0.0000) 0.0352 (0.3916) -1.1127 (0.0003) 0.2119 NaN 0.0026 (0.5454) -0.8038 (0.0001) 0.1856 NaN 0.0038 (0.3329) 0.6465 (0.0000) 0.3375 NaN -0.1058 (0.0094) 0.1084 NaN 0.0100 (0.0000) 0.0313 (1.0000) -0.1082 (0.0865) 0.1534 NaN 0.0088 (0.0003) 0.4294 (0.0000) 0.0744 Nan 0.0007 (0.8523) -0.0461 (0.5338) 2.8386 (0.0110) 3.5000 (1.0000) -3.5000 (1.0000) 0.0885 NaN -0.0038 (0.3766) 0.1774 (0.0000) CONV. ARBITRAGE DEAD SHORT BIAS -0.0063 (0.4414) -5.0000 (1.0000) EMERG. MARKETS EQUITY MKT. NTRL EVENT DRIVEN 0.0082 (0.0000) 0.1085 (0.0016) FIXED INC. ARB 0.0079 (0.0000) 0.0277 (0.2035) -1.0154 (0.0037) GLOBAL MACRO LONG SHORT MANAGED FUTURES -0.0009 (0.8760) 0.0536 (0.6969)
NaN 0.0084 (0.0176) -0.1622 (0.0000)
NaN
0.0750 NaN 0.0100 (0.0000) -0.0737 (0.0000)
0.0756 NaN 0.0094 (0.0000) 0.0313 (0.0039)
NaN
NaN 0.0168 (0.0001) -0.0170 (0.7093)
0.4585 (0.0567) 0.0646 NaN 0.0035 (0.3164) 0.0491 (0.0788) 0.1150 (0.1669)
NaN
NaN
0.3575 0.0075 (0.0706) 1.5000 (1.000) -1.000 (1.0000) 1.500 (1.0000) 0.2976 NaN
0.0503 -0.0048 (0.3606) -0.4016 (0.0002) 0.5282 (0.0036) 0.1008 NaN
48
Term spread
. 1 2 3 4 R adj. . 1 2 3 R adj.
0.0071 (0.0290) -0.1246 (0.0041)
AAA
0.0125 (0.0001) -0.2800 (0.0043) 0.0607 NaN NaN -0.0041 (0.3023) -0.4845 (0.0000) 0.7938 (0.0535) 0.4827 0.0083 (0.0000) 0.1255 (0.0014) NaN 0.0064 (0.1589) -0.2203 (0.0010) NaN 0.0086 (0.0011) 0.0381 (0.0060) NaN -0.0087 (0.4144) 0.1605 (0.0033) -0.2624 (0.0361) 0.4028 NaN 0.0090 (0.0000) 0.0227 (0.0787) -0.6533 (0.0000) 0.3550 NaN -0.0185 (0.0000) -0.0232 (0.6285) -1.1435 (0.0019) 0.0686 NaN 0.0119 (0.0000) 0.2458 (0.0000) -0.4118 (0.1444) 0.3338
0.0612 0.0054 (0.0874) -0.3197 (0.0014) 0.0768 NaN
Credit spread MSCI Emerging Market
. 1 2 3 4 R adj. 1 2 3 R adj. . 1 2 3 4 R adj. 1 2 3 4 R adj.
0.0817
0.0808
GSCI
0.0055 (0.0887) 0.1549 (0.0076) 0.0521 -0.0037 (0.4479) -0.3212 (0.1159) 0.7540 (0.0093) 0.0662 0.0018 (0.6522) -0.5001 (0.0218) 17.0059 (0.0721) 0.0963
Gold
0.0088 (0.0000) 0.1936 (0.0028) -0.2355 (0.0094) 0.0596
0.0039 (0.3731) -0.1608 (0.3764) 0.5362 (0.0379) 0.0599
Currency
49
1.5.3.3 Performance of the non-linear multi-factor predictive models
This table gives the TSA portfolios performances resulting from the use of the previous non-linear multi-factor models as the estimators of the expected future returns. The performances are given for a 60-month holding period starting in January 2000 and ending in December 2003.
Table 12. Non-linear multi-factor models performance
Model / Annualized (in%) Benchmark 1 (Equally) Benchmark 2 (Buy-and-hold) Benchmark 3 (Perfect timer) Benchmark 4 (Minimum variance) Linear model with lagged return (3-month moving average) Quadratic multi-factor model X X X X X X Multi-factor model with option-like regressors X X X Return 9.72 9.91 57.63 8.97 14.16 16.73 16.00 11.47 13.15 12.83 12.27 14.60 13.77 Standard Deviation 3.29 3.49 10.17 1.79 6.38 10.43 8.82 4.79 5.19 9.03 4.61 5.77 8.75 Track Error1 0.00 0.25 4.65 0.73 1.44 2.66 2.06 0.97 1.57 1.97 0.94 1.70 1.90 Info. Ratio1 n/a 0.75 10.31 -1.03 3.09 2.64 3.05 1.80 2.18 1.58 2.72 2.87 2.14 %Up 85 81 100 95 87 81 83 78 88 69 80 86 68 Average Gain Loss 0.89 0.91 4.80 0.76 1.40 1.79 1.70 1.11 1.22 1.51 1.15 1.35 1.55 -0.08 -0.08 0.00 -0.01 -0.22 -0.39 -0.37 -0.16 -0.12 -0.44 -0.13 -0.13 -0.40 Hit Ratio1 0 59 100 49 69 66 63 53 59 47 56 61 47 Draw Down 2.19 2.47 0.00 0.37 4.24 6.10 5.66 2.16 3.15 7.96 2.31 3.15 7.07 Turn Over 11 10 854 37 385 687 454 613 955 681 663 992 719 P1 P2 P3
only as a reference
1. Respect to the Benchmark 1 (equally-weighted) Note: This table is computed with OLS_TREMONT_RF2_V12.M program.
50
Multi-factor models with option-like regressors clearly outperform the benchmarks and most of the others non-linear models with respect to the information ratio. Theses non-linear multi-factor models outperform clearly the benchmarks and the linear multi-factor models with respect to the information ratio. The multi-factor model with optionlike regressors has the highest information ratio and therefore, shows a good predictive power. In a theoretic world (with no re-balancing costs, etc), the non-linear multi factors models confirm the superior performance of the Tactical Style Allocation programs compared to the benchmarks, which do not use such predictive models. Nevertheless, we saw previously that the multi-factor model with option-like regressors uses persistence in hedge fund returns. And therefore, it is identical to the linear single factor models. But the 3-month moving average linear single-factor model is still our best model since its information ratio is higher (higher than 3). We also note that optimization programs for all models have again very high turnover, between 600 and 900 percent. In addition to high turnover, all the TSA portfolios we have seen display very poor diversification (see Appendix C.2). In brief, the non-linear multi-factor models with option-like regressors have a good predictive power in term of information ratio, but still the nave linear single-factor model on the 3-month moving average in own returns remains superior.
51
2 A Practical Application: TSA in Fund of Hedge Funds

In this second part, our goal is to try to implement a realistic tactical style allocation strategy based on our findings relative to the evidence of return predictability in hedge fund indexes. This strategy could be set up by fund of hedge funds (FoHF) managers or even more by multi-strategy managers as the latter can more freely reallocate funds among the different styles at his disposal. In the case of fund of hedge funds, portfolio reallocation is subject to numerous operational constraints such as minimum investments, lock-up periods or redemption notification, sales and early redemption fees to cite a few of them. In our attempt to set up a realistic tactical style allocation, we also have to deal with two important points that characterize the TSA portfolios computed in part 1 and which is the direct consequence of the use of mean-variance optimization programs, that is:

the turnover of the TSA portfolios are too high, and the diversification of the TSA portfolios are too poor
Indeed, we have shown in the first part of our paper that the annual turnovers of most of our TSA portfolios range from 400% to 700% and that their allocation most often exhibits a concentration in a single investment style of more than 60%. All that is making them practically impossible to be implemented in the real world. Having said that, the hedge fund industry is currently experiencing a profound mutation
as institutional investors, including pension funds and endowments, are showing a growing interest in exploring the role of hedge funds in their strategic asset allocation, and as the emergence of investable hedge fund indexes has given more flexibility (high level of liquidity) in hedge funds investing.
These two current trends are beneficial for the future of hedge fund style timing.
52
In the following subsection, we will incorporate these two types of constraints, that is:

those inherent to hedge funds (redemption notification), and those inherent to mean-variance optimization (turnover and diversification)
We will see if our TSA portfolios using our predictive models still give good results in term of information ratio. We will only use the perspective of a fund of hedge funds manager and thus ignoring the case of a multi-strategy manager.
2.1 Operational Constraint: Redemption Notification

First, we will take into account the operational constraint inherent to hedge fund investment, i.e. the redemption notification. We will assume that hedge funds offer monthly redemption and that the notice period range from one day to a month. Before going further, we have to precise that the optimal portfolio weights we computed via our optimization programs in the first part of this paper concern the next month (t+1). Unfortunately, hedge fund index performances are only published around the middle of each subsequent month, it means that we cannot take our investment/disinvestment (subscription/redemption) decision at the end of the month (t) for allocation in month t+1, but we have to wait until the middle of the next month (t+1) to take the decision to invest in month t+2 or t+3 depending on the redemption notification period. Indeed, if the notification period is less than 15 days we can invest in t+2, in the other case we can only invest in t+3. That means that we are forced to use the portfolio weights calculated for t+1 (wt+1) to do our reallocation at t+2 or t+3 (see Appendix C.1 phase 4). In the table below, we show how our TSA portfolios perform with respect to the benchmark when our optimal portfolio weights (wt+1) are applied successively to the actual returns of the month t+2 (Rt+2) and t+3 (Rt+3). Our comments follow just afterwards.
53
Table 13. Performance of our TSA portfolios with operational constraints (investment in month t+2 and t+3)
Model \ Annualized (in%) Benchmark 1 (Equally) Benchmark 2 (Buy-and-hold) Benchmark 3 (Perfect timer) Benchmark 4 (Minimum variance) Return 9.72 9.91 57.63 8.97 Standard Deviation 3.29 3.49 10.17 1.79 Track Error1 0.00 0.25 4.65 0.73 Info. Ratio1 n/a 0.75 10.31 -1.03 %Up 85 81 100 95 Average Gain Loss 0.89 0.91 4.80 0.76 -0.08 -0.08 0.00 -0.01 Hit Ratio1 0 59 100 49 Draw Down 2.19 2.47 0.00 0.37 Turn Over 11 10 854 37 P1 P2 P3 X X X X X X X X X
Investment in month t+1

14.16 16.73 16.00 12.61 13.03 11.98 10.90 12.19 10.55
6.38 10.43 8.82 4.01 3.94 6.56 5.46 9.01 8.32
1.44 2.66 2.06 1.09 1.30 1.42 1.32 2.34 1.92
3.09 2.64 3.05 2.65 2.55 1.59 0.90 1.06 0.43
87 81 83 85 85 73 81 76 69
1.40 1.79 1.70 1.16 1.18 1.28 1.19 1.50 1.44
-0.22 -0.39 -0.37 -0.11 -0.09 -0.29 -0.28 -0.48 -0.56
69 66 63 59 59 53 53 51 51
4.24 6.10 5.66 3.13 3.15 3.15 4.49 6.10 6.36
385 687 454 384 594 446 717 892 793
STATISTIC multi-factor model (Amenc, Bied and Martellini model) with lagged return ECONOMIC multi-factor model with lagged return
only as a reference

X X X X X X X X X
9.8 10.22 10.56 11.78 12.07 11.49 11.42 11.81 11.37
6.1 9.35 7.58 4.29 4.24 7 6.29 8.77 9.09
1.25 2.19 1.68 1.06 1.17 1.53 1.25 1.91 1.96
0.06 0.23 0.5 1.95 2.01 1.15 1.36 1.1 1.35
76 78 76 85 83 66 81 76 73
1.17 1.39 1.35 1.08 1.13 1.23 1.28 1.44 1.71
-0.35 -0.54 -0.47 -0.1 -0.13 -0.27 -0.33 -0.45 -0.52
61 56 61 56 56 46 61 54 61
8.72 11.14 9.08 3.14 3.17 3.92 8.92 11.14 10.05
392 687 464 383 594 475 729 912 801
54
Model \ Annualized (in%)
Return
Standard Deviation
Track Error1
Info. Ratio1
%Up
Average Gain Loss
Hit Ratio1
Draw Down
Turn Over

P1 P2 P3 X X X X X X X X X
7.91 10.57 9.2 11.56 11.54 10.96 7.24 5.73 6.73
6.34 10.24 8.24 4.36 3.32 7.3 6.24 8.78 9.07
1.49 2.56 1.98 1.10 1.16 1.51 1.25 2.19 1.97
-1.21 0.33 -0.26 1.67 1.57 0.82 -1.98 -1.82 -1.52
73 76 66 81 83 61 63 68 56
1.05 1.51 1.3 1.08 1 1.23 0.95 1.14 1.18
-0.39 -0.63 -0.53 -0.07 -0.04 -0.23 -0.35 -0.66 -0.62
54 63 56 61 53 53 46 46 47
9.7 11.09 11.08 1.66 1.63 3.82 6.53 10.65 10.72
391 666 463 379 574 474 724 912 783
STATISTIC multi-factor model (Amenc, Bied and Martellini model) with lagged return ECONOMIC multi-factor model with lagged return 1.
with respect to the Benchmark 1 (equally-weighted)
55
The above results are quite surprising. First, our 3-month moving average model, which was previously awarded as our preferred model in term of information ratio, exhibits a dramatic decrease in performance when the reallocation is made at t+2 and t+3. On the other hand, the statistic multi-factor model, which was previously seen as inferior, proves to be more resilient. It also becomes our best model with respect to the information ratio. With a reallocation made in the month t+3, this latter stands well above 1, while our 3-month moving average model is close to zero or even negative. As for the economic multi-factor model, its information ratio is also decreasing steadily and becomes negative when the reallocation is made at t+3. It turns out to be very difficult to explain why the performance of our statistic multi-factor model does not deteriorate like all the other models when we reallocate at t+2 and t+3.
2.2 Investment Constraint: Turnover and Diversification

It is well known that the allocation of an optimal portfolio is very sensitive to inputs and more particularly to estimates of expected future returns. Optimal portfolios will not stay optimal for very long and will require constant rebalancing as the current market conditions change, incurring significant costs. This fact has been clearly shown in the first part of our paper where the annual turnover stands between 400% and 700% for our preferred models. In addition to that, we have also revealed the poor diversification that characterized our optimal portfolios (see Appendix C.2). One way to diminish these two phenomenons is to set constraints in the portfolio weights. So, we keep the non-negativity constraints and put some upper bound constraints in place. An upper weight constraint of 20% seems appropriate since it will force our optimal portfolios to invest in more than five different strategies, which is a typical rule in fund investing.
56
Table 14. Performance of our TSA portfolios with upper weight constraint of 20%
Model \ Annualized (in%) Benchmark 1 (Equally) Benchmark 2 (Buy-and-hold) Benchmark 3 (Perfect timer) Benchmark 4 (Minimum variance) Return 9.72 9.91 57.63 8.97 Standard Deviation 3.29 3.49 10.17 1.79 Track Error1 0.00 0.25 4.65 0.73 Info. Ratio1 n/a 0.75 10.31 -1.03 %Up 85 81 100 95 Average Gain Loss 0.89 0.91 4.80 0.76 -0.08 -0.08 0.00 -0.01 Hit Ratio1 0 59 100 49 Draw Down 2.19 2.47 0.00 0.37 Turn Over 11 10 854 37 P1 P2 P3 X X X X X X X X X
Without any upper weight constraint

14.16 16.73 16.00 12.61 13.03 11.98 10.90 12.19 10.55
6.38 10.43 8.82 4.01 3.94 6.56 5.46 9.01 8.32
1.44 2.66 2.06 1.09 1.30 1.42 1.32 2.34 1.92
3.09 2.64 3.05 2.65 2.55 1.59 0.90 1.06 0.43
87 81 83 85 85 73 81 76 69
1.40 1.79 1.70 1.16 1.18 1.28 1.19 1.50 1.44
-0.22 -0.39 -0.37 -0.11 -0.09 -0.29 -0.28 -0.48 -0.56
69 66 63 59 59 53 53 51 51
4.24 6.10 5.66 3.13 3.15 3.15 4.49 6.10 6.36
385 687 454 384 594 446 717 892 793
only as a reference
With upper weight constraint of 20%

Benchmark 4 (Minimum variance) Linear model with lagged return
8.48 X X X X X X X X X 11.81 13.46 12.9 11.23 11.12 11.69 10.92 10.06 11.57
2.68 4.13 4.9 5.99 3.6 4.35 5.66 3.96 4.01 5.26
0.57 0.67 0.92 1.09 0.52 0.96 1.08 0.7 0.66 0.93
-2.17 3.14 4.08 2.91 2.93 1.47 1.83 1.72 0.51 1.99
85 83 85 75 86 76 80 81 78 80
0.8 1.09 1.24 1.28 1.02 1.05 1.15 1.01 0.95 1.11
-0.1 -0.11 -0.12 -0.2 -0.08 -0.12 -0.17 -0.1 -0.11 -0.14
44 66 71 61 63 58 56 63 56 58
1.92 1.55 2.39 2.39 1.03 2.45 3.2 1.89 1.64 1.97
26 206 446 205 280 262 253 389 428 424
STATISTIC multi-factor model (Amenc, Bied and Martellini model) with lagged return ECONOMIC multi-factor model with lagged return 1.
with respect to the Benchmark 1 (equally-weighted)
57
The first thing we note when we add upper weight constraint to our portfolio is that their tracking errors are significantly reduced. It seems logical as their allocations are now bound to be closer from our equally-weighted benchmark portfolio. Also, their returns are reduced. These two trends have opposing effect on the information ratio. Therefore, the final result in term of information ratio depends on their relative changes. The table 14 shows that the performances of our portfolios are more or less unchanged as the two mentioned trends compensate each other. On the other hand, the turnovers of our portfolios are substantially reduced (-200% annually). Naturally, the diversification is also greatly improved (see Appendix C.3). So, we can conclude that the setting of upper weight constraints is benefic since it does not seem to deteriorate the information ratio of our optimal portfolios Also, Alexander (2001) suggests common methods for lowering the turnover and thus cutting rebalancing costs. That includes:
using very long-term averages to construct covariance matrix and mean returns, so that the efficient frontier becomes more stable over time assigning current portfolio weights as a weighted average of current and past optimal allocations. This has the effect of smoothing allocations over time, but the resulting portfolio may be far from optimal because it may not respond enough to current market conditions.
setting rebalancing limits so that allocations are changed only if the weights recommended by the optimal portfolio exceed them. Depending on the range of these limits, which is an arbitrary choice, turnover can be substantially reduced, but then portfolios may be far from optimal.
using strong priors for the mean returns doing a limited amount of rebalancing in the direction indicated by the latest meanvariance analysis.
Lhabitant (2004) argue this way of doing and instead encourage the selection of another objective function (as opposed to a function of mean and variance) rather than setting any sort of subjective constraints. He suggests among other things to use an objective function
58
incorporating the third and fourth moments of hedge fund returns distribution, as they are quite important for these instruments, contrary to the traditional products. In conclusion, we can affirm that hedge fund portfolio management is more an art than a science! It is currently one of the more challenging problems facing academics and practitioners.
3 Conclusion
In this paper, we extend the empirical analysis of Amenc, Bied and Martellini (2002) and implement several types of factor models to analyze the sample evidence on return predictability of hedge fund indexes. We assessed the out-of-sample performance of optimal portfolios using mean-variance optimization programs and found similar results with the Amenc paper as far as the information ratio (relative to an equally-weighted index of all funds) was concerned. However, other predictive models proved to be as or even more successful. But more informative was the fact that a nave model turned out to be our best model. Indeed, a predictive model based solely on the 3-month moving average of the corresponding hedge fund index lagged returns produced quite outstanding results, stressing the fact that predictability in hedge fund index returns is in fact more the result of persistence in hedge fund index performance.
Finally, taking into account the operational/investment constraints which characterize hedge fund investing, such as redemption notification, the performance ranking of our predictive models are altered and a statistic multi-factor model turns out to be our model of choice.
59
Appendix A. Hedge Fund Index Data

A.1 Hedge Fund Classification
In our quest to have a basic understanding of the hedge fund strategies and their differences, we first use a box-and-whiskers plot10.
Two broad and distinctive sets of hedge funds can be clearly seen from this graphical representation of the return time series. The non-directional set which includes the first style as well as the three in the middle. These styles have in common a relatively small interquartile range (or volatility) compares to the five others, which form the directional set11. From these two sets, we still have to divide each of them by two in order to end up with four distinct main strategies (Lhabitant, 2004): Non-directional: 1) Relative value arbitrage strategies 2) Event-driven strategies Directional: 3) Equity long/short strategies 4) Tactical trading strategies => => => => HF1 HF5 HF2 HF7 HF4 HF3 HF9 HF6 HF8
10
A box-and-whiskers plot has several graphic elements: The lower and upper lines of the "box" are the 25th and 75th percentiles of the sample. The distance between the top and bottom of the box is the interquartile range. The line in the middle of the box is the sample median. If the median is not centered in the box, that is an indication of skewness. The "whiskers" are lines extending above and below the box. They show the extent of the rest of the sample (unless there are outliers). Assuming no outliers, the maximum of the sample is the top of the upper whisker. The minimum of the sample is the bottom of the lower whisker. Here, an outlier is a value that is more than 2.5 times the interquartile range away from the top or bottom of the box. The plus sign at the top of the plot is an indication of an outlier in the data. See Appendix A.2 for further justification of this classification (the drawdown plot for instance)
11
60
1) RELATIVE VALUE STRATEGIES
These types of strategies seek to capitalize on relative pricing discrepancies between related financial securities or between different markets. They fall under the non-directional category as they mostly target spreads. These strategies bet that two securities or market prices will converge over time. Historically, relative value strategies have been characterized by low exposure to market risk and moderate and stable returns and as such can be seen as Risk Reducers (Amenc et al., 2002a). We distinguish three types of relative value strategies:
Convertible Arbitrage (HF1) style seeks to exploit pricing anomalies between convertible
securities (convertible bonds, warrants, convertible preferred stocks) and their underlying equity (stock). Convertible securities tends to be underpriced because of market segmentation; investors discount securities that are likely to change types: if issuer does well, convertible bond behaves like a stock; if issuer does poorly, convertible bond behaves like distressed debt. Managers typically buy (or sometimes sell) these securities and then hedge part of or all of associated risks by shorting the underlying stock of the issuing firm. Delta neutrality is often targeted. Over-hedging is appropriate when there is concern about default as the excess short position may partially hedge against a reduction in credit quality. The delta neutral position profits from any increase in volatility, the position being typically long volatility or long gamma. TASS divides returns into two components: Static returns = Coupon payment on the bond + interest earned on the short sale rebate dividend on the stock sold. Volatile returns stem from the adjustments of the delta hedge over time. Profits are magnified through the use of leverage (up to 8:1).
Equity Market Neutral (HF4) style (also referred to as statistical arbitrage), seeks to exploit
pricing inefficiencies between related equity securities while at the same time exactly neutralizing exposure to market risk, usually on an equal dollar or zero beta basis. Mean reversion is the dominating idea here: stocks that are expected to converge up as they are valued below the mean are held long and those that are expected to converge down are sold short. Leverage is used to magnify profits.
Fixed-Income Arbitrage (HF6) style encompasses a wide range of strategies that seek to
exploit pricing anomalies within and across global fixed income markets. Typical strategies are yield curve arbitrage, sovereign debt arbitrage, corporate versus government yield spreads, municipal bond versus Treasury yield spreads, cash versus futures (basis trading) 61
and mortgage-backed securities arbitrage. Managers often use futures to hedge out interest rate risk. In general, interest rate risk, foreign exchange risk and inter-market spread risk are hedged, yielding a non-directional, low volatility strategy with steady returns. Leverage (up to 15:1) is used to magnify profits, as spreads tend to be very small (3 to 20 basis points). Fung and Hsieh (1999) find that fixed income arbitrage funds in particular and arbitrage funds in general are short volatility, i.e. they perform best in calm markets and worst in volatile markets.
2) EVENT-DRIVEN STRATEGIES (HF5)
These types of strategies seek to exploit opportunities due to extraordinary situations or significant corporate restructuring events. These events include spin-offs, mergers and acquisitions, liquidations, bankruptcy reorganizations, re-capitalization and share buybacks. All trades depend on heavy fundamental analysis, as deep understanding of the corporation and all the issues surrounding it is necessary. Amenc, Martellini and Vaissi (2002) characterize event driven strategies as return enhancers as they are highly correlated with the market and offer high risk-adjusted returns. These strategies are long term in nature and thus have long redemption periods. We identify two predominant styles in this category:
Merger Arbitrage style (also referred to as risk arbitrage) involves investments in event-
driven situation that include a merger or acquisition, including leverage buyouts, mergers and hostile takeovers. A typical trade is to buy the stock of the company being acquired while shorting the stock of the acquirer. The most important risk is deal breakage after the announcement. Merger arbitrage strategies have to be supported by an accommodating regulatory environment, low interest rates and a stable steady economy. This makes them highly cyclical. In addition, a low amount of merger activity hinders the construction of a welldiversified portfolio and narrow spreads fail to compensate for losses resulting from failed transactions.
Distressed Securities funds focus on debt or equity of companies that are, or are expected to
be, in financial or operational difficulty. The securities of such companies generally trade at substantial discounts. The managers take on credit and liquidity risk, and wait for the
62
securities to appreciate in value after a restructuring is complete. Here also, the most important risk is that the restructuring fails. They try to capitalize on two types of misspricing: first, the fundamental value, which is the actual value of the companys bond and second, the relative value which is the value of the bond with respect to that of other securities in the same company, a strategy referred to as intra capitalization or capital structure arbitrage (Ineichen 2002).
3) EQUITY LONG/SHORT STRATEGIES
These strategies invest in equities, and combine long investments with short sales to reduce but not eliminate market exposure. As they are exposed to market fluctuations, they exhibit lower risk-adjusted returns. They seek to exploit market opportunities. We will identify long/short equity, short sellers, emerging markets and sector fund. We distinguish three types of equity long/short strategies:
Dedicated Short (HF2) style seeks to exploit an anticipated fall in securities market prices.
They also profit from the interest earned on the cash proceeds from the short sale. This style is viewed as a pure risk diversifier.
Equity long/short (HF8) style attempts to profit from misspricing in the market by holding
undervalued securities and selling short overvalued ones, thus doubling the alpha. It is by far the most popular strategy (a third of the industry in 2003). It can concentrate on a specific region, sector or market capitalization. It takes advantage of the hedge fund managers ability to sell short, a matter still restricted to many traditional long only managers. Returns also arise from the interest earned on the cash proceeds from the short sale. Leverage can be used to amplify returns. This strategy also has a variable beta: it can be either net long, net short or neutral to the market. It is sometimes hedged using index futures.
Emerging Markets (HF3) style seeks to take advantage of opportunities in all types of
securities (equities, corporate bonds, sovereign debt, ) in the less efficient emerging markets, usually located in Latin America, Eastern Europe, the former Soviet Union, parts of Asia and Africa. It is mostly on the long side, as short selling is restricted and the use of derivative products with which to hedge is rarely possible. Local bonds are usually below investment grade. Emerging markets are characterized with high volatility and low correlation with developed markets.
63
4) TACTICAL TRADING STRATEGIES
They refer to strategies that speculate on the direction of market prices of currencies, commodities, equities and/or bonds on a systematic or discretionary basis. We distinguish two predominant styles:
Global Macro (HF7) managers tend to make leveraged, directional, opportunistic
investments in global currency, commodity, equity and bond markets on a discretionary basis. Macro managers use a top down global approach. Derivatives are used to accentuate the impact of market moves. There are no limitations in country, sector or type of instrument traded, as flexibility is the name of the game. The key here is timing the market not necessarily exploiting market inefficiencies. It falls under the directional strategies and return enhancers category. Returns can be very high but are also very volatile, occasional sudden falls have been known to occur.
Managed Futures/CTAs (HF9) managers primarily trade in listed financial and commodity
futures market and currency markets around the world. These markets are the most liquid in the world, allowing managers to adjust their risk profile almost continuously. As with global macro managers, they are by no means homogeneous, but are usually split in two groups: Systematic traders. They identify price trends through the use of technical trading methods and try to capitalize on such opportunities using futures positions, with stop losses in place. They mainly rely on quantitative models. Discretionary traders. In contrast, they base their trading decisions on fundamental and technical analysis, as well as on their experience and trading skills developed over the years.
64
A.2 Summary Statistics of Hedge Fund Index Returns

Asness et al. (2001) warn the investors to be cautious when analyzing monthly returns as the presence of stale prices due to either illiquidity or managed pricing can artificially reduce estimates of volatility, and correlation with traditional indexes (market exposure). In a table below, we show different statistics using either the smoothed (original) or the unsmoothed data series. We could have unsmoothed the serially correlated return series for the computation of the variances and covariances matrix when it is used as input for portfolio optimization (see step 4 in section 1.4).
65
Statistical Summary of Tremont Hedge Fund Indexes Returns (1994-2003)

(Annualized Figures) CONV. ARB mean (arithmetic) mean (geometric) median avg monthly gain avg monthly loss gain-to-loss ratio % of winning months volatility skewness kurtosis JB test (p-value) AC(1) AC(2) AC(3) AC(4) AC(5) LB-Q test (p-value) Sharpe Ratio (rf = 4%) Maximum Drawdown Drawdown Beta (MSCI World) 1-month VaR (99%)1 1-month mVaR (99%)1
1
SHORT BIAS -1.64 -3.17 -4.87 66.05 -37.03 1.14 45.00 18.02 0.92 2.15 0.00 0.10 -0.04 -0.01 -0.08 -0.10 0.51 -0.31 43.64 30.34 -0.92 -43.56 -34.70
EMERG. EQUITY EVENT MARKETS MKT.NTRL DRIVEN 8.81 7.10 14.98 57.52 -37.66 1.00 59.17 17.76 -0.58 3.71 0.00 0.30 0.02 -0.01 -0.06 -0.08 0.02 0.27 45.15 28.73 0.67 -32.51 -53.25 10.70 10.65 10.16 14.00 -5.42 2.37 84.17 3.07 0.21 0.24 0.63 0.29 0.20 0.10 0.03 0.06 0.00 2.18 3.55 3.55 0.08 3.56 3.92 11.60 11.40 13.42 19.32 -14.91 1.11 80.00 6.04 -3.46 22.95 0.00 0.35 0.15 0.04 0.01 -0.02 0.00 1.26 16.04 14.38 0.24 -2.44 -23.02
FIXED INC. ARB 6.89 6.80 9.71 12.05 -13.59 0.79 81.67 3.95 -3.25 16.61 0.00 0.40 0.09 0.02 0.07 -0.01 0.00 0.73 12.47 11.75 0.01 -2.30 -11.35
GLOBAL MACRO 15.31 14.49 15.73 38.99 -27.64 1.05 70.83 12.12 -0.04 1.98 0.00 0.05 0.04 0.08 -0.09 0.23 0.11 0.93 26.78 21.00 0.16 -12.87 -18.81
LONG SHORT 12.82 12.16 10.10 35.26 -22.17 1.23 66.67 11.00 0.22 3.35 0.00 0.16 0.06 -0.05 -0.08 -0.17 0.10 0.80 15.05 14.21 0.46 -12.77 -19.43
MANAGED VALUE EQUALLY FUTURES WEIGHTED WEIGHTED 7.86 7.08 2.61 41.83 -24.40 1.28 55.83 12.14 0.03 0.58 0.61 0.04 -0.12 -0.01 -0.01 -0.01 0.87 0.32 17.74 10.84 -0.15 -20.38 -21.77 11.50 11.11 10.23 26.66 -18.65 1.17 70.83 8.48 0.08 1.73 0.00 0.11 0.04 -0.01 -0.08 0.05 0.72 0.88 13.81 13.81 0.28 -8.23 -11.14 9.13 9.04 9.53 15.39 -10.12 1.36 77.50 4.21 -0.04 0.85 0.29 0.19 0.06 0.03 -0.06 0.11 0.23 1.22 7.12 7.12 0.07 -0.66 -1.63
10.61 10.49 14.30 17.45 -15.63 0.96 81.67 4.78 -1.57 4.06 0.00 0.55 0.40 0.13 0.12 0.07 0.00 1.38 12.04 12.04 0.04 -0.50 -6.11
these figures are not annualized
66
Statistical Summary of UNSMOOTHED Tremont Hedge Fund Indexes Returns (1994-2003)

(Annualized Figures) CONV. ARB mean (arithmetic) mean (geometric) median avg monthly gain avg monthly loss gain-to-loss ratio % of winning months volatility skewness kurtosis JB test (p-value) AC(1) AC(2) AC(3) AC(4) AC(5) LB-Q test (p-value) Sharpe Ratio (rf = 4%) Maximum Drawdown Drawdown Beta (MSCI World) 1-month VaR (99%)1 1-month mVaR (99%)1
1
SHORT BIAS -1.66 -3.52 -5.54 73.49 -41.46 1.08 46.67 19.83 0.89 2.02 0.00 0.01 -0.05 0.00 -0.07 -0.10 0.74 -0.29 45.88 31.84 -1.02 -47.79 -38.14
EMERG. EQUITY EVENT MARKETS MKT.NTRL DRIVEN 8.49 5.31 14.68 82.09 -48.14 0.96 57.50 23.99 -0.83 4.19 0.00 0.03 -0.07 0.01 -0.05 -0.04 0.92 0.19 50.85 33.40 0.99 -47.31 -79.21 10.77 10.68 10.98 16.41 -8.19 1.80 79.17 4.13 0.13 0.85 0.25 -0.04 0.10 0.04 -0.02 0.06 0.76 1.64 3.96 3.96 0.11 1.16 0.75 11.47 11.05 14.47 25.98 -17.57 1.22 70.83 8.60 -3.82 27.59 0.00 -0.01 0.05 -0.01 0.01 -0.02 1.00 0.87 20.06 18.01 0.37 -8.52 -40.98
FIXED INC. ARB 6.85 6.65 10.33 15.87 -18.55 0.73 76.67 6.05 -1.71 9.87 0.00 0.04 -0.08 -0.05 0.09 -0.01 0.70 0.47 17.68 16.33 0.05 -7.23 -22.14
GLOBAL MACRO 15.32 14.41 15.66 42.25 -28.93 1.06 69.17 12.78 -0.04 1.84 0.00 0.00 0.03 0.09 -0.11 0.24 0.08 0.89 27.05 21.18 0.17 -14.40 -20.25
LONG SHORT 12.85 11.93 10.26 41.72 -26.85 1.15 65.00 12.96 0.15 2.91 0.00 0.00 0.04 -0.05 -0.05 -0.19 0.30 0.68 17.79 16.78 0.54 -17.31 -24.56
MANAGED VALUE EQUALLY FUTURES WEIGHTED WEIGHTED 7.88 7.04 3.48 44.99 -25.49 1.30 55.00 12.59 -0.02 0.59 0.59 0.01 -0.12 -0.01 -0.01 -0.01 0.89 0.31 18.09 11.00 -0.15 -21.42 -23.31 11.52 11.03 9.54 32.16 -19.11 1.34 65.00 9.51 0.02 1.52 0.01 0.00 0.02 0.00 -0.08 0.07 0.91 0.79 14.50 14.50 0.31 -10.60 -13.80 9.12 8.98 10.82 19.38 -11.65 1.45 70.00 5.10 -0.13 0.47 0.62 0.00 0.02 0.04 -0.09 0.13 0.63 1.00 7.85 7.85 0.09 -2.75 -3.78
10.66 10.23 14.44 26.18 -21.14 1.00 71.67 8.89 -1.01 5.74 0.00 -0.08 0.21 -0.18 0.07 0.04 0.05 0.75 18.13 18.00 0.12 -10.02 -25.13
these figures are not annualized
67
CSFB/Tremont Hedge Fund Indices Correlation Matrix (1994-2003)

This table shows the correlation coefficients between all the predictive variables used in this paper. The figures come from the monthly time series in percent. The correlation coefficients higher than 75% are in bold.
CONV. ARBITRAGE DEAD SHORT BIAS EMERG. MARKETS EQUITY MKT.NTRL. EVENT DRIVEN FIXED INC. ARB. GLOBAL MACRO LONG/ SHORT MANAGED FTRS HEDGE FUND - MTD EQUALLY-WEIGHTED
1.00 -0.23 0.32 0.31 0.59 0.55 0.29 0.26 -0.22 0.40 0.44 1.00 -0.57 -0.35 -0.63 -0.08 -0.13 -0.72 0.25 -0.47 -0.13 1.00 0.22 0.68 0.30 0.41 0.58 -0.14 0.65 0.65 1.00 0.38 0.09 0.21 0.35 0.13 0.33 0.34 1.00 0.39 0.37 0.65 -0.24 0.66 0.55 1.00 0.45 0.21 -0.08 0.45 0.52 1.00 0.42 0.25 0.86 0.82 1.00 -0.07 0.78 0.52 1.00 0.09 0.37 1.00 0.84 1.00
68
EQUALLY-WEIGHTED
HEDGE FUND - MTD
CONV. ARBITRAGE
EQUITY MKT.NTRL.
DEAD SHORT BIAS
EMERG. MARKETS
GLOBAL MACRO
MANAGED FTRS
FIXED INC. ARB.
EVENT DRIVEN
LONG/ SHORT
Appendix B. Predictive Variable Data

B.1 Summary Statistics of Predictive Variables
The table below presents summary statistics for the predictive variables. The last column is the result of the Augmented Dickey-Fuller test of a unit root with 95% of confidence level.
Statistical Summary of the Risk Factors (1994-2003)
(Monthly Figures)
Mean US equity mkt World equity mkt Emerging equity mkt Small cap equity mkt Dividend yield Implied volatility s.t. interest rate Term spread Default spread US bond mkt High-yield mkt Currency Gold Commodities Oil 0.98% 0.48% 0.26% 0.92% 1.79% 21.38% 4.20% 1.48% 0.81% -0.01% 0.59% -0.04% 0.11% 0.44% 0.97% Std. dev. 4.57% 4.47% 6.86% 5.70% 0.55% 6.37% 1.68% 1.14% 0.23% 1.17% 2.10% 1.57% 3.53% 5.59% 7.47% AC(1) -0.0072 0.0454 0.1487 0.0863 0.9799 0.8599 0.9729 0.9436 0.9409 0.1717 0.1408 0.3105 -0.0735 0.0574 0.3346 AC(2) -0.0256 -0.0616 0.0314 -0.0619 0.9579 0.6989 0.9413 0.8796 0.877 -0.1111 -0.0341 -0.031 -0.1643 -0.1217 -0.0136 AC(3) 0.0722 0.0337 0.0086 -0.1496 0.9325 0.5957 0.9054 0.8192 0.8255 0.1477 -0.0107 -0.0339 0.0298 0.2014 -0.0473 AC(4) -0.0655 -0.0171 -0.1281 -0.0923 0.9076 0.5577 0.8669 0.7529 0.7817 0.0149 0.0187 0.006 0.0395 -0.0032 -0.0162 AC(5) 0.093 -0.013 -0.0537 -0.0862 0.8828 0.5448 0.8261 0.675 0.7478 -0.0929 0.0918 -0.0411 0.0723 0.1865 0.0452 Stationary YES YES YES YES NO NO NO NO NO YES YES YES YES YES YES
69
Risk Factors Correlation Matrix (1994-2003)

This table shows the correlation coefficients between all the predictive variables used in this paper. The figures come from the monthly time series in percent. The correlation coefficients higher than 75% are in bold.
Small cap equ. mkt
Emerg. equity mkt
World equity mkt
Implied volatility
s.t. interest rate
High-yield mkt
Default spread
Dividend yield
US equity mkt
Commodities
US bond mkt
Term spread
Currency
Gold
US equity mkt World equity mkt Emerging equity mkt Small cap equity mkt Dividend yield Implied volatility s.t. interest rate Term spread Default spread US bond mkt High-yield mkt Currency Gold Commodities Oil
1.00 0.80 0.69 0.71 0.06 -0.19 0.08 -0.06 -0.14 0.03 0.51 -0.10 -0.08 0.04 -0.14 1.00 0.78 0.72 0.01 -0.23 -0.08 0.10 -0.01 -0.08 0.49 -0.21 0.09 0.15 -0.05 1.00 0.70 -0.06 -0.12 -0.18 0.17 0.12 -0.13 0.50 -0.16 0.08 0.13 0.06 1.00 -0.01 -0.20 -0.02 0.04 -0.06 -0.08 0.54 -0.10 0.13 0.18 -0.01 1.00 -0.64 0.09 0.34 -0.32 -0.06 0.08 -0.13 -0.01 0.01 0.02 1.00 -0.33 -0.10 0.46 0.07 -0.22 -0.02 0.00 -0.11 -0.10 1.00 -0.79 -0.82 0.07 -0.07 0.30 -0.24 -0.04 -0.05 1.00 0.53 -0.25 0.03 -0.28 0.19 0.06 0.14 1.00 0.00 -0.05 -0.22 0.23 0.10 0.11 1.00 0.22 -0.14 0.10 0.09 -0.06 1.00 -0.08 0.02 0.02 -0.07 1.00 -0.27 -0.11 -0.17 1.00 0.21 0.21 1.00 0.62 1.00
70
Oil
Appendix C. Others
C.1 Methodology Scheme
The figure below presents the different steps from the calibration of the predictive model to the construction of the TSA portfolios with or without the operational constraints.
Predictive model 64748
model 6447448 predictive nave model

: E ( Rt +1 ) = X t + t
1 Calibration
Et(Rt+1) = Rt or MA(Rt)
Et(Rt+1) = X t
predictive factor model
Portfolio optimization ?
3
historical variances-covariances matrix historical skewness and kurtosis Et(Rt+1) = expected return Rt+1 = actual return
wt+1
4a 4 months : t
Last month September
4b
4b
wt+1 x Rt+1
t+1
Today 15 / 10 / 04 Investment Decision Time
wt+1 x Rt+2
t+2
Next month November
wt+1 x Rt+3
time t+3
Next 2 month December
Performance calculation Without constraint: With constraint: (wt+1 x Rt+1) + (wt+2 x Rt+2) + + (wt+k x Rt+k) (wt+1 x Rt+2) + (wt+2 x Rt+3) + + (wt+k-1 x Rt+k) (wt+1 x Rt+3) + (wt+2 x Rt+4) + + (wt+k-2 x Rt+k)
portfolio R NC portfolio RC
4a 4b 4b
portfolio RC
To compare
71
C.2 Optimal portfolio weights (without any upper weight constraint)

Global Minimum Variance
Optimizer P1
Optimizer P2
Optimizer P3
Lagged return model (3-month moving average)
STATISTIC Model (Amenc, Bied and Martellini model) with lagged returns
ECONOMIC Model with lagged returns
72
C.3 Optimal portfolio weights (with upper weight constraints of 20%)

Global Minimum Variance
Optimizer P1
Optimizer P2
Optimizer P3
Lagged return model (3-month moving average)
STATISTIC Model (Amenc, Bied and Martellini model) with lagged returns
ECONOMIC Model with lagged returns
73
References
Agarwal V. and Naik N. (1999), "On Taking the 'Alternative' Route: Risks, Rewards and Performance Persistence of Hedge Funds", Working Paper. Agarwal V. and Naik N. (2001), "Characterizing Systematic Risk of Hedge Funds with Buyand-Hold and Option-Based Strategies", Working Paper. Agarwal V. and Naik N. (2003), "Risk and portfolio decisions involving hedge funds", submitted to The Review of Financial Studies. Alexander C. (2001), "Market Models - A Guide to Financial Data Analysis", John Wiley & Sons Amenc N., El Bied S. and Martellini L. (2002), "Evidence of predictability in hedge fund returns and multi-style multi-class style allocation decisions", Financial Analysts Journal. [published in 2003] Amenc, N., Martellini L. and Vaissi M. (2002a) Benefits and Risks of Alternative Investment Strategies. Amenc N., Malaise P., Martellini L. and Sfeir D. (2003), "Tactical Style Allocation - A New Form of Market Neutral Strategy". Asness C., Krail R. and Liew J. (2001), "Do Hedge Funds Hedge" Brealey R. A. and Kaplanis E. (2001), "Changes in the Factor Exposures of Hedge Funds", Working Paper. Brooks C. (2002), "Introductory Econometrics for Finance", Cambridge Ferson W. E. (2003), "Tests of Multifactor Pricing Models, Volatility Bounds and Portfolio Performance", Handbook of the Economics of Finance, Chapter 12 Fung W., and D.A. Hsieh (2001), "The Risk in Hedge Fund Strategies: Theory and Evidence From Trend Followers", The Review of Financial Studies, 14(2), 313-341. Fung W., and D.A. Hsieh (2001a), "Asset-Based Hedge Fund Styles and Portfolio Diversification", Working Paper. Fung W., and D.A. Hsieh (2002), "Hedge Fund Benchmarks: Information Contents and Biases", Financial Analysts Journal, 58(1), 22-34. Fung W., and D.A. Hsieh (2002a), "Risk in Fixed-Income Hedge Fund Styles", ???, 22-34. Ineichen, A. M. (2002), "Absolute Returns: The Risk and Opportunities of Hedge Fund Investing" Lhabitant F.-S., (2002), "Hedge Funds - Myths and Limits", John Wiley & Sons
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Lhabitant F.-S., (2004), "Hedge Funds - Quantitative Insights", John Wiley & Sons Lhabitant F.-S., (2004a), "Hedge Funds Investing: A Quantitative Look Inside the Black Box", Working Paper Lhabitant F.-S. and Learned De Piante Vicin M. (2004), "Finding the Sweet Spot of Hedge Fund Diversification", Working Paper Lo A. (2002), "The Statistics of Sharpe Ratios", Financial Analysts Journal, 58(4), 36-52. Sharpe W. (1992), "Asset Allocation: Management Style and Performance Measurement", Journal of Portfolio Management, 18(2), 7-19. Sidani R. and Soueissy M. (2003), "The Risks Underlying Hedge Funds Strategies", MBF Master's thesis
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Predictability in Hedge Fund Index Returns and Implications For FoF Style Allocation

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Predictability in Hedge Fund Index Returns and Implications For FoF Style Allocation

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Predictability in Hedge Fund Index Returns and its application in Fund of Hedge Funds style allocation

By Philippe Pillonel Laurent Solanet

Masters Thesis November 2004

1 Evidence of Predictability in Hedge Fund Index Returns

1.1 Review of Literature and Background Theory

1.1.1 Asset Return Predictive Models

1.1.2 Hedge Fund Return Predictive Models

NAVt - NAVt -1 NAVt -1

Table 1. Performances and summary statistics of Tremont hedge fund indexes

1.3 Predictive Variables

Short term interest rate (proxied by the yield on 3-month T-Bill )

Table 2. Summary statistics for the predictive variables

t59 t60 t61

constraint (mean-variance approach)

p = Var ( R p ) = Var ( RBench ) = Bench

P3: Maximization of the excess return of the portfolio with respect to a

benchmark, subject to a tracking error constraint of 2%

is the return of a portfolio invested in each of the

Benchmark 1: an equally-weighted benchmark made of the 9 hedge fund indices i.e.

Benchmark 4: a global minimum variance portfolio. We use the covariances matrix

None of these benchmarks use a predictive model.

allocation portfolio is greater than the return on the benchmark

terms). The drawdown gives an intuitive idea of severity of loss7.

1.5 The Predictive Models

1.5.1 Linear Single-factor Predictive Models

Figure 3. CSFB/Hedge Fund indexes serial correlation

1.5.1.1 Single-factor model

For each strategy, we highlight the highest R.

1.5.1.2 Single-factor model with own lagged-return

CONV. ARBITRAGE 0.0038 (0.0027) 0.5525 (0.0000) 0.2996

DEAD SHORT BIAS

EMERG. MARKETS 0.0042 (0.3520) 0.3004 (0.0007) 0.0852

EQUITY MKT. NTRL 0.0061 (0.0000) 0.2937 (0.0010) 0.0803

EVENT DRIVEN 0.0058 (0.0008) 0.3460 (0.0001) 0.1147

FIXED INC. ARB 0.0033 (0.0029) 0.4044 (0.0000) 0.1570

1.5.1.3 Single-factor model with own lagged-return (moving average)

is the error term at time t.

1.5.1.4 Performance of the linear single-factor predictive models

Hit Ratio1 0 59 100 49 61 56 47 53 63 59 69 66 63 63 63 61 39 56 39

Linear model with lagged return

Linear model with lagged return

1.5.2 Linear Multi-factor Predictive Models

The performance of the Short Biased strategy versus S&P500.

The performance of the Event Driven strategy versus S&P500.

The performance of the Long/Short strategy versus S&P500.

The performance of the long/Short strategy versus MSCI ex. US.

The performance of the Short Biased strategy versus RUSSEL 2000.

The performance of the Event Driven strategy versus RUSSEL 2000.

The performance of the Long/Short strategy vs. RUSSEL 2000.

Based on these figures, in next sections we study:

Table 6. Predictive Models (Amenc, Bied and Martellini method)

1.5.2.2 An economic multi-factor model

Yt = + 1X1, t-1 + 2X2, t-1 + + nXn, t-1 + t

This second relationship is then of the type:

Yt = + 0Yt-1 + 1X1, t-1 + 2X2, t-1 + + nXn, t-1 + t

1.5.2.3 Performance of the linear multi-factor predictive models

Return 9.72 9.91 57.63 8.97

Hit Ratio1 0 59 100 49 69 66 63 53 49 63 59 59 53 47 51 53 53 51 51

ECONOMIC multi-factor model with lagged return

invested in Long/Short (a directional strategy).

Figure 11. Allocation of Economic multifactor models with lagged return

Figure 12. Allocation of Economic multifactor models without lagged return