Benchmarking Hedge Funds: The Choice of the Factor Model

23 Pages Posted: 7 Sep 2010 Last revised: 29 May 2013

See all articles by Manuel Ammann

Manuel Ammann

University of St. Gallen - School of Finance

Otto R. Huber

Credit Suisse

Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance; University of St. Gallen - School of Finance

Date Written: August 28, 2011

Abstract

There is still no consensus regarding a generally accepted factor model to assess risk-adjusted hedge fund performance. In this paper, we compare three alternative factor models: the widely used Fung and Hsieh (2004) seven-factor model, a recently proposed extension to an eight-factor model, and a model that selects the relevant risk factors based on a forward stepwise regression approach. Over a fairly long time period from 1994 to 2009, the differences in alphas resulting from the three alternative factor models are small. However, during crisis periods, such as the recent credit crisis, we find a substantial difference in alphas resulting from the Fung and Hsieh (2004) seven-factor model as compared to the other two models. The emerging markets factor, which is included in the eight-factor model and is chosen by the stepwise-based model for 7 out of 11 hedge fund strategies, seems to capture a large part of hedge fund return volatility during crisis periods. Both the stepwise and the eight-factor model generate qualitatively similar results even on the strategy level. Unlike the stepwise-based factor model, the eight-factor model uses the same set of risk factors for all hedge fund strategies. Given its much easier implementation, the eight-factor model seems to be a good choice for a broadly used factor model and a suitable successor for the widely used seven- factor model.

Keywords: Hedge Funds, Performance Measurement, Alpha, Factor Models, Crisis

JEL Classification: G11, G12, G23

Suggested Citation

Ammann, Manuel and Huber, Otto R. and Schmid, Markus, Benchmarking Hedge Funds: The Choice of the Factor Model (August 28, 2011). Available at SSRN: https://ssrn.com/abstract=1672543 or http://dx.doi.org/10.2139/ssrn.1672543

Manuel Ammann

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Otto R. Huber (Contact Author)

Credit Suisse ( email )

Eleven Madison Avenue
9th Floor
New York, NY 10010
United States
2123253726 (Phone)

Markus Schmid

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, 9000
Switzerland

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

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