Hedge fund return specification with errors-in-variables

Abstract

In linear models for hedge fund returns, errors-in-variables may significantly alter the measurement of factor loadings and the estimation of abnormal performance. The higher moment estimator (HME) introduced by Dagenais and Dagenais (1997) effectively deals with these issues. Results on individual funds show that the HME specification does not uncover systematic performance biases, but can modify estimated alphas in most cases and identifies relative persistence for directional funds in bearish market conditions. Overall, the risk premia calculated with HME remain relatively stable when compared to ordinary least squares specifications. © 2010 Macmillan Publishers Ltd.