Alternative Investment - September 20, 2012

Robust Assessment of Hedge Fund Performance through Nonparametric Discounting

In this publication, produced as part of the "Advanced Modelling for Alternative Investments" research chair at EDHEC-Risk Institute supported by Newedge, we evaluate the performance of hedge funds through a new non-linear risk adjustment of returns.

The risk adjustment is such that it prices exactly the usual set of risk factors considered in the hedge fund literature. This non-linear risk adjustment goes beyond the usual linear regression methodology used in many hedge fund performance papers, including non-linear exposures based on option-like features.

The approach proposed in this paper overcomes two important limitations of the linear methodology: it captures the non-linear exposure of a hedge fund strategy to several risk factors, and it is not limited to non-linear shapes resembling standard option payoff patterns. We apply this methodology to various hedge fund indices as well as to individual hedge funds, considering a set of risk factors including equities, bonds, credit, currencies and commodities.

The main message that emerges from our analysis on the performance of hedge fund strategies is that exposure to higher-moment risks on the various factors matters. Analysing the performance of HFRI indices on primary strategies and sub-classes of primary strategies, we report sizeable differences in performance, between the linear and the non-linear risk adjustment. Most often the non-linear risk adjustment reduces the performance but for some sub-classes it enhances their performance.

We also show how to conduct a risk analysis and provide an example where a change in a single risk factor can affect the average performance of funds when more robust risk adjustment is applied.

This research was produced as part of the Newedge research chair at EDHEC-Risk Institute on "Advanced Modelling for Alternative Investments."

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