Hedge Fund Performance under Misspecified Models
48 Pages Posted: 18 Sep 2020 Last revised: 22 Sep 2020
Date Written: July 27, 2020
We develop a new approach for evaluating performance across hedge funds. Our approach allows for performance comparisons between models that are misspecified – a common feature given the numerous factors that drive hedge fund returns. The empirical results show that the standard models used in previous work omit similar factors because they (i) perform exactly like the CAPM, and (ii) produce large and positive alphas. In contrast, we observe a large and statistically significant decrease in performance with a new model formed with alternative factors that capture variance, correlation, liquidity, betting-against-beta, carry, and time-series momentum strategies. Overall, the results suggest that the average returns of hedge funds are largely explained by mechanical trading strategies.
Keywords: Hedge funds, performance, model misspecification, large panel
JEL Classification: G11, G12, C14, C33, C58
Suggested Citation: Suggested Citation