Hedge Fund Performance under Misspecified Models
60 Pages Posted: 18 Sep 2020 Last revised: 3 Jun 2021
Date Written: June 2, 2021
We develop a new approach for evaluating the entire alpha distribution across hedge funds. Our methodology allows for performance comparisons between models that are misspecified – a common feature given the numerous factors that drive hedge fund returns. Empirically, we find that the standard models used in previous work are subject to misspecification as they perform like the CAPM and produce large and positive hedge funds alphas. We then construct a new model based on alternative trading strategies (including variance, carry, and time-series momentum) and document a large and statistically significant decrease in performance. Whereas this new model remains misspecified, it identifies several key factors that drive hedge fund returns.
Keywords: Hedge funds, performance, model misspecification, large panel
JEL Classification: G11, G12, C14, C33, C58
Suggested Citation: Suggested Citation