Style Analysis and Classification of Hedge Funds

Abstract

Hedge funds play an increasingly important role in institutional portfolios as an alternative to investments in traditional asset classes. Yet, the minimal disclosure requirements hedge funds face, coupled with an investment mandate that typically allows the use of leverage, short selling, derivatives and highly illiquid securities, present serious challenges for investors. These challenges include, among others, correctly assessing risk/return characteristics, accurately measuring left-tail risk of funds with relatively short return histories as well as comparing performances of funds within the same style. This article addresses these issues through the use of return-based style analysis. It demonstrates how investors can use its results to better understand the nature of risks and exposures of various strategies, and the extent to which investments in various individual funds are correlated. The article also examines the common practice of classifying hedge funds into styles based on their self-reported investment strategy. A simple technique that can help identify inconsistencies between the actual and self-proclaimed style of a fund based on a measure of distance between the return time-series of the two is presented.