Hedge Fund Risk Factors With Option-like Structures

Abstract

The authors start with the observation that hedge funds are not obliged to disclose sources of earnings and trade strategies. For this reason little is known on how returns are achieved. One approach to shed some light on this matter is based on Sharpe [1992], which introduced a model for the explanation of returns of traditional mixed funds (e.g., composed of equities and bonds). Mixed funds usually pursue a strategy of “long only” whereas hedge funds also use short selling and leveraging, and act in a much more flexible way. These trade strategies of hedge funds lead to option-like structures, which are not covered by the basic Sharpe model. They discuss and describe the possibilities to include such structures into a regression model. Offering data on the various such strategies, they present the empirical results of an analysis of the risk factors of the Standard & Poor's hedge fund indices. They conclude with the view that their study confirms the findings documented in the literature and that further research could be directed toward capturing further risk factors in order to increase the explanatory power of regression models.