Hedge Fund Risk Dynamics: Implications for Performance Appraisal
Journal of Finance 64, p.987-1037, 2009

Nicolas P.B. Bollen and Robert E. Whaley

ABSTRACT
Hedge fund managers have the freedom to shift asset classes, strategies, and leverage in response to changing market conditions and arbitrage opportunities. Consequently, accurate performance appraisal requires a model of hedge fund risk dynamics. The standard measure of performance is the abnormal return defined by a hedge fundís constant exposure to risk factors. We allow the exposures to change within an optimal changepoint regression. Using a large sample of funds during the period January 1994 through December 2004, we demonstrate that estimates of abnormal returns, and corresponding fund rankings, are highly dependent on correctly identifying changes in exposure to risk factors.