Zephyr has recently developed a template that attempts to apply Bill Sharpe’s returns-based style analysis methodology to the world of hedge funds. Sharpe originally developed this multi-factor optimization process in an attempt to replicate as much of an active manager’s return patterns as possible by using the right combination of passive benchmarks. In order for this process to work there are three fundamental rules that one must follow:
1. The passive indices must be exhaustive of the opportunity set available to the manager,
2. The passive indices should be exclusive to avoid overlap or double-counting, and
3. The passive indices should have returns that “differ” or have low correlations
While quite useful in the world of traditional, long-only management, anyone with a background in alternative investments will quickly grasp the difficulties of applying RBSA to hedge funds. First and foremost, hedge fund indices are not true, passive benchmarks like seen in traditional asset classes, but instead are category averages of funds following a similar strategy. Second, the kinds of strategies that some hedge funds follow are extremely idiosyncratic and would be hard to replicate with any set of factors. Third, many hedge funds have short histories, complicating replication efforts. In spite of these challenges, Zephyr has put together this template using the HFR Hedge Fund indices.
HFR has done a very respectable job forming a logical hierarchy for the diverse hedge fund universe. It is this framework that is used for the basis of our returns-based style analysis. Key to this framework is the establishment of four very broad hedge fund styles, namely:
1. Equity Hedge
4. Relative Value Arbitrage
Within each of these broad styles there exist many substyles, and there are additional strategies that fall outside this hierarchy. The Zephyr template “HFR Style Template” was built using this framework.
The template and returns-based style analysis seems to work fairly well when analyzing a Hedge Fund-of-Fund and using the four major strategies listed above as the factors in the analysis. Looking across all of the well-diversified fund-of-funds the R2s indicate fairly good fits for most of the broad, macro strategies. However, the RBSA approach doesn’t work as well when applied to single hedge funds focused on a particular style or substyle. Only in a minority of the cases do the R2s indicate good fits.
For an in-depth discussion of the HFR Style Template and the accompanying HFR R2 Template, see this write-up. We hope you find this template useful.
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