Analysis of hedge fund strategies using slack-based DEA models

Author(s): UD Kumar, AB Roy, H Saranga and K Singal

Source: The Journal of the Operational Research Society, Vol. 61, No. 12 (December 2010),
pp. 1746-1760
Published by: Palgrave Macmillan Journals on behalf of the Operational Research Society
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Journal of the Operational Research Society (2010) 61, 1746-1760 2010 Operational Research Society Ltd. All rights reserved. 0160-5682/10 ^

www.palgrave-jou rnals.com/jors/

Analysis of hedge fund strategies using slack-based

DEA models
UD Kumar, AB Roy, H Saranga* and K Singal
Indian Institute of Management, Bangalore, India

Hedge funds have made a significant impact on the performance of world financial markets in recent times. Our
objective in this paper is to develop a robust framework for the evaluation of hedge funds by incorporating a
maximum number of performance measures through public data sources. We analyse the hedge fund strategies
(styles) using a variety of classical risk-return measures with the help of slack-based Data Envelopment
Analysis (DEA) models to determine a unique performance indicator. The main thrust is to investigate the risk
return profile of 4730 hedge funds classified under 18 different strategies using multiple inputs and outputs. The
originality of the work lies in applying Slack-Based DEA to decipher the risk-return profile of these strategies
using advanced risk-return measures such as Value at Risk, drawdown, lower and higher partial moments and
skewness. We find that the correlation between the ranking of hedge fund strategies based on Sharpe ratio and
the DEA models is very low; at the same time, there is a significant correlation between rankings obtained
by the application of DEA using different sets of input/output measures. We have also compared the DEA
rankings with other traditional financial ratios such as modified Sharpe ratio, Sortino ratio and Calmar ratio.
The paper also studies the impact of events such as the Asian financial crisis on the performance of hedge
funds. The study around the event shows that only a relatively small number of strategies performed better
during times of turmoil.
Journal of the Operational Research Society (2010) 61, 1746-1760. doi:10.1057/jors.2009.143
Published online 11 November 2009

Keywords: data envelopment analysis; hedge fund; Sharpe ratio; Calmar ratio; Sortino ratio

Introduction (Eling and Schuhmacher, 2007). Scholz (2007) has discussed

several modifications to the Sharpe ratio to overcome some
Hedge funds have always intrigued regular investors. With
of the limitations of Sharpe ratio, but all these modifications
the outlandish fees that hedge funds charge, it is natural
still consider single risk and single return measure to capture
that investors expect high returns compared to other invest-
ment choices such as mutual funds. The sector's allure is in the performance of an asset.
The lack of a comprehensive methodology to evaluate
its supposed ability to make positive returns irrespective of
hedge fund performance is attributed to the complex nature
market conditions. The potential for absolute returns, plus the
of trading strategies adopted by the hedge fund managers,
lack of correlation between hedge funds and almost all other
which are often not revealed in the public domain. Although
asset classes, is an irresistible mix for most investors (Prosser,
most hedge funds use many of the same liquid asset classes
2007). As a result, a significant portion of academic research
as mutual funds, they use dynamic trading strategies that
on hedge funds focuses on the performance evaluation of
frequently involve short sales, leverage and derivatives with a
hedge funds, which has resulted in a multitude of perfor-
mandate to make absolute returns, irrespective of the market
mance measures that have cropped up over the last few years.
environment (Fung and Hsieh, 1997). Therefore, any perfor-
However, a classical measure like the Sharpe ratio (Sharpe,
mance evaluation methodology for hedge funds needs to
1966, 1994), which was initially developed for mutual fund
take into account both the underlying strategy as well as the
evaluation, is one of the most widely used metrics in the hedge
risk-return structure of fund performance in a comprehensive
fund performance measurement till date, despite the obvious
manner. The single input, single output performance indices
unsuitability of the Sharpe ratio for hedge fund evaluation due
that are in popular use today, such as Omega, Sortino Ratio,
to the non-normal nature of hedge fund returns (Kao, 2002;
Calmar ratio, Sterling ratio, Jensen measure, Treynor ratio
Gregoriou and Gueyie, 2003). This raises questions about the
and Modified Sharpe ratio etc. (Sortino and van der Meer,
suitability of the multitudes of these other metrics, which most
1991; Gregoriou and Gueyie, 2003; Agarwal and Naik, 2004;
often result in an identical ranking to that of the Sharpe ratio
Alexander and Baptista, 2004) consider only one aspect of
return and one aspect of risk, forcing one to consider all these
* Correspondence: H Saranga, D-108, Faculty Block D, UM Bangalore,
Bannerghatta Road, Bangalore, Karnataka 560076, India. performance indices simultaneously to incorporate other
E-mail: haritha.saranga@gmail.com aspects of risk and return, creating further confusion in the

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minds of investors. To address this drawback in hedge fund
performance measurement, some researchers have proposed
the application of Data Envelopment Analysis (DEA)-based
models, which have the ability to incorporate multiple inputs
and multiple outputs simultaneously and result in a single
performance measure. Eling (2006) has listed all the existing
DEA-based studies on the hedge funds and proposes an
appropriate framework for the selection of inputs and outputs,
which plays a very critical role in DEA efficiency evaluation.
Selection of inputs and outputs in DEA is a highly researched
topic in DEA as the selected inputs and outputs can change
the efficiency scores of Decision Making Units (DMUs)
(Norman and Stocker, 1991; Casu et al, 2005). In the case
of hedge funds, the DEA efficiency scores should be treated
as the performance indicators of hedge funds, however,
throughout this paper, we use the terminology 'efficiency'
to be consistent with the DEA literature. Eling (2006) also
discusses the most suitable DEA models for hedge fund
performance evaluation based on a variety of factors, such
as scale advantages/disadvantages, ranking requirements
etc. However, firstly, none of the existing DEA applications
have considered an integrated approach to evaluate both the
hedge fund strategies and the fund performance in tandem.
Secondly, most of the proposed DEA models so far are appli-
cable only for non-negative input/output data and no DEA
application to hedge funds has made use of slack-based DEA
models, thus the multi-dimensional performance evaluation
capability of DEA is severely underutilized. One exception is
the study by Nguyen-Thi-Thanh (2006), who suggests use of
a selection of classical DEA models depending upon whether
the negative data is present in the input or output variables.
In the current study, we try to bridge this gap by firstly
proposing an integrated framework that evaluates strategy
wise performance in Stage 1 and identifies the best funds
from the most efficient strategies in Stage 2, by incorpo-
rating multiple aspects of risk-return measures simultane-
ously. Secondly, we propose the application of Slack-based
DEA models that are capable of analysing negative data for
both efficiency estimations and super efficiency estimations
in order to rank the respective strategies and corresponding
hedge funds.
Hedge fund managers use more than 30 investment strate-
gies. The criteria used to classify hedge funds into various
categories are discussed in Getmansky et al (2004). Fung
and Hsieh (1997) identified dominant investment strategies
in hedge funds by analysing 409 hedge funds. From an
investor's perspective it is worth analysing the performance
of hedge fund strategies, as most often strategy is the only
information revealed to the investor by the fund managers. In
the second stage, we club all the hedge funds under the most
efficient strategies into one sample and evaluate their relative
performance through application of slack-based super effi-
ciency DEA models. This two-stage analysis not only allows
us to identify the best strategies but also enables us to zero in
on the most efficient funds among the best strategies. In our
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UD Kumar et a- Analysis of hedge fund strategies 1 747
study we have found a relatively high correlation between
performances of hedge funds within a particular strategy as
compared to that of funds across different strategies. Here, we
would like to draw attention to the fact that we have also used
a larger data set (around 5000 hedge funds) spread across
many strategies (18 strategies), as compared to previous
DEA studies on hedge funds (Gregoriou, 2003; Gregoriou
et al 2005; Wilkens and Zhu, 2005; Eling, 2006;
Nguyen-Thi-Thanh, 2006). We have also compared hedge
fund strategy ranking of DEA models with traditional finan-
cial ratios such as modified Sharpe ratio, Sortino ratio and
Calmar ratio.
Growth of hedge funds and performance measurement
Hedge fund evolution
The first known hedge fund was started by Alfred Jones in
1949. Jones used a combination of both leverage and short-
selling strategies to enable investing in both rising and falling
markets. During the 1950s and 1960s Jones's fund consis-
tently outperformed the best equity mutual funds and thus
attracted more players in the hedge fund arena. By 1968 there
were 200 hedge funds in the US. The 1990s saw a stellar
growth in hedge funds with exceptional performance by few
star managers. The number of hedge funds grew from 610
in 1990 to more than 9400 in 2006 (Naik and Tapley, 2007).
Figure 1 shows the growth of hedge funds between 1990 and
2005. Throughout this period, hedge funds continued to attract
investment from high net worth individuals, private banks,
insurance companies, pension plans and hedge fund of funds.
However, in the process, hedge funds have also attracted a
lot of bad reputation to their name. A speculation regarding
their large carry trade positions in yen led the meltdown of
the financial markets on 27th February 2007. The case of the
Bayou Group hedge fund has been making rounds in courts
after the group declined to return the principal amounts to
the investors who had exited from the fund before its crash
(Justin, 2005). The more publicized Amaranth hedge fund has
been found guilty of taking huge bets on natural gas futures.
When faced with a liquidity crunch in the gas futures market,
the fund had to file for bankruptcy, bringing bad repute to
the whole hedge fund industry (White, 2006). Hedge funds
over the years have seen many scandals; the recent one is
the Bernard Madoff scandal that resulted in a loss to the
tune of $50 billion to the investors. However, Gregoriou and
Lhabitant (2009) claim that Madoff never claimed to be a
hedge fund manager. Bernard Madoff Investment securities
(BMIS) claimed that they are able to execute a conserva-
tive strategy that would deliver annual return of 10%- 12%
by actively trading a very specific portfolio of stocks and
options. Gregoriou and Lhabitant (2009) also point out that
several banks refused to do business with Madoff and one of
them even blacklisted BMIS. In spite of all these problems,
the hedge funds industry has seen a phenomenal growth till
2008 and industry experts predict hedge funds to grow further
1748 Journal of the Operational Research Society Vol. 61, No. 12

Figure 1 Growth of hedge funds between 1990 and 2005.

Source: Figure 1 is plotted using the hedge fund data from Bloomberg Database.

Returns - Stock market vs Hedge funds

1600000 -i ^^
1400000 - w00000000"^ ^^

| 800000 - h**<***+^^^000^'
600000 - ^"T^ ^"T^
400000 -
200000 -
0 -I

2000 2001 2002 2003 2004 2005 2006 2007

Year

A Stock returns B Hedge funds returns

Figure 2 Returns of Hedge funds vis--vis stock market index.

(Nayar, 2009). We would like to point out that scandals are
not unique to hedge funds; many frauds are reported in the
highly regulated mutual fund market as well.
Hedge fund investors are concerned with two simple
questions - the risk of investing in a hedge fund and the
expected returns. A look at the data regarding hedge fund
performance reveals that apprehensions about the underper-
formance of hedge funds relative to the stock market are
anything but valid. From the year 2001 to 2006, hedge funds
have yielded excess returns to the tune of 30% on an average
over the traditional investor's return from stock markets, as
can be noted from Figure 2, which compares the cumulative
returns that would be earned by an investor when investing
in a stock market portfolio vis--vis hedge funds with an
initial investment of $1000000. We have used the net asset
values (NAV) data downloaded from Bloomberg Database
to arrive at the Figure 2. The stock market performance is
estimated based on the performance of S&P 500 index. It
is seen that hedge funds have ubiquitously outperformed
the stock market during the period. As the average investor
might suspect, the high returns come at considerably larger
risks. It is a popular belief that most hedge funds use global
macro strategies and simultaneously place large directional
bets on stocks, currencies, bonds, commodities and gold,
thereby using a lot of leverage.
Hedge funds are speculative investments and the strategies
used by the fund managers play a crucial role. Connor and
Lasarte (2005) provide a detailed analysis of various strate-
gies used by hedge fund managers and how they are used in
practice. For example, 'equity market neutral strategy' is the
original hedge fund strategy that uses a combination of buys
and short-sales (sometimes augmented by options and future
position) to offset correlation between portfolio return and
the overall market return (Connor and Lasarte, 2005). Event-
driven strategies look for events that are expected to make an
impact over a relatively short period of time.
The risk return measures of hedge funds
The most commonly used measure of risk is volatility, that is,
the annualized standard deviation of returns. Most academic
studies (Harper, 2003) demonstrate that hedge funds, on
average, are less volatile than the market. For example, based
on our calculations using data from the Bloomberg database,
for the bull market period of 1994-2000, volatility of the
S&P 500 was about 14%; whereas volatility of the aggre-
gated hedge funds was only about 10%. That is, for about
two-thirds of the time, the expected returns were within 10%
of the average return. Thus, contrary to popular belief, hedge
fund returns are relatively less volatile and more concentrated
than the market returns.

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However, the negative skewness in hedge funds has
attracted the attention of several researchers and many theories
have been put forth to explain it (Mitchell and Pulvino, 2001;
Goetzmann et al, 2003; Taleb, 2004). The non-normality of
hedge fund returns makes it imperative to devise new tech-
niques of hedge fund risk and return measurement. As the
typical distribution of a hedge fund is negatively skewed,
measures of downside risk are more potent in describing
the actual risk associated with hedge funds (Jorion, 2000;
Estrada, 2001, Agarwal and Naik, 2004; Alexander and
Baptista, 2004). Specifically, measures like Semi Deviation
(Estrada, 2001), Extreme Value Theory (EVT), Value at Risk
(VaR), Conditional Value at Risk (CVaR) etc, are more appro-
priate measures of risk. For return measures, Arithmetic
Excess Returns (AER), Geometric Excess Returns (GER) and
Kurtosis have been found to be more suitable among others.
Liang and Park (2007) analysed the risk-return trade off
in hedge funds using semi-deviation, VaR, expected shortfall
and tail risk using the deciles portfolio approach, mentioned
in Fama and French (1992). They found that during the period
1995-2004, hedge funds with high Expected shortfall (ES)
outperformed those with low ES by an annual return differ-
ence margin of 7% after adjusting for auto-correlation and
heteroskedasticity. Agarwal and Naik (2004) used empirical
distributions of returns of funds to determine expected short-
fall or CVaR. Their observations clearly reveal that the mean-
variance framework is inadequate to measure the downside
risk and hence they suggest the ES -optimization technique
instead. Bali and Gokcan (2004) estimated VaR for hedge fund
portfolios using a normal distribution, a fat-tailed generalized
error distribution (GED), the Cornish-Fisher (CF) expansion
and the EVT. They used the hedge fund research indexes and
found that the EVT approach and the CF expansion capture
tail risk better than the other approaches. However, VaR is also
subject to severe criticism. Lo (2001) points out that merely
several years of historical data may not show the distribution
of returns and therefore questions the usefulness of VaR-based
risk management. Traditionally, VaR has always suffered from
these theoretical shortcomings. It does not provide for the
magnitude of the possible losses below the threshold it iden-
tifies. VaR also lacks convexity and monotonicity along with
continuity (Artzner et al, 1999).
Most models of performance analysis of financial assets
use variance as the measure of risk and mean return as the
measure of return from a portfolio. Variance does not separate
the upside risk (that investors seek) from the downside risk
(the detrimental one). Hence, a classical measure of perfor-
mance like the Sharpe Ratio has been modified to incorpo-
rate alternative risk measures like drawdown, lower partial
moments and Modified Value at Risk, (MVaR) leading to
the formulation of new measures like the Sortino Ratio and
Omega or Calmar Ratio.
All financial ratios, whether classical or modern, allow
for the integration of only one dimension of risk and
return, which often results in similar rankings to that of the
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UD Kumar et a/- Analysis of hedge fund strategies 1749
classical Sharpe ratio, which is widely considered as an
unsuitable method of measuring the hedge fund performance
(Eling and Schuhmacher, 2007). Consequently, a single
measure that comprehensively reports the performance of a
hedge fund is still wanting. It is here that DEA can be used
to incorporate the numerous 'risk and return' measures for
a hedge fund and thereby arrive at a single efficiency score
describing the performance.
Data envelopment analysis models for hedge funds
Charnes et al (1978) introduced DEA to measure the scale
efficiencies of various public sector firms. Central to a DEA
model is the notion of a DMU, which is basically an abstract
representation (of a firm in a given industry), that produces
a collection of outputs by consuming a set of inputs. In the
current paper, different DMUs constitute the different strate-
gies used by different fund managers. The DEA models are
based on a linear programming formulation that determines
the relative efficiency of a specific DMU with respect to the
remaining DMUs.
The first DEA model, introduced by Charnes et al (1978),
assumes that the size of a DMU does not affect the efficiency
of a firm. It is aptly called the Constant Returns to Scale
(CRS) model, also known as the CCR model, and provides
the global technical efficiency measure. As, this assumption
may not always hold good in practice, Banker et al (1984)
developed a DEA model called the variable returns to scale
(VRS) model, also known as the BCC model, which calcu-
lates local pure technical efficiency, under the assumption of
VRS. The VRS model includes an additional constraint on
'jS (J^j^j - 1)' which while restricting the feasible region
to a convex hull, ensures that the variable returns to scale
assumption is satisfied.
The use of risk as input and return as output to analyse
the performance of financial assets was practised by many
researchers in the past. The reason for this is that the fund
managers have the option of choosing a strategy that has
higher or lower risk (input) to achieve certain rate of return
(output). Several authors have used DEA to analyse the
performance of hedge funds (Gregoriou, 2003; Gregoriou
et al, 2005; Eling, 2006; Nguyen-Thi-Thanh, 2006).
Gregoriou et al (2005) have used BCC and super efficiency
BCC models to identify the number of efficient and ineffi-
cient funds with eight different strategies using a dataset of
641 funds. Eling (2006) makes use of three different models,
namely, Constant Returns to scale (CCR), BCC and super-
efficiency DEA to analyse the performance of hedge funds
using inputs and outputs chosen with the help of rank corre-
lation and principal component analysis. In the case of hedge
funds, the input and output measures, such as skewness of
returns and the principal components of inputs and outputs
can take negative values. As the traditional DEA models
like the CCR and the BCC cannot accommodate negative
data, some data transformation methodology is usually used
1750 Journal of the Operational Research Society Vol. 61, No. 12

before the application of DEA models when negative data x >xo (7)
exists in both inputs and outputs. Nguyen-Thi-Thanh (2006),
for example, suggests adding a constant to outputs of all y^yo (8)
DMUs when negative values are present to transform them
into positive outputs. Seiford and Zhu (2002), however, state 3U>o
that this kind of transformation of data may affect DEA
We have used DEA Solver Pro 5.0 to solve the SBM and
results and rankings. Portela et al (2004) point out that the
Super-SBM models. The scheme used for transforming nega-
most frequently used DEA model in the presence of nega-
tive outputs in SBM models is discussed in the manual of DEA
tive data is the VRS additive model developed by Chames
et al (1985). However, the VRS additive model is not units Solver Pro 5.0 and by Duzakin and Duzakin (2007). In the
following section, we have briefly discussed the scheme used
invariant (Portela et al, 2004).
by DEA Solver Pro 5.0 to deal with negative output values.
Various DEA models have been proposed to deal with nega-
Assume that output r of DMU o is negative, that is, yro ^ 0.
tive data (Lovell and Pastor, 1995; Portela et al, 2004). Tone
Then we define two variables y+ and y~ as shown below:
(2001) and Duzakin and Duzakin (2007) have demonstrated
the use of slack-based DEA models to solve problems with
vr+ = max7=i,2,...,w{^; 'yrj > 0} (9)
negative outputs. The DEA models used in this paper have
been inspired by the works of Cooper et al (2000) and Tone y~ = min;=i)2,...,{yr7 |vr; > 0} (10)
(2001). The Slack-Based Measure (SBM) of Efficiency, which
If the output r has no positive elements, then we define
is described below in Model 1, gives a non-radial measure that
y+ = y~ = 1. Once the values of y+ and y~ are calculated
allows for non-proportional reductions in inputs or augmen-
using Equations (9) and (10), we replace the term s+/yroin
tations in outputs (Cooper et al, 2000; Tone, 2001).
the objective function (Equation 1) as stated below.
Model 1: Slack-based DEA model If v+ > y~ then we replace s+ /yro by the term

The slack-based DEA model with n DMUs, m inputs X=jc17 e

Rmxn and s outputs y = yu e Rsxn is given by: y7{y-y7)/{yt-yro) z z

If y+ = y- then we replace s+/yro by the term

1 - SLi^r/^
minp= s+

s {y7)2/B{y+ - yro) (U)

Subject to constraints: where B (in Equation 12) is a large value (in the DEA Solver
Pro 5.0 the value of B = 100). Note that the values of yro
X + s-=xo (2)
in the constraints are not changed. This scheme takes into
YX - s+ = y0 (3) account the magnitude of the non-positive output positively
and the score obtained is units invariant. Recently, Sharpe
et al (2007) presented a modified slack-based DEA model to
deal with negative inputs and outputs, generalizing the model
A DMU is SBM efficient if p* = 1, which is equivalent
to s~* = 0 and s+* = 0. The efficient DMUs can be further by Portela et al (2004).

discriminated using Super-SBM models (Tone, 2002).

Hedge fund data and DEA inputs and outputs
Model 2: Super-SBM model In this section, we describe the data collection methodology
Super slack-based DEA model is given by: for individual hedge funds and the corresponding hedge fund
strategies. We also describe two different methodologies used
to choose input/output sets for DEA application in the current
study.
min 6 = ^
-jyr=iyr/yro
s
Hedge fund data description
Subject to constraints:
For this study, data was collected from the Bloomberg
n
database on net asset values (NAVs) for 4730 hedge funds,
J2 jXj^x (5) spanning a time period of 14 years, from 1995 to 2007.
We initially began with a sample of 5520 hedge funds
n and withdrew 790 funds from the sample due to non-
E xjyj>y (6) availability of continuous data for the study period. The
data collected was on a monthly basis, which commenced

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 UD Kumar et a/ - Analysis of hedge fund strategies 1751

Table 1 DEA inputs-outputs

Authors Inputs Outputs

Gregoriou (2003) Lower partial moments of order 1 Higher partial moments of order 1
Gregoriou and Gueyie (2003) Lower partial moments of order 2 Higher partial moments of order 2
Lower partial moments of order 3 Higher partial moments of order 3
Wilkens and Zhu (2005) Standard deviation Average return
Lower partial moments of order 0 Minimum return
Skewness
Nguyen-Thi-Thanh (2006) Standard deviation Average return
Excess kurtosis Skewness
Eling (2006) Conditional value at risk Higher partial moment of order 0
Lower partial moments of order 0 Higher partial moment of order 3

Table 2 DEA inputs and outputs for hedge fund strategies

Risk Measures - Input Return Measures - Output

Standard Deviation Arithmetic Excess Return (AER)

Lower Partial Moment of order 0 Geometric Excess Return (GER)
Lower Partial Moment of order 1 Higher Partial Moment of order 0
Lower Partial Moment of order 2 Higher Partial Moment of order 1
Lower Partial Moment of order 3 Higher Partial Moment of order 2
Maximum Drawdown (MD) Higher Partial Moment of order 3
Average Drawdown (AD) Skewness
Standard Deviation of Drawdown (SDD)
Value at Risk (VaR)
Conditional Value at Risk (CVaR)
Modified Value at Risk (MVaR)

on January 1995 and continued till April 2007. These
hedge funds were grouped according to fund strategies. The
following 18 different strategies were found: Convertible,
Corporate/ Preferred, Currency, Derivative, Emerging market,
Equity Directional, Equity Market Neutral, Event Driven,
Fixed income directional, Fixed income relative value,
Flexible portfolio, Geographically focused, Global Macro,
Government/ Corporate, Managed Futures, Multi-Strategy,
Sector Funds and Various Assets. After the grouping was
done, the NAV for each strategy was arrived at using the
average NAV of all funds within the strategy bucket. The
NAV data was then normalized with the April 2007 NAV set
to 1 . Subsequently, the monthly NAV data was used to calcu-
late the returns for each of the 18 strategies for the period
between January 1995 and April 2007.
One major argument against hedge funds is that only funds
that are performing well provide the data. Also, there could
be a significant difference between the performance of live
and dead funds. However, Ding and Shawky (2007) show
that at the strategy level there is no difference between the
performance of dead funds and live funds.
Selection of inputs and outputs for DEA analysis
Selection of appropriate DEA models, especially the inputs
and outputs has been a focus of DEA research for many
years (Banker and Morey, 1986; Norman and Stocker, 1991;
Pastor et al, 2002; Serrano Cinca and Mar Molinero, 2004).
Pastor et al (2002) used the concept of efficiency contri-
bution measure that compares the efficiency scores of two
DEA models differing in either one input or output. To
reduce the curse of dimensionality Adler and Golany (2002)
developed a model combining DEA and principle compo-
nent analysis (PCA) to strengthen the discriminating power
of DEA. Serrano Cinca and Mar Molinero (2004) proposed
a methodology that evaluates efficiencies for all input and
output combinations that are further analysed using PCA.
Appropriate input and output selection has been one of the
most critical issues in the application of DEA to financial
assets (Eling, 2006; Nguyen-Thi-Thanh, 2006). Table 1 shows
the inputs/outputs that have been hitherto used for the analysis
of hedge funds. Eling (2006) suggests the use of rank corre-
lation analysis and PCA to decide inputs and outputs, as they
help not only in reducing the number of inputs and outputs,
but also in identifying the most appropriate input/output set.
In the current study, while computing the performance scores
in both stages of DEA implementation (for each strategy and
each fund within the most efficient strategy), risk measures
were taken as inputs and return measures as outputs. An
exhaustive list of the input and output parameters are given
in Table 2. Traditionally, researchers in the field of financial
asset management have used risk measures such as Sharpe
ratio, modified Sharpe ratio, Sortino ratio, Calmar ratio etc to
measure the performance of financial assets. However, many
of these ratios have limitations as almost all of them assume

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1752 Journal of the Operational Research Society Vol. 61, No. 12
that the return follows a normal distribution and use one
risk and one return measure to calculate the performance of
an asset. For example, Sharpe ratio assumes that the return
follows a normal distribution and does not differentiate the
good volatility from bad volatility. In our model, we have
used secondary variables listed in Table 2, as we wanted
to include all types of risks and returns that may or may
not follow a normal distribution to provide flexibility to our
model. For example, lower order partial moments capture the
downside risk of an asset. Bawa and Lindenberg (1977) argue
that models based on mean-lower partial moment have better
ability to explain the market data.
For each hedge fund strategy, several input and output
measures were calculated using the NAV data and finally
a performance score has been arrived at for each strategy.
Although it is possible that funds within the same strategy
may have low correlations, evaluation of our data shows
that correlations between funds within the same strategy are
markedly higher than between strategies. Thus, it is reason-
able to assume that funds within a strategy have relatively
more similarities and can therefore be grouped together to
provide a rough measure of the underlying strategy. We
used two different methodologies to arrive at the appropriate
input/output sets for the DEA application: (i) Spearman's
Rank Correlation (SRC) and (ii) Principal Component Anal-
ysis (PCA). Based on SRC, the following inputs and outputs
were short listed for use in the DEA models:
Risk measures - inputs
1. Standard Deviation of Drawdown (SDD). SDD for fund i
is given by:
K
SDDik= YsDfk (13)
'j*=i
Where Dik is the drawdown of fund /, and K is the number
of drawdowns.
2. Value at Risk (VAR). VAR for fund i is given by:
VARi = -(rfta + Z0LSDi) (14)
Where, SDt is the standard deviation, and is given by:
1 T
V " l t=i
rit is the return of fund / for month t (= 1 , 2, . . . , T) and rfa
is the average return of fund i over a long duration of time
V and Za is the critical value of standard normal variate.
Return measures - outputs
1. Higher Partial Moment of order 0 (HPMO). Where:
HPM0 = Pr{rit^r} (16)
Where, t is the minimum acceptable return.
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2. Skewness. For fund /, skewness is given by:
1T
Si = jY,^-rlf/SD] (17)
t='
Next, we calculated all the input/output measures listed in
Table 2 for all the 18 strategies and carried out a PCA to arrive
at two input components and two output components that
explained more than 70% of the variation in the input/output
data, respectively.
Analysis of SBM DEA results
Summary statistics for all the 18 strategies, including the
number of funds in each strategy are reported in Table 3,
wherein the DEA inputs and outputs selected through SRC
analysis, are also reported. The average return for each
strategy was calculated by taking the average of returns
corresponding to all the funds within that strategy.
Discussion of DEA output and comparison with Sharpe ratio
The results of application of DEA SBM with both sets of
input and output measures (as given by SRC and PCA) are
enumerated in Table 4, which also contains, for the purpose
of comparison, the rankings based on Sharpe ratio, Sortino
ratio, Calmer ratio and modified Sharpe ratio. It is interesting
to note that the DEA ranking has low correlation with tradi-
tional performance measures such as Sharpe ratio (12.79%).
Many researchers in the past have argued that Sharpe ratio is
not relevant for hedge funds as the hedge fund returns do not
follow normal distribution (Kao, 2002; Gregoriou and Gueyie,
2003) and is not suitable for alternative investment strate-
gies. Bertrand (2005) has listed several reasons why Sharpe
ratio is not a suitable measure for hedge funds and claims
that Sortino ratio is a better measure compared to Sharpe
ratio. The Wall Street Journal on 1 February 2001 reported
that the Art Institute of Chicago lost $43 million by investing
in a hedge fund called 'Integral Investment Management'
in which the fund manager claimed that their fund had the
highest Sharpe ratio in the industry (Bertrand, 2005). In our
opinion, the main reason for low correlation between Sharpe
ratio and DEA model is due to the fact that Sharpe ratio does
not differentiate good volatility from bad, whereas in the DEA
model we have differentiated good and bad volatility by calcu-
lating higher and lower order partial moments. Another reason
being the consideration of multiple risk return measures used
in our DEA model vis--vis the single input - single output
measures used in Sharpe ratio calculations. The correlation
between rankings based on DEA rank correlation model with
Sortino ratio is 32.02%, a significant improvement over corre-
lation between DEA and Sharpe ratio (12.79%). The better
correlation in this case is probably due to the fact that Sortino
ratio differentiates the good and bad volatility and thus we
observe better correlation between DEA and Sortino ratio.
 UD Kumar et al- Analysis of hedge fund strategies 1753

Table 3 Summary statistics of strategies and the Spearman rank correlation input/output values

Fund strategy Number of funds Average return (%) SDD VAR HPMO Skewness
Convertible 1 0.85 0.026 -0.032 0.619 -0.464
Corporate/Preferred 1 0.76 0.034 -0.036 0.551 -0.065
Currency 1 0.41 0.010 -0.011 0.457 -0.218
Derivative 1 -0.02 0.039 -0.075 0.462 -0.245
Emerging Market 132 0.24 0.042 -0.068 0.565 -2.129
Equity Directional 921 0.74 0.025 -0.027 0.585 2.113
Equity Market Neutral 290 1.38 0.122 -0.022 0.524 10.311
Event Driven 141 1.77 0.204 -0.037 0.673 10.446
Fixed Income Directional 89 0.30 0.021 -0.036 0.503 -1.436
Fixed Income Relative Value 195 0.79 0.096 -0.028 0.524 6.024
Flexible Portfolio 15 0.46 0.017 -0.017 0.500 3.887
Geographically Focused 3 0.40 0.014 -0.010 0.446 0.451
Global Macro 51 0.53 0.045 -0.029 0.463 5.740
Government/Corporate 7 1.48 0.047 -0.002 0.762 7.075
Managed Futures 351 0.87 0.081 -0.047 0.449 8.869
Multi-Strategy 2516 1.13 0.096 -0.050 0.571 8.944
Sector Funds 1 0.08 0.009 -0.013 0.253 -4.376
Various Assets 14 0.64 0.034 -0.017 0.563 2.659

Table 4 Ranking of hedge fund strategies using DEA-SBM and Sharpe ratio

Strategy Sharpe DEA- Rank DEA-PCA Sonino Calmar Modified sharpe

ratio correlation ratio ratio ratio

Value Rank Value Rank Value Rank Value Rank Value Rank Value Rank

Convertible 0.176 2 1 1 0.01 18 86.20 2 0.34 2 0.33 2

Corporate/Preferred 0.102 4 0.21 18 0.06 16 44.97 6 0.14 4 0.23 7
Currency -0.007 13 1 11 1 -2.81 14 0.04 10 0.41 1
Derivative -0.114 17 1 11 1 0.29 12 -0.001 15 -0.005 18
Emerging Market -0.043 15 1 11 1 -16.94 16 0.051 7 0.06 17
Equity Directional 0.129 3 1 11 1 76.59 3 0.05 8 0.30 4
Equity Market Neutral 0.079 5 1 11 1 72.44 4 -0.016 16 0.11 12
Event Driven 0.066 8 1 11 1 15.56 9 0.012 14 0.09 15
Fixed Income Directional -0.055 16 1 1 0.02 17 -19.84 17 0.032 11 0.14 9
Fixed Income Relative Value 0.039 10 0.68 15 1 1 -0.007 13 0.019 13 0.08 16
Flexible Portfolio 0.026 11 1 11 1 17.80 8 0.098 5 0.27 6
Geographically Focused -0.015 14 0.33 17 0.32 15 -4.93 15 0.162 3 0.28 5
Global Macro 0.024 12 0.94 14 1 1 2.99 11 0.043 9 0.12 10
Government/Corporate 0.223 11 11 1 287.04 1 0.35 1 0.31 3
Managed Futures 0.055 9 1 11 1 34.90 7 -0.019 17 0.11 13
Multi-Strategy 0.0734 6 1 11 1 52.64 5 -0.025 18 0.12 11
Sector Funds -0.376 18 0.99 13 1 1 -37.36 18 0.085 6 0.09 14
Various Assets 0.066 7 0.66 16 0.53 14 11.186 10 0.030 12 0.19 8

We have also compared the results with Calmar and modi-
fied Sharpe ratio. In our opinion, the results based on DEA
should be treated as different from the results based on other
risk ratios such as Sharpe ratio, Sortino ratio, Calmar ratio
etc. For example, the Calmar ratio is usually calculated using
the latest 36 months return whereas DEA results are based on
the returns during the entire period.
The results of DEA SBM (using inputs and outputs as deter-
mined by the SRC) showed that, out of the total of 18 strate-
gies, 12 were found to be efficient strategies and defined the
corresponding efficiency frontier. When inputs and outputs
were selected by the PC A, 13 strategies emerged as efficient
strategies. The results obtained from the application of DEA
models are quite contradictory to the results given by the
Sharpe Ratio analysis. As mentioned earlier, it is interesting
to note that the ranking of hedge funds using Sharpe ratio and
12 other performance measures resulted in nearly identical
ranking (Eling and Schuhmacher, 2007). From an investor's
viewpoint, the rankings arrived at using DEA are more mean-
ingful as more than one measure of risk and return are taken

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1754 Journal of the Operational Research Society Vol. 61, No. 12

Table 5 Ranking of hedge fund strategies using Super SBM* and Sharpe ratio

Strategy DEA-Principal DEA-Spearman Rank Sharpe ratio

Component (PCA) Correlation (SRQ

Value Ranking Value Ranking Value Ranking

Convertible 1.02 6 0.17 2
Currency 1 5 1.34 2 -0.01 11
Derivative 1 5 1 8 -0.11 14
Emerging Market 15 1 8 -0.04 12
Equity Directional 1 5 1 8 0.13 3
Equity Market Neutral 1.06 2 1.05 5 0.08 4
Event Driven 1.45 1 1.12 4 0.07 6
Fixed Income Directional 1 8 -0.05 13
Fixed Income Relative Value 1 5 0.04 8
Flexible Portfolio 1 5 1.41 1 0.03 9
Global Macro 1 5 0.02 10
Government/Corporate 1.01 4 1.32 3 0.22 1
Managed Futures 1.02 3 1.02 7 0.06 7
Multi-Strategy 15 1 8 0.07 5
Sector Funds 1 5 -0.38 15

* Please note that some of the strategies listed in the table are inefficient either w.r.t PCA model or w.r.t SRC model and hence the cells corresponding
to these strategies under that DEA model are empty. For example, Convertible Strategy is found to be inefficient under PCA model and hence is not
included in the super SBM evaluation with PCA input/output set.

into account simultaneously, especially when the Sharpe ratio
has failed in the past in predicting the performance (Bertrand,
2005).
As may be noted from Table 4, it was difficult to
differentiate between the 12 efficient strategies under the
DEA-Rank Correlation or the 13 efficient strategies under
the DEA - Principal Component Analysis, as all of them
have an efficiency score of T. In order to arrive at a
ranking that has greater discriminatory power, we applied
the Super-SBM model on these two sets of efficient strate-
gies using input/output sets from DEA-Rank Correlation and
DEA-PCA respectively. The results of Super-SBM applica-
tion are listed in Table 5.
The results from Stage 1 analysis, shown in Tables 4
and 5 differentiate efficient strategies from inefficient strate-
gies, but as the investors are interested in knowing a fund's
performance, it is necessary to analyse the individual perfor-
mance of the hedge funds. This can be done in two ways:
(1) On the basis of Stage 1 analysis, if an investor has already
decided on which strategy to invest in, but is not sure as to
which fund to invest in under this strategy, she can apply the
DEA Super SBM to all the funds under this strategy and find
the most efficient fund; (2) On the other hand, if the investor
is not even sure about which strategy to invest in, she could
shortlist the top four to five strategies and apply the DEA
Super SBM to all the funds under these strategies and find
the most efficient fund.
To demonstrate the latter concept, we carried out the
Stage 2 analysis by collecting all the hedge funds (a total
of 775) from four efficient strategies, namely, (i) Managed
futures, consisting of 342 hedge funds; (ii) Equity Market
Neutral, consisting of 285 hedge funds; (iii) Event Driven,
consisting of 141 funds; and (iv) Government/Corporate,
consisting of seven hedge funds. Note that these four strate-
gies were shortlisted based on their super efficiency ranking
with PCA input/output set, for the sake of demonstration.
We then carried out SBM DEA and Super-SBM DEA on
this set of hedge funds using both sets of inputs/outputs. The
top 20 efficient firms with the Spearman Rank Correlation
input/output set are shown in Table 6, and the results from
the PCA results are shown in Table 7. As can be noted from
Table 6, there are 15 efficient funds from Managed Futures,
four funds from Equity Market Neutral and one efficient fund
from Event Driven. It is notable that there is no efficient fund
from the Government/Corporate strategy. Similarly, from
Table 7, one can note that there are nine efficient funds from
Managed Futures, eight from Equity Market Neutral, two
from Event Driven and one from the Government/Corporate
strategy. Note that the number of efficient funds from each
strategy in this case is proportional to the number of funds
in each strategy.
The most important factor to note from Table 6 however
is that, IMJICMD GU Equity fund, which tops the list of
efficient funds is from the Managed Futures strategy that
ranks seven in the strategy level Super efficiency analysis.
This is to be expected, as we have taken averages of fund
level performance measures to compute the risk-return pattern
of strategies during the strategy level analysis. Thus, it is
quite possible that, a fund whose performance is significantly
above average in a given strategy turns out to be more effi-
cient than the efficient funds from the higher ranking strate-
gies. As can be noted from Table 7, the results corresponding
to the PCA input/output also show that the STILNWF KY
Equity Fund, the KINGLBB VI Equity and the ERGBLRG

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 UD Kumar et a/ - Analysis of hedge fund strategies 1755

Table 6 Super-SBM efficiency ranks and corresponding scores of individual funds with Spearman Rank Correlation (SRC)
inputs/outputs

Hedge fund SRC score SRC rank

IMJICMD GU Equity- Managed Futures 1.358 1

MONEQPO KY Equity- Equity Market Neutral 1.005 2
COVETS A VI Equity- Managed Futures 1.000 3
BEACH3X KY Equity- Managed Futures 0.961 4
ACERCBE FP Equity- Managed Futures 0.736 5
IQSPERF KY Equity- Managed Futures 0.701 6
RABSPSF KY Equity- Event Driven 0.565 7
OKUOPPA VI Equity- Equity Market Neutral 0.514 8
ESROGLB BM Equity- Managed Futures 0.473 9
SAILFXL BM Equity- Managed Futures 0.403 10
MATADOR VI Equity- Managed Futures 0.378 1 1
ORSYFFF FP Equity- Managed Futures 0.339 12
SLFPUIK FP Equity- Managed Futures 0.328 13
SUPERFU KY Equity- Managed Futures 0.301 14
FRIEDDIV CN Equity- Managed Futures 0.260 15
CONBFII ID Equity- Managed Futures 0.181 16
RMNRTAA LX Equity- Equity Market Neutral 0.164 17
SCOGNIU KY Equity- Equity Market Neutral 0.158 18
GI ANEXE VI Equity- Managed Futures 0.154 19
ERGMXXL BM Equity- Managed Futures 0.148 20

Table 7 Super-SBM efficiency ranks and corresponding scores of the individual funds with Principal Component Analysis (PCA)
inputs/outputs

Hedge fund PCA score PCA rank Frequency of reference

STILNWF KY Equity- Equity Market Neutral 3.397 1 25

KINGLBB VI Equity- Equity Market Neutral 2.341 2 733
ERGBLRG BM Equity- Equity Market Neutral 1.076 3 87
ORFFUT2 FP Equity- Managed Futures 1.006 4 458
SMONREG VI Equity- Equity Market Neutral 1.000 5 12
MOALWDA BH Equity- Event Driven 1.000 5 4
GIAALGD VI Equity- Managed Futures 1.000 5 38
STRAFOR VI Equity- Managed Futures 1.000 5 56
ITCORPL BZ Equity- Government/Corporate 0.995 9 0
DAIBCCF KY Equity- Managed Futures 0.690 10 0
BEAUMOF VI Equity- Managed Futures 0.568 11 0
RMNRTAA LX Equity- Equity Market Neutral 0.522 12 0
PRODOPP KY Equity- Event Driven 0.475 13 0
IMJICMD GU Equity - Managed Futures 0.395 14 0
PAPHDAU BM Equity- Managed Futures 0.390 15 0
SGLSQAE ID Equity- Equity Market Neutral 0.378 16 0
BEACMLP KY Equity- Equity Market Neutral 0.336 17 0
FAISIGM VI Equity- Equity Market Neutral 0.181 18 0
HENGCUU KY Equity- Managed Futures 0.156 19 0
ORSYFFF FP Equity- Managed Futures 0.100 20 0

BM Equity, which rank one, two and three, respectively in the
PCA Super-efficient list, in fact belong to the Equity Market
Neutral strategy, which ranks second in the strategy level
super efficient analysis using PCA input/output set. Two funds
from the Event Driven strategy, which tops the list of effi-
cient strategies in the PCA analysis, in fact rank five and 13,
respectively in the fund level PCA analysis. Thus, this two-
performances. Investors, who are convinced about investing
in a given strategy, can find the most efficient fund within that
strategy; and investors who are looking for the best fund to
invest in, irrespective of a strategy, can identify the most effi-
cient fund among the top ranking strategies, so as to accrue
both strategy level advantages and the fund level performance
benefits.

stage DEA framework provides investors with more specific These results also suggest that the performance of hedge
insights into both the strategy level as well as the fund level funds is not dictated solely by the underlying strategy. Funds

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1756 Journal of the Operational Research Society Vol. 61, No. 12
belonging to relatively inefficient strategies may achieve
stellar performances due to various other factors. Thus, on
the surface at least, it does seem that the fund managers play
a pivotal role in generating above average returns and hence
there is some justification to the high performance fees that
hedge funds charge.
DEA evaluation also provides further details on the perfor-
mance of strategies and funds by providing reference sets
and target input/output values for the inefficient units. The
reference sets are basically a set of frontier units, which are
closest in nature to the inefficient unit under consideration
and provide benchmarking information. For example, in the
current context, the fund in the reference set of an ineffi-
cient fund, say 'O', may either have similar risk structure
(inputs) to that of 'O' and performs better than 'O' in its
returns (outputs), or it may have similar returns as fund 'O'
but with a lower risk level than fund 'O'. Therefore, fund 'O'
can benchmark itself against its reference set while targeting
its performance improvement and all DEA models, including
the SBM, can provide a target input/output set to fund 'O'
to catch up with its reference set of funds. More importantly,
for the investor, who is looking for an efficient fund to invest
in, this information sheds more light by providing informa-
tion about the efficient funds that become part of a reference
set for the inefficient funds. The more times an efficient fund
figures in a reference set, the better it is considered to be, as it
means that there are so many inefficient funds in its horizon
that are performing with a similar risk-return structure but are
lagging behind.
To demonstrate how this additional information can be used
in the latter case for identifying the efficient funds, we have
listed the number of times an efficient fund has figured in
a reference set in column 4 of Table 7. As one can note,
KINGLBB VI Equity Market Neutral, which is ranked two
in the super efficiency analysis has appeared in significantly
more number of reference sets (733) than the STILNWF KY
Equity fund (only 25 reference sets), which has topped the
list. Similarly, 0RFFUT2 FP Equity, which is ranked four,
has figured in more reference sets (458) than the ERGBLRG
BM Equity (87), which is ranked three. In some contexts, this
kind of information can significantly aid the decision-making
process. Similarly, the inefficient funds can make use of the
reference sets coupled with input/output targets to improve
their performance in the long run so as to catch up with
the more efficient funds and also to become more attractive
to the investors. DEA also provides Returns to Scale infor-
mation, which specifies whether a particular fund is in the
Increasing Returns to Scale, the Constant Returns to Scale or
the Decreasing Returns to Scale region. This kind of informa-
tion is very relevant because it can aid the funds in determining
whether to aim for a higher scale or not, and the investors
can rely on this information to make decisions regarding their
investments, which is of great significance especially because
hedge funds by nature deal with huge scales of investments
(Eling, 2006). However, these topics are beyond the scope of
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this paper, and the interested reader can refer to related DEA
literature for more details (Cooper et al, 2000; Saranga, 2009).
Comparison with the z-test and a look at the 1997 Asian
market crisis
We carried out the standard z-test to compare the results of
the DEA application. A test of the hypothesis using the z-test
for difference of mean returns showed that at 95% confidence
interval,
1. Convertible Strategy is better than Currency, Emerging
Market, Fixed Income Directional, Geographically
Focused and Sector Funds.
2. Corporate/Preferred Strategy is better than Sector Funds.
3. Currency is better than Fixed Income Directional and
Sector Funds.
4. Emerging market is better than Currency, Derivative,
Flexible, Geographically Focused and Sector Funds.
5. Equity Directional is better than Fixed Income Direc-
tional.
6. Fixed Income Directional is better than Sector Funds.
7. Fixed Income Relative Value is better than Sector Funds.
8. Flexible Portfolio is better than Global Macro and Sector
Funds.
9. Geographically Focused is better than Sector Funds.
10. Government/Corporate is better than Currency, Fixed
Income Directional, Fixed Income Relative Value, Flex-
ible Portfolio, Geographically Focused, Global Macro,
Multi Strategy and Sector Funds.
As one may note from the comparison of Tables 4 and 5 with
the above results, except for statements 2 and 9 and a few
subparts of statements 1 and 4, all the remaining statements
hold good in the DEA results in terms of efficiency. Thus, the
strategies that form the DEA efficiency frontiers do seem to
dominate the inefficient strategies in terms of greater returns.
Hence, the z-test results, to a large extent, substantiate the
DEA framework for investors looking for better investment
opportunities.
Another main area that interests investors is regarding the
performance of the funds during times of financial turmoil.
The results of the 1997 crisis hypothesis testing showed
that:
1. Convertible was better than Emerging Market, Flexible
Portfolio and Geographically Focused.
2. Corporate/Preferred is better than Emerging Market and
Flexible portfolio.
3. Currency is better than Geographically Focused and
Fixed Income Directional.
4. Emerging Market is better than Geographically Focused.
5. Equity Directional is better than Currency, Geograph-
ically Focused, Emerging Market and Fixed Income
Directional.
 UD Kumar et al- Analysis of hedge fund strategies 1757

Table 8 Hurst ratio of hedge fund strategies

Fund strategy Hurst ratio Percentage funds with Hurst ratio > 0.5
Convertible 0.614928836
Corporate/Preferred 0.6759 1 9455
Currency 0.63104202
Derivative 0.422106608
Emerging Market 0.548469488 0.643939394
Equity Directional 0.522237473 0.541893362
Equity Market Neutral 0.522139864 0.555555556
Event Driven 0.545091 1 17 0.70212766
Fixed Income Directional 0.516935304 0.595505618
Fixed Income Relative Value 0.537536424 0.649484536
Flexible Portfolio 0.511 225024 0.4
Geographically Focused 0.574467373
Global Macro 0.531611215 0.652
Government/Corporate 0.533457288
Managed Futures 0.500021886 0.477011494
Multi-Strategy 0.520759735 0.551875499
Sector Funds 0.673799402
Various Assets 0.48203474 0.357142857

*Note that Convertible, Corporate/Preferred, Currency, Derivative and Sector Funds constitute a single fund (refer to Table 3) and hence the percentages
are not given, while Geographically Focused and Government/Corporate also have only seven and three funds, respectively.

6. Equity Market Neutral is better than Geographically the z-test substantiate this finding with a 95% confidence
Focused, Emerging Market and Fixed Income Direc- level, as shown in Table 9.
tional.

7. Event Driven is better than Emerging Market. Stability of hedge fund returns
8. Fixed Income Directional is better than Emerging Market.
Stability of returns is a major concern for any investor, espe-
9. Flexible Portfolio is better than Fixed Income Directional.
cially in the case of hedge funds. One of the metrics used
10. Global Macro is better than Emerging Market.
for checking stability is the Hurst ratio, which is usually
11. Managed Futures is better than Emerging Market and used to check whether the returns of the funds are stable
Flexible Portfolio.
or just random. It differentiates the funds that are consistent
12. Multi-Strategy is better than Emerging Market and Flex-
performers from the ones that experienced strokes of luck.
ible Portfolio.
Hurst ratio as defined by Koh Francis et al (2004) is calcu-
lated as
A close look at the results reveals that nine strategies
performed distinctly better than the Emerging market strategy Hurst Ratio =

during the Asian finacial crisis. The Asian financial crisis
started in July 1997 in Thailand and South Korea with the
financial collapse of Thai Bant and Kia, and affected curren-
cies, stock markets and other asset prices in Asian countries,
including the Four Asian Tigers (Taiwan, South Korea, Hong
Kong and Singapore). Indonesia, South Korea and Thailand
were the countries most affected by the crisis; Hong Kong,
Malaysia, Laos and the Philippines were also hit by the
slump; while China, India, Taiwan, Singapore and Vietnam
were relatively unaffected. Japan was not affected much by
this crisis but was going through its own long-term economic
difficulties. However, all the nations mentioned above saw
their currencies dip significantly relative to the US dollar,
though the harder hit nations saw extended currency losses.
Out of all the countries affected, South Korea was hit the
hardest. Thus, it is not difficult to see that the hedge funds
investing in Emerging Markets of Asia were liable to be more
adversely affected than most other strategies. The results of
LogAf - Log a
where M(t) = (max(0 - min(t))/S(t); N = length of shorter
sub-periods into which a manager's return record has
been sub-divided; t = number of sub-periods into which a
manager's return record has been sub-divided; S(t) = standard
deviation of data over sub-period t; a = constant term that is
negligible if track record is 5 years or less (Ignored for our
case).
The results obtained for different hedge fund strategies for
Hurst ratio are shown in Table 8. It can be seen that most of
the strategies have Hurst ratio greater than 0.5. This implies
that the returns obtained by the fund managers in these strate-
gies are persistent and the managers can be said to have 'hot
hands'. A value less than 0.5 means that the returns tend to
fluctuate randomly but converge to a stable value over time.
The Hurst ratio for S&P 500 comes out to be 0.57. Out of all
the strategies - Emerging Markets, Event Driven and Fixed
Income Relative Value are the strategies that can be said to

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 1758 Journal of the Operational Research Society Vol. 61, No. 12

' t? ^ co^HOOt-iomrocoo^toov.o have higher percentage of funds with persistent returns. The
correlation between beta and Hurst ratio comes out to be
0.004; hence it can be said that the beta values are not corre-
& > '- ir-mio^oocsoNcnocn^-H -^j- lated to the Hurst ratio values. It is worthwhile noting that
except for the Derivative Strategy, all the other strategies that
were found to be efficient through DEA models have Hurst
"So ^oocnoooooor-'inoovo on <N ratio greater than 0.5 (Table 9).

Conclusions

1"8
The significant growth in hedge funds fuelled by greater
interest from investors has increased the need for appropriate
II W
methodologies to measure performance of hedge funds and
"as
the corresponding trading strategies. This paper shows with a
O
^ 5 ^ ^-Hoor-Hoor-^t-- r- <n o o brief review of existing literature on hedge funds, that tradi-
* ^5> ^ fi h es O' in cN^o
I tional measures of performance like mean-deviation ratio,
which use single risk-return aspects, are not sufficient to
'S S 's s ^ <NO*-iooor-(N^H co vo io f- r- capture the complete risk return profile of hedge funds. A
I * s w -^ s *S ^ovo^HooiOTfvor- Tt ^ m ^t m
recently proposed approach that incorporates multiple risk-
k^
return measures through the PCA and the Spearman Rank
" ^ c Correlation technique in performance measurement is adopted
i to compare the hedge funds, both at the strategy level and at
s the fund level. Application of slack-based DEA models that
I are capable of utilizing negative input/output data to compute
S '? ^ 'mvoO'-H > m o' a m ri es the efficiency scores has been clearly demonstrated, with the
I help of more than 4730 hedge fund data. The framework
"s-^-b^^ n io m O ^ rtoomoooo>o proposed in the current paper serves as a comprehensive guide
abb^ onooono^o o'o'mooOMnoo
S3
to an investor looking for alternative investments in hedge
^*
funds. As the proposed framework, through DEA-PCA and
c
DEA-Rank Correlation, incorporates multi-dimensional risk

i
> OnOnOnO ^OO^OOOOCNTi-m
-2-is^ oor^<^o moN^inONO'^h
return analysis, it has the potential to account for the complex-
'S S ities involved in hedge fund transactions and also the dynamic
nature of trading strategies. One can also use this framework to
1
^0f3v "Ht- ooomcNOsooomo gather additional information needed to support the decision-
ta making process, which many a time may still use traditional
measures like the Sharpe's ratio (with two-dimensional risk
I return analysis) due to various reasons. The additional infor-
"SO
^^ in in cno'ooo'OHMrf) mation like reference sets and input/output targets will supple-
N
ment the primary knowledge and aid the decision process,
ON especially in situations where multiple funds/strategies are
S found to be equally profitable and compete for similar invest-
ment opportunities.
In today's global economic environment where hedge
s cnmO'-HOOvooNoooo^oaNr^ funds have a significant influence on macro-economic events
C^ -i o' o h lor-moocnracs
such as the 1997 Asian financial crisis, the 2000 asset bubble
burst and the Yen carry trade and the more recent sub-prime

S
mortgage crisis, it is imperative to develop comprehen-
sive performance measurement methodologies that aid the
decision-making process of large investors. Through use of
standard z-tests and Hurst ratio analysis, we find that the DEA
1 il! i-jjj, application results are not just robust, but more importantly,

i m |-| g ||| f can determine the most consistent and profitable performers.
One of the limitations of DEA is that as the number of
I || tf f ItJtJ! 11 1
<3 uuuwwmwEEouSS
inputs and outputs increase, the number of efficient firms also
increases. To some extent, this problem can be addressed by

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using super efficiency DEA models, but further research is
required to tackle this problem, especially if sample size of
DMUs is small.
Acknowledgements - We thank the anonymous referees and the editor for
their constructive comments that have helped us to improve the quality
of this research work.
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Received July 2008;
accepted September 2009 after one revision