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Which Hedge Fund Styles Hedge Against Bad Times?

55 Pages Posted: 18 Aug 2013 Last revised: 24 Feb 2015

Charles Cao

Pennsylvania State University

David Rapach

Saint Louis University - John Cook School of Business

Guofu Zhou

Washington University in St. Louis - Olin School of Business; CAFR (China Academy for Financial Research)

Date Written: February 20, 2015

Abstract

We investigate an important question for institutional investors — namely, which hedge fund investing styles help to hedge against bad times? We define good versus bad times as (1) up and down equity market regimes derived from the 200-day moving average of the S&P 500 price index or (2) nonstressed and stressed financial market regimes determined endogenously using the Federal Reserve Bank of Kansas City Financial Stress Index and threshold estimation. Our findings reveal that only a few hedge fund styles limit or alter their risk exposures to provide valuable hedges against bad times; in contrast, other styles remain substantially exposed to — or become more exposed to — particular risk factors and correspondingly suffer large losses during bad times. In the context of “balanced” 40-30-30 ortfolios that allocate across U.S. stocks, bonds, and individual hedge fund styles, we find that the Global Macro, Managed Futures, and Multi-Strategy styles provide large investors with especially valuable hedges against bad times.

Keywords: Asset-based style factors, Multifactor model, Regime switching, Financial stress,Threshold regression, Portfolio performance

JEL Classification: C24, C58, G11, G12

Suggested Citation

Cao, Charles and Rapach, David and Zhou, Guofu, Which Hedge Fund Styles Hedge Against Bad Times? (February 20, 2015). Available at SSRN: https://ssrn.com/abstract=2311464 or http://dx.doi.org/10.2139/ssrn.2311464

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

David Rapach

Saint Louis University - John Cook School of Business ( email )

3674 Lindell Blvd
St. Louis, MO 63108-3397
United States

Guofu Zhou (Contact Author)

CAFR (China Academy for Financial Research)

Shanghai Advanced Institute of Finance
Shanghai P.R.China, 200030
China

Washington University in St. Louis - Olin School of Business ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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