Hedge Fund Performance Under Fama-French Four-Factor Model

There are many models to evaluate the performance of hedge funds. In this article, we analyzed the performance of the overall hedge fund index as well as different styles of hedge funds based on the Fama-French Four-Factor model. The time period we looked at for the whole dataset is from January 1994 to December 2010.

The Hedge Fund dataset used in this project is from Dow Jones Credit Suisse Hedge Fund Indexes, from 1994 to 2010. The index uses the Credit Suisse Hedge Fund Database, which tracks approximately 8000 funds and consists only the funds with a minimum of US$50M under management, a 12-month track record, and audited financial statements. The index is asset-weighted, is calculated and rebalanced on a monthly basis, and reflects performance net of all fees and expense. In addition to the overall index, the dataset also includes indexes by hedge-fund style. The styles used in this project are Convertible Arbitrage, Emerging Markets, Event Driven, Fixed Income Arbitrage, Global Macro, Long/Short Equity and Managed Futures. The market dataset used in this project is monthly market returns, 1-month Treasury bill rates, and monthly returns of the four empirical factors (Market, SMB, HML and MOM), from 1994 to 2010.

Below is the result of the regression under Four-Factor Model.

The regression results for the Four-Factor model are reported in Table above. For the overall hedge fund index, the market beta is 0.32 with a t-stat of 12.24; the size beta is 0.09 with a t-stat of 2.76; the value beta is 0.02 with a t-stat of 0.58; and the momentum beta is 0.12 with a t-stat of 5.53. Overall, there is some exposure to the size and momentum factors but none to the value factor, and the market risk remains to be an important risk factor for the overall hedge fund industry. The Four-Factor alpha is 26 basis points with a statistically significant t-stat of 2.25. In other words, after controlling for their exposures to markets, size, value and momentum by using the Four-Factor model, the hedge funds on average still provide positive and statistically significant alpha.

Overall, we find that while the Four-Factor model might not be very useful in explaining fund styles such as convertible arbitrage, managed futures, fixed-income arbitrage or global macro, it is very useful in explaining the returns in Long/short equity hedge fund. Controlling for all the four factors, the long/short equity hedge funds still provide a positive and statistically significant alpha of 24 basis points per month with a t-stat of 2.43.