Testing the Accuracy of Hedge Fund Analysis

In this case we use the style benchmark not to determine the skill of the manager, but rather the accuracy of our style analysis. There are three useful measurements of fit which we can examine in order to evaluate the accuracy of the style analysisR-Squared, Tracking Error and Beta. Figure 2 tells us that the correlation (R-Squared) between the funds returns and the returns of the benchmark is a reasonably high 73.2%. The horizontal axis on Figure 3 shows the Tracking Error. Tracking Error is the standard deviation of excess return (the difference between the manager and benchmark). If the style benchmark does a good job of representing the behavior of the fund, the Tracking Error will be low. Each dot on the graph in Figure 3 represents a three year period, with the dots getting larger over time (the largest dot is the most recent period). In this case the Tracking Error ranges between 2% and 3%. The last measure of fit is the rolling Beta. The blue dots in the graph in Figure 4 represent a rolling 36 month beta to the style benchmark. The beta will give us a clue as to the amount of leverage in a fund. In this case the leverage is not absolute but relative to a peer group average since the indexes we are using represents actual hedge fund returns. These three statistical measures back up what we already knew, that the style benchmark for this fund of funds is accurate.

Figure 4

We have used StyleADVISORs flexibility to put all of the information together so that we can see both the style benchmark and the measures of fit on one page, as shown in Figure 5. Next we will use this same page to look at different funds. After that we will add additional pages with different index palettes for more detailed analysis.

Style Analysis on other kinds of Hedge Funds

Hedge fund style analysis is particularly good at identifying a dominant style or strategy. The Merger fund is a mutual fund that does merger arbitrage. Figure 6 displays the results of a style analysis on this fund using the same palette of indexes we used earlier. Here we see over a 90% loading on merger arbitrage and a relatively high 67% R-squared. Figure 7 is an analysis of a hedge fund specializing in convertible arbitrage. Again we have over 90% of the style attributed to convertible arbitrage with a 73% R-squared. StyleADVISOR has done a good job of picking the dominant strategy in these cases.

Figure 8 shows the style analysis of an emerging market fund where there is a 100% loading on the Barclays Emerging Markets composite. This is a clear result, but leaves you wanting to know more. Figure 9 uses a set of regional emerging market indexes (Asia, Eastern Europe, and Latin America), allowing us to see regional exposure. This emerging market hedge fund seems to be almost equally split between these three regions.

Hedge Fund Style Analysis Generates Insightful Questions