The Risk in Fixed-Income Hedge Fund Styles By

We acknowledge the LBS Centre for Hedge Fund Research and Education for providing the hedge fund data used in this paper. Earlier versions of this paper were presented at Abstract This paper studies the risk in fixed-income hedge fund styles. Principal component analysis is applied to groups of fixed-income hedge funds to extract common sources of risk and return. These common sources of risk are related to market risk factors, such as changes in interest rate spreads and options on interest rate spreads. We call these asset-based style factors (" ABS "). The paper finds that fixed-income hedge funds tend to be exposed to a common ABS factor: credit spreads. Hedge fund strategies came under intense scrutiny in the wake of the stressful market events surrounding the collapse of Long-Term Capital Management (LTCM). Several studies have been sponsored by regulatory agencies of financial markets: the President's Working Group on Financial Markets [1999], and Bank for International Settlements [1999a, b, and c]. In addition to the macro question as to whether hedge funds have a destabilizing influence on markets, these studies directed much of their attention to a particular type of strategy used by fixed-income hedge funds: Convergence Trading. Just what are the risk characteristics that caught the attention of financial regulators and how do they differ from other hedge fund strategies? Understanding hedge fund risk is a non-trivial task. Information on hedge funds is hard to come by. As private investment vehicles, hedge funds 1 are exempt from the disclosure requirements on publicly traded companies and mutual funds. Although the hedge fund industry is gradually shifting towards greater disclosure, there is still a need to model the link between hedge fund returns and asset returns. Hedge fund managers rarely disclose their trading strategies. This leaves researchers with the daunting task of modeling highly complex strategies with incomplete data sets. Challenging as it seems, the rewards can be substantial. A model like this will allow hedge fund investors and counterparties to identify and explicitly measure the different types of hedge fund risk. By linking these strategy risks to asset prices with long histories, we may even be able to predict hedge fund returns during market extremes. A number of steps must be taken to achieve this. First, we need to extract common risk factors in groups of fixed-income hedge funds. Typically, hedge funds are grouped by " location " and " …