Hedge Funds’ Dynamic Strategic & Tactical Asset Allocation and Dynamic Risk Exposure in a Regime Switching Framework

Introduction:

Hedge funds engage in dynamic trading strategies, use leverage opportunistically, take positions in non-linear instruments and take concentrated bets. These techniques result in non-linear payoffs at the single Hedge Fund and at the Fund of Hedge Fund level. The following approach is therefore to assess Hedge Fund strategies' risks, to forecast Hedge Fund style returns and to construct optimal strategic and tactical hedge fund allocations that reflect the option-like and nonlinear features of those strategies.

Description:

Hedge funds usually exhibit non-normal payoffs for multiple reasons such as the use of derivatives, structured products, and dynamic trading strategies. Further, hedge funds take state-contingent opportunistic bets that account for a significant part of their returns and risks. Despite ever growing research on the topic, most studies on hedge funds' performance so far focused on classical linear factor models, non-parametric models or linear factor models with option like factors.

The proposed framework departs from those approaches and utilizes factor models based on the regime switching theory, where non-linearity in the exposure is captured by factor loadings that are state dependent. The regime switching approach first identifies the current and future likely states of the markets - a stochastic process based on numerous risk factors with forecasting power that identifies and translates the current and future states of the markets in quintiles after which a state dependent factor loading process is able to capture hedge funds’ exposure to the market risk factor in these different states or market conditions.

Empirical results show that switching regime factor models can explain a larger proportion of the variation in returns of hedge funds, as opposed to classical linear factor models, non-parametric models and linear factor models with option like factors. The justification for this greater explanatory power can be linked to both the dynamic nature of hedge funds' strategies and to the tendency of market factors' to synchronize or become more dependent in periods of stress.

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