Risk characterization, stale pricing and the attributes of hedge funds performance

Abstract

The objective of this article is to evaluate the performance of hedge funds and characterize the underlying risk dynamics. Using a fairly well-known database of a set of aggregate hedge fund indices from CSFB/Tremont, we investigate whether hedge fund returns reflect the stale or managed price effect. We demonstrate that performance persistence of hedge fund is not only related to the serial correlation in hedge fund returns, but also to the correlation between hedge fund returns and lagged market portfolio returns. We find evidence of non-synchronous pricing for a significant number of hedge fund indices, and show that both stock and bond markets capture the important uncertainty components of hedge funds average returns. Our empirical results indicate that average fund alpha and risk premium should be estimated in an integrated market. Otherwise, it is difficult to identify the common sources of uncertainty. Our results imply that hedge funds that cannot get rid of the idiosyncratic component by diversification will generate lower (and in some cases below the benchmark) average returns. © 2011 Macmillan Publishers Ltd.