AN ANALYSIS OF THE RISK FACTORS UNDERLYING HDGE FUND RETURNS
John Okunev and Derek White
A repeating theme in this volume is that what you get with hedge fund investments may be more than what you see and that may not be a good thing. The extensive literature on hedge fund styles, to which Okunev and White add their voice here, is an attempt to reveal more about hedge fund risk and return than is found in standard measures used in the mutual fund industry.
Okunev and White provide a method for correcting reported hedge fund returns for “smoothing,” in part an artifact of infrequent trading and illiquid pricing of positions taken by the fund managers. Their methodology for removing first and second order autocorrelations this effect shows that “de-smoothed” hedge fund index returns may have as much as two times the volatility as the originally reported returns for some categories of hedge funds.
They then use their de-smoothed returns to identify linear and non-linear (i.e., option-like) risk factors that best explain the returns. By associating hedge fund index returns with factors, investors can understand the actual risk drivers behind those returns. It may be the case that hedge fund categories have returns explained by similar risk drivers, even when their measured correlations are low.
Okunev and White find, just as others have recently found, that nonlinear factors are important to understanding the distribution of hedge fund index returns. In particular, short option structures consistently appear in the explanation of returns.
The finding of important non-linear effects motivates the use of value-at-risk historical simulations to estimate the risk in hedge fund indexes. The historical simulation value-at-risk approach lets the data speak for itself in measuring risk. Okunev and White use the estimated risk factor mappings from their style analysis in risk estimation.
The de-smoothed returns are likely a better historical record than the reported returns. But for risk estimation a forward looking estimation is required. The risk factor mappings indicate how a hedge fund return will respond to specific future realizations of possible market movements. Therefore a simulation using the factor mappings will simulate the effects of the trading dynamics that take place, and provide a more truthful estimate of likely future extreme returns.
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ERRATA AND OTHER MATERIAL
- Other research by John Okunev:
- Other research by Derek White:
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