Hedge Funds: Do They Do What They Say They Do?

Abstract

The purpose of this research is two-fold, to determine if hedge funds follow their stated strategy styles and to examine how hedge funds’ strategy allocations evolve over time in response to changed economic and market conditions. Our key advance is that we show that standard linear style models like that of Sharpe (1992) can be applied to hedge fund returns as long as the returns of the style indices in the model themselves display the nonlinear option-like characteristics of hedge fund returns. For our research, the returns of our sample of Funds of Hedge Funds are strongly correlated to the returns of portfolios of hedge fund investment style indices. In this way, we capture the spirit of Fung & Hsieh's (2002) Asset-Based Style Factors for Hedge Funds. Based on our results, it appears that the answer to the first question is “somewhat”, while we find ample evidence of significant shifts in allocation among the Fund of Hedge Funds from the first sample period (1997-2001) to the second (2002-2006). The changes in allocation appear to rationally reflect the changed economic conditions and investment opportunities existing at the time.