Dynamic Trading Strategies of Equity Hedge Funds: Empirical Evidence on How They Adapt to Market Conditions
27 Pages Posted: 12 Jun 2012
Date Written: June 12, 2012
Hedge funds shift investment strategies in response to changing market conditions. We adjust hedge fund returns for their risks in an estimation that accounts for regime-switching effects. Index factors are used to capture the returns from buy-and-hold strategies followed by hedge fund. Besides, in order to capture the nonlinear dependence of hedge fund returns on these market indexes, we construct investable higher-moment factors and option-like strategies. Because our trading factors are mostly based on the equity markets, we focus on the equity-oriented hedge funds from the Hedge Fund Research database. Especially, we test whether these factors can explain the time series behavior of returns of a market neutral, short selling and long/short equity hedge funds. Average exposure sensitivities for systematic skewness are statistically significant for all funds. Equity hedge funds are moreover shown to follow a conservative investment strategy as they reduce their (linear or nonlinear) exposures in down-market regime relative to tranquil- or up-market regimes.
Keywords: hedge funds, markov chain, beta regimes, higher moments
JEL Classification: G11, G12
Suggested Citation: Suggested Citation