Risk in Fixed-Income Hedge Fund Styles

SEPTEMBER 2002 THE JOURNAL OF FIXED INCOME 1 H edge fund strategies came under intense scrutiny with the stressful market events surrounding the near collapse of Long-Term Capital Management (LTCM). Several studies were sponsored by regulatory agencies in the financial markets, including the President’s Working Group on Financial Markets [1999], and the Bank for International Settlements [1999a, b, and c]. Besides asking whether hedge funds have a destabilizing influence on markets, the groups directed much of their attention to a particular type of strategy used by fixed-income hedge funds: convergence trading. What are the risk characteristics of this strategy that caught the attention of financial regulators, and how do they differ from other hedge fund strategies? Understanding hedge fund risk is complicated. Information on hedge funds is hard to come by. Although the hedge fund industry is gradually shifting towards greater disclosure and historical performance data is now readily available, we have yet to successfully model the link between hedge fund returns and observable asset returns.1 A model that would 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, one may be able to predict hedge fund returns even 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 strategy. Location refers to where (or what) a manager trades, such as stocks, bonds, commodities, or currencies. Strategy refers to how a manager trades, such as buy-and-hold, long-short, or trend-following. Style describes a combination of location and strategy, such as buy-and-hold on stocks or trend-following on currencies. We use the peer groupings of Hedge Fund Research (HFR), a vendor of hedge fund data. Since funds that use similar styles have correlated returns, their common styles can be extracted by principal components analysis. These common styles are called style factors. Second, we link the extracted style factors to observable market prices. In this case, we use asset-based style (ABS) factors to provide explicit links between hedge fund returns and observable asset prices; see Fung and Hsieh [2002] for a detailed discussion of asset-based hedge fund style factors. Mitchell and Pulvino [2001] have simulated the returns of a merger arbitrage strategy applied to announced takeover transactions between 1968 and 1998. This strategy generates returns that are similar to those of merger arbitrage funds. Risk in Fixed-Income Hedge Fund Styles