Portfolio Optimization for Hedge Funds Through Time-Varying Coefficients

55 Pages Posted: 22 Sep 2012 Last revised: 12 Aug 2013

See all articles by Benoit Dewaele

Benoit Dewaele

Université Libre de Bruxelles (ULB)

Date Written: May 8, 2013

Abstract

In this paper, we show the interest of the time-varying coefficient model in hedge fund performance assessment and selection. We argue that the alpha of hedge funds is dynamic and that the time-varying alpha captures this dynamic behavior. Therefore, forming portfolios based on their time-varying alpha should lead to outperforming portfolios. Using a persistence analysis, we check this conjecture and show that contrary to top performers in terms of OLS alpha, the top performers in terms of past time-varying alpha generate superior and significant ex-post performance. Additionally, this analysis shows that persistence exists in the hedge fund industry and can be as long as 3 years. Secondly, building on the conclusion that the time-varying analysis gives a better picture of the alpha of the manager at a certain point in time, we use the time-varying analysis to obtain estimates of the expected returns of hedge funds. Using those estimates to construct a mean-variance optimal portfolio enhances the performance of this portfolio, suggesting that in terms of hedge fund performance detection, the time-varying model is superior to the OLS analysis.

Keywords: Hedge Funds, Time-Varying Coefficient Models, Alpha, Performance Persistence

JEL Classification: C22, G11, G23

Suggested Citation

Dewaele, Benoit, Portfolio Optimization for Hedge Funds Through Time-Varying Coefficients (May 8, 2013). Available at SSRN: https://ssrn.com/abstract=2150056 or http://dx.doi.org/10.2139/ssrn.2150056

Benoit Dewaele (Contact Author)

Université Libre de Bruxelles (ULB) ( email )

CP 132 Av FD Roosevelt 50
Brussels, Brussels 1050
Belgium

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