Hedge Fund Performance Attribution Analysis when Returns are Non-Normal: An

Evaluation of the Trading and Risk-Management Style of Fixed-Income Relative

Value Arbitrage Hedge Fund Managers
Bernard Murphy, Mark Cummins
Kemmy Business School, University of Limerick
John Frain
Department of Economics, Trinity College Dublin
May 2007
Abstract
In this paper we evaluate hedge fund performance when returns are
non-normal and display non-linear dependencies with underlying asset
classes. We focus in particular on the non-directional and hybrid classes of
xed-income strategies; convertible arbitrage, xed income arbitrage and
distressed debt where relative-value trading is the dominant style. We
rst employ a statistically rigorous factor analysis procedure to uniquely
identify a sibling class of strategies whose return-generating processes we
posit are driven by a common factor; namely, a buy-and-hold exposure to
global credit risk. We augment this risk factor with a germane set of trad-
ing strategy risk-factors which parsimoniously capture the variation in key
market variables and which can capture the proprietary trading and risk-
management style of hedge fund arbitrageurs. Using a standard ordinary
least squares estimator we provide evidence that the xed-income sector
has a neutral exposure to shifts in the market volatility term structure.
We interpet this as evidence of a proprietary hedging expertise which
can account for some of the excess risk-adjusted return generated by the
strategy. We check our results for robustness using a maximum likelihood
alpha-stable estimator which is capable of overcoming the statistical in-
ference and hypothesis testing limitations of standard linear statistical
models and their estimators when returns are non-normal. We provide
strong evidence to show that by not properly accounting for non-normality
eects in the regression framework, a signicant fraction of a strategys
excess risk-adjusted return can be incorrectly attributed to manager skill.
Nonetheless, our results suggest that the major proportion of the absolute
returns generated by these hedge funds is justiably attributable to the
relative value acumen and the proprietary trading and risk-management
expertise of fund managers. These strategies it would appear generate
both "alpha" and "beta" returns for their investors.
1
Keywords : Hedge funds; relative value arbitrage; alpha-stable residu-
als; implicit factor models; maximum-likelihood estimation; performance
attribution analysis; trading strategy risk factors.
Corresponding Authors: bernard.murphy@ul.ie frainj@tcd.ie
2
1 Introduction
Hedge funds are privately-organised investment partnerships which were origi-
nally geared towards an elite mix of high net worth private clients, family trusts
and institutional investors. Not originally intended for retail investors, hedge
funds have beneted therefore from being lightly regulated and not constrained
in the style of investing they follow. As a result, hedge funds can typically
be dynamically long and short both traditional and alternative asset classes,
can use derivatives for both position taking and implementing tactical hedges
and are free to aggressively leverage their investment capital in the search for
absolute returns.
It is estimated that the global hedge fund industry has grown from $950
Billion by year-end 2004 [2] to circa $1.3 Trillion (AUM) by year-end 2006 [1].
Over the next four years global institutional investments in hedge funds are
expected to triple to $1 Trillion, of which 65% is attributable to pension plans in
search of long-term portfolio diversication benets. In Ireland however, there
is currently a considerable amount of apathy towards increasing allocations to
alternatives and to hedge funds in particular. This is due in part to perceived
crowding-out in the hedge fund industry [10] and the associated diculty in
identifying consistent top
1
4
-tile performing managers or funds. We suspect
however that other factors are important, such as a lack of understanding of
hedge fund strategies and associated tactical hedges, high perceived value-at-
risk exposures associated with excessive use of leverage and derivatives and
implicit in heavily skewed and kurtotic returns distributions, and a prevailing
lack of trust due to the absence of reporting and compliance requirements -
all in all a formidable set of due diligence obstacles as perceived by traditional
investment managers.
Nonetheless, as the hedge fund industry continues to grow it will seek autho-
risation to solicit investors in the traditional investment world - in particular,
pension funds - and will undoubtedly adopt a more accomodative stance to the
disclosure and compliance requirements of nancial regulators. Against this
market backdrop the need for institutional asset managers to augment their
in-house due-diligence competencies for the particular case of hedge funds will
become more obvious. In anticipation of a growing industry need therefore,
we present a performance evaluation framework (based on a weak-form im-
plementation of a style-based factor model) in this paper which can overcome
the limitations of standard linear statistical models when faced with a combi-
nation of a non-linear
1
return dependency on the underlying asset classes and
1
Although hedge fund managers trade the same asset classes as traditional fund managers,
it is the dynamical and leveraged nature of their investment strategies, along with the extensive
use of derivatives for both position-taking and risk-management purposes that gives rise to
this non-linear dependency. See Fung and Hsieh [6] who characterise the payo prole of
trend-following commodity trading advisor (CTA) funds as analogous to that of an equity
lookback straddle (long combination of a lookback Put and Call) where the exposure can be
characterised in properietary trading speak as long gamma. The authors further characterise
the return prole on Global/Macro funds as analogous to that of an equity collar and the
exposure of Fixed Income Arbitrage funds as being essentially short vega, or equity market
3
non-normality in the regression residuals. Our focus is on the non-directional
class of hedge fund strategies in which market-neutrality, relative-value and ar-
bitrage are the dening trading and risk-management objectives of the fund. To
accomodate heterogeneity in the return generating processes across this family
of strategies, we therefore adopt the tactic of evaluating aggregate hedge fund
performance on a sector-by-sector basis.
1.1 Empirical Contribution of Paper
This paper extends the hedge fund performance evaluation literature in three
key dimensions. First, we employ a statistically rigorous factor analysis proce-
dure to uniquely identify a "sibling class" of strategies whose return-generating
processes we posit are driven by a common factor; namely, a buy-and-hold ex-
posure to global credit risk. Second, adopting the perspective of a nancial
engineer or proprietary derivatives trader, we identify and construct a germane
set of "trading strategy" risk-factors
2
which parsimoniously capture the varia-
tion in key market variables and which can capture the proprietary trading and
risk-management "style" of xed-income hedge funds. Third, we then assess
the empirical potential of these factors to explain a strategys return-generating
process, in particular its market-neutrality, by using a maximum-likelihood
alpha-stable estimator. The latter can implicitly account for non-normality
risk without the need to construct explicit factor proxies for systematic higher-
moment risk exposures.
We present empirical evidence that the xed-income arbitrage and distressed
debt sectors display signicant stand-alone exposures to primary risk factors
such as global credit, but not to secondary risk-factors such as the slope or
shape of the yield curve. We show that rather than viewing these members of
the non-directional and hybrid classes of hedge fund strategies as relatively low-
risk and beneting from the self-proclaimed quantitative expertise and relative-
value acumen of the fund manager, they can at times be seen as unhedged
leveraged bets - which can go very wrong during extreme market movements
when the normal Laws of Finance break down. Indeed the demise of Long
Term Capital Management in late 1998 provides indisputable ex-post evidence
in support of this view.
volatility.
2
For the Convertible and Fixed Income Arbitrage investable indices for example, we regress
excess fund returns against germane global credit and mortgage-backed securities index data.
For the latter index we also regress against two implicit orthogonal interest rate factors -
parallel shift and slope factors derived from a principal components analysis of forward (par)
swap rate curves - to determine the exposure to these risk factors. We also regress against
interest rate swaptions data to capture non-linearity dependencies between strategy returns
and the underlying xed-income asset class, in eect capturing a strategys net exposure to
interest rate volatility.
4
1.2 Structure of Paper
The paper is set out as follows. In Section 2 we provide a taxonomic clas-
sication for the dependent variable data used in the study and comment on
both the relevance of, and the steps taken to mitigate, well-known biases such
as survivorship, selection and back-ll bias for our hedge fund dataset. De-
scriptive statistics for our hedge fund data are presented and various statistics
for the goodness of t of the returns series to both a Normal and a non-Normal
(c-stable distribution) alternative distribution are presented which provide sig-
nicant insights into the investment styles followed by hedge funds. In order to
capture the well documented consequences of trading strategy[5] and leverage
factors on hedge funds return generating processes, we uniquely propose and
construct a time-series of implicit statistical factors derived from a principal
components analysis of movements in forward swap rate curves. We augment
these factors with liquid forward-at-the-money Libor swaption data to capture
non-linear dependencies to the underlying interest rate asset class. Finally,
we propose extending the set of regressor variables to include both the VIX
volatility index to capture non-linear dependencies with the equity asset class
(in eect, the US stock market) and a global high yield index to capture sys-
tematic exposures to the credit asset class. We emphasise that the selection
of regressor variable data is linked to the specic empirical focus of this paper;
namely, to examine the performance of the non-directional or market-neutral
class of sibling strategies, Convertible Arbitrage, Fixed Income Arbitrage and
the hybrid strategy Distressed Debt.
In Section 3 we implement a factor analysis screening methodology to iden-
tify likely-candidate regressor variables on which we regress the excess returns
generated by various style-specic hedge fund strategies. Based on our interpre-
tation of the rotated factor loadings we make the general case for including both
trading strategy (market-timing, dynamic hedging) and location choice (buy-
and-hold in a given asset class) risk factors when evaluating the performance of
the directional / market-timing and the non-directional / market-neutral hedge
fund styles, respectively. In the case of the latter class of strategies we pro-
vide an ex-post heuristic statistical justication for selecting the explanatory
variable datasets discussed in Section 2.
In Section 4 we specify a weak-form version of a style-based linear factor
model and present estimates of Jensens alpha and of factor coecients based
on ordinary least squares (OLS) estimation. Even using a naive OLS estimator
we are able to make signicant observations concerning the attribution of per-
formance to manager skill, in particular to a proprietary hedging competency
in the xed-income markets.
In Section 5 we provide a robustness check to the normally distributed residu-
als assumption underlying the OLS estimator used in Section 4. We propose and
implement an alternative maximum-likelihood / alpha-stable estimator which
can account for non-normality in the regression residuals and can allow more
robust statistical inference and hypothesis testing be undertaken, assuming a
good t to the residuals series. Notwithstanding optimisation diculties en-
5
countered in the numerical maximisation of the log-likelihood function, we nd
that in all cases a signicant fraction of excess risk-adjusted return is incorrectly
attributed to manager skill. Based on our interpretation of the t of an alpha-
stable distribution to hedge fund returns, we conclude that this component of
excess return is in fact compensation for systematic kurtosis and in particular
skewness risk. Nonetheless, we nd that a signicant fraction of the excess
returns generated are due to manager skills. These strategies it would appear
generate both alpha and beta returns for their investors.
Section 6 concludes with a discussion of the implications of our ndings
for traditional investment funds such as pension funds. In light of the more
accomodative stance being adopted by the hedge fund industry towards disclo-
sure and compliance requirements, we propose how the statistical framework of
Section 4 can be deployed to robustly estimate the value-at-risk of hedge fund
portfolios.
2 Preliminary Data Screening
In the following sections we rst provide descriptive statistics for the hedge
fund / dependent variable data used in our study and introduce the c-stable
distribution which underlies the maximum-likelihood based regression analysis
in Section 4. We then describe a factor analysis procedure which we use in
conjunction with a certain amount of intuition to identify and propose germane
regressor variable data for the regression studies subsequently implemented in
Section 4.
2.1 Hedge Fund Dataset
Our hedge fund data is based on the net-of-fee monthly returns on a market-
representative subset of the approximately 400 largest funds which have reported
to the 4000-plus fund Credit Suissse / Tremont (CS/T) database over the sample
period January 1994 through November 2005. Launched in 1999 but backdated
to January 1994 to mitigate some of the well-known database biases discussed
below, the CS/T broad-based hedge fund index illustrated in Figure 1 is the
rst asset-weighted index to have been introduced for the hedge fund industry.
Like traditional asset class indices the CS/T investable hedge fund index
is asset-weighted and is transparently replicable through direct holdings in the
10 style-dierentiated funds that make up the index. The 10 strategy-based
sectors or styles include the 6 largest assets under management (AUM) funds
operating in each sector and can therefore be regarded as being representative
of aggregate performance both across sectors and for the industry generally.
Figure 1 also illustrates the screening methodology employed in the con-
struction of both the broad-based and the 10 style-specic hedge fund indices.
In light of the performance attribution context for our study, we focus only on
the investable subset of funds that are included in the database.
6
Figure 1: CSFB / Tremont Hedge Fund Index Database Construction
Although the problem of high attrition rates in the hedge fund industry is
well documented
3
, since 1994 (the start of our sample period) the CS/T data-
base has included the performance histories of funds that have ceased operations
or have blown up. Consequently, the commonly-reported problems attribut-
able to "survivorship bias" have been largely mitigated as a consequence of the
rigorous rules-based approach to constructing the CS/T index. In regard to
possible "selection bias", we emphasise again that the non-inclusion of closed
funds in the database is largely irrelevant in light of the performance attribution
focus of our study. We focus only on investable hedge funds which by deni-
tion are open to institutional (funds-of-hedge funds, pension funds) and private
(high net worth, family trusts) investors, for whom our ndings are likely to
be of greatest relevance. Finally, the "backll / instant history bias" result-
ing from the immediate backlling of a funds performance history when rst
included in the index is not present in the CS/T database.
Descriptive statistics for the hedge fund dataset are presented in Table 1
following
4
. Various statistics for the goodness of t of the return series to both
a Normal and a exible non-Normal (c-stable, explained in greater detail in
3
See Edwards (1999) [3] who cites attrition rates of about 25% for US-domiciled hedge
funds and greater than 50% for non-US funds over the period 1989 to 1996.
4
The c-stable parameters fc. o. ~. cg have been estimated by numerically maximising the
relevant log-likelihood function. The monthly log-densities are recursively numerically gen-
erated from an inverse numerical Fourier transform of the c-stable characteristic function.
Section 5 and Appendix A detail the procedure involved.
7
Section 5) alternative distribution are presented. The goodness of t normal-
ity tests indicate considerable problems with the t of a Normal distribution,
whereas the c-stable distribution provides a better t
5
. The symmetry parame-
ter (1 _ _ 1) in the latter drives the skewness of the returns distribution
with a zero value indicating a symmetric distribution. The stability para-
meter c determines the weight in the tails with a value of 2.0 indicating (in
conjunction with = 0) a Normal distribution. The parameter is positive
and measures dispersion, while the parameter c is a real number and can be
thought of as a location measure.
5
We defer addressing the empirical implications of these ndings to Section 5 but alert the
reader at this juncture to previous research (see [?]) which reveals that non-normality in the
dependent variable data typically also manifests as non-normality in the regression residuals
generated by a standard ordinary least squares (OLS) estimator. Consequently, key distrib-
utional assumptions underlying the OLS estimator are violated which can result in spurious
conclusions being drawn from standard statistical inference and hypothesis tests. Section 5
will demonstrate how a maximum likelihood c-stable estimator can be implemented to pro-
vide a robustness check on standard OLS based inferences about the performance attribution
characteristics of the hedge fund investment strategies examined in this paper.
8
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9
Figure 2: Taxonomy of Hedge Fund Strategies
Closer inspection of Table 1, in conjunction with the classication taxon-
omy illustrated in Figure 2, reveals some interesting insights into the dynamical
and leveraged nature of hedge fund investment strategies, and indeed the het-
erogeneity in the investment styles followed. For example, the skewness or
symmetry parameter of the c-stable distribution (i.e. ) is estimated at or very
close to the negative limit of the parameter for the Event Driven, Fixed Income
Arbitrage, Convertible Arbitrage and Distressed Debt strategies. Bearing in
mind the relatively stable nature of the return-generating processes underlying
the xed-income arbitrage funds, Figure 3 below reveals what must be seen as
the very considerable losses incurred by the Fixed Income and Convertible Ar-
bitrage strategies over the post Russian Debt Crisis August-October period in
late 1998 when sharply widening credit spreads (on non-US sovereign and both
US lower tier investment and non-investment grade corporate debt) took their
toll. The Distressed Debt index reported monthly returns of -12.45%
6
, -1.43%
and +0.89% respectively for the same three-month period.
6
Between the start of the Russian debt crisis on August 17th 1998 and September 10th
1998, yields on emerging market debt as reected in the J.P. Morgan emerging market bond
index had risen to a spread of 17.05 full percentage points above comparable-maturity US
Treasury yields. Similarly, yields on US B-rated bonds (the very market where convertible
issues were commonplace) rose to almost 11% above Treasury and 5.7% above high investment
grade corporates. See Edwards ??.
10
Being relatively stable strategies the non-directional funds would therefore
have taken longer to recover from these losses than did the more opportunistic
Global / Macro and Emerging Markets directional funds, whose sample re-
turn skewness over the 11-year period was therefore not as extreme as their
xed income counterparts. The evidence is indisputable that the credit mar-
ket exposures of the xed-income oriented funds in particular resulted in their
incurring especially high losses during this eventful period in the history of the
hedge fund industry. It is not surprising therefore that these strategies should
present with negatively-skewed return distributions for the sample period - a
distributional characteristic which is well captured by the stable distribution
symmetry parameter .
Figure 3: Negative Skewness in HF Returns Autumn 1998
In contrast to the xed-income strategies, the Dedicated Short Bias strategy
presents with a signicantly positively-skewed returns distribution ( - +1.0)
for the sample period, which is consistent with the opportunistic and market-
timing / directional nature of the funds investment style in the equity asset
class. As a nal observation, the Broad Hedge Fund Index has a relatively
symmetrical ( - 0) if somewhat fat-tailed (c - +1.5) returns distribution,
which is reective of the disparate hedge fund styles (which is implicit in the
negatively and positively skewed return distributions) comprising the index,
and indeed is implicitly reective of the highly-leveraged nature of many of
these strategies.
11
2.2 Preliminary Screening for Explanatory Variable Data
The purpose of traditional style regression (or performance attribution) analysis
is to identify the set of best exposures to traditional asset class benchmarks
so as to minimise (mutual) fund tracking variance. A high R
2
value from the
regression analysis implies that a high proportion of total return variance can
be explained by the return variation in the benchmark asset classes. A high
R
2
value is therefore conrmation of high dependent variable correlation to the
factor asset classes. Although this form of analysis works well for traditional
buy-and-hold investment strategies, the dynamically-directional and leveraged
nature of hedge fund investing makes this form of analysis ill-suited
7
for evalu-
ating the alternative investment strategies deployed by hedge funds.
Mindful of these limitations and the need for a parsimonious factor structure,
as a preliminary screening device we factor-analyse a multivariate system of
returns observed for a panel of "investment strategies"; comprising buy-and-
hold strategies in the ten style-specic hedge fund strategies which report to the
Credit Suisse / Tremont database, and a long-only strategy in the equity asset
class (Diversied US Large Capitalisation Equity and Diversied Bond. The
buy-and-hold equity strategy is proxied by relative movements in the S&P500
large-cap index.
Before describing the screening procedure we rst specify the linear factor
model which forms the basis of the regression analyses carried out in Section 4.
The model can be represented as
1
t;HF
= c +
X
k
/
k
1
kt
+c
t
(1)
Based on an excess return specication 1
k
denotes the risk-premium required
(in equilibrium) per unit exposure of the investable hedge fund index to the /
th
factor, in other words the "price of risk" for the /
th
factor. The intercept term
c (Jensens alpha) in Eqn. 1 denotes the excess mean fund return over and
above the fair-value or risk-adjusted return of the strategy.
Maintaining notational consistency with the factor model notation in Eqn.
1, the inputs - outputs to the factor analysis algorithm can then be concisely
7
See Fung and Hsieh [5] who report that almost half (48%) of the hedge funds evaluated in
their database had R
2
s below 25%, in contrast to the same proportion of mutual funds with
estimated R
2
s above 75%.
12
summarised as follows
X

= multivariate T-by-d observed excess returns system

X

i
= T-by-1 = c
i
+W
i
F +c
i
i = 1. .... d
1 = /-by-1 independent standardised common factors
W = d-by-/ matrix of Factor Loadings
d = No. of "Investment Strategies"
= cov(e)
= d-by-d diagonal matrix of specic variances
X
X
= d-by-d returns covariance matrix
X
X
= WW
T
+
where the elements of the factor loadings matrix W are estimated by maximum
likelihood. Thus, WW
T
denotes the variation in the system explained by
the common factors. Note that the factors are not unique in the sense that
principal components are and indeed this is reected in the variety of methods
available to generate the rotated factor loadings that are presented in Table 1
below.
Mindful of the fact that factor analysis seeks to explain as much as possible
the o-diagonal nature of the variation in a multivariate system, we are con-
scious that the multivariate returns system under investigation ideally ought to
be highly correlated. But since hedge funds generate returns which are typically
uncorrelated
8
with traditional asset class returns, and indeed are quite hetero-
geneous across the strategies they follow, our factor analysis at best can only
be used as a preliminary screening tool to identify likely-candidate regressor
variables. Nonetheless, as a form of heuristic diagnostic, factor analysis can
provide useful insights into the nature of the pervasive risk-factors which are
driving the variation in both hedge fund and traditional investment strategies.
The results of the factor analysis for a 3-factor model are presented in Table
2. Factor loadings are presented in columns 2 through 4 with specic variances
presented in column 5.
To facilitate a meaningful interpretation of the common factors which are
driving hedge fund returns, the latent factors have been optimally rotated so
that each measured variable (investment strategy) has only a small number of
large factor loadings (i.e. is inuenced by a small number of common factors),
8
The elements of the diagonal specic variance matrix can be interpreted as indicators
of the cross-sectional variation in a strategys returns not explained by the common factors.
A value of 1.0 for example indicates that the return variation is due entirely to specic factors
(note that the factor analysis algoritm standardises the input return vectors to have unit
variance) and that common factor inuences on the returns to this style are negligible. The
converse applies in the case where the specic variance for an investment style is equal to 0.
Given the relatively uncorrelated nature of hedge fund returns - both with traditional asset
classes and across sector-based strategies - the eect on the style-based specic variances is
manifest in the majority of the strategies listed in Table 2.
13
No. " Investment Strategy " Factor 1 Factor 2 Factor 3 diag []
1 Broad HF Index 0.476 0.095 0.676 0.005
2 CB Arbitrage -0.127 0.632 0.110 0.631
3 Short Bias -0.765 -0.139 0.209 0.338
4 Emerging Mkts 0.377 0.346 0.167 0.467
5 Equity Market Neutral 0.234 0.168 0.053 0.850
6 Event Driven 0.200 0.877 -0.047 0.005
7 Distressed Debt 0.131 0.878 -0.098 0.128
8 FI Arbitrage -0.195 0.413 0.377 0.683
9 Global / Macro 0.014 0.054 0.947 0.055
10 Equity Long/Short 0.978 -0.107 0.146 0.064
11 Managed Futures -0.001 -0.286 0.367 0.859
12 US LC Equity 0.588 0.149 -0.056 0.546
Table 2: Factor Loadings 3-Factor Model
preferably only one or two. In a sense the objective is to identify possible
sibling hedge fund strategies which are commonly aected by one or two dom-
inant factors. Then based on ones understanding of the dynamic trading and
risk-management strategies followed by the siblings, it might be possible to se-
lectively link the latent factors to either "location choice" / investable asset
class or "trading strategy" factors which can then be used in a more informed,
case-by-case regression analysis of sector-based hedge fund returns.
We emphasise again that we seek to identify not only potential return-
generating risk-factors but also germane hedge factors which might explain the
source of a strategys marker-neutrality. Figure 4 below illustrates.
Figure 4 allows a more intuitive interpretation of the common factors which
are driving the multivariate return system represented in Table 1. Each "in-
vestment strategy" is located by a vector in three-dimensional factor space, with
the orientation and length of each vector indicating the extent of the variation
in returns explained by the relevant dominant factor. For example, the factor
loadings in Table 1 might appear to suggest that the rst factor (Factor 1) could
be a traditional "location choice" style factor (i.e. buy-and-hold a diversied,
large-cap exposure to the US equity asset class) due to its sizeable common
inuence on the returns of the equity-based investment strategies. However, a
closer inspection of Figure 4 would incline one to identify Factor 1 as a dynami-
cal "trading strategy" factor (i.e. market-timing in the equity asset class). The
large absolute loadings of the dynamic Equity Long/Short and Dedicated Short
Bias strategies (dashed vectors) to this factor contrast sharply with those of
both the traditional long-only US equity strategy
9
and the Equity Market Neu-
9
With the exception of the bear market of the early 2000s the US equity market was
largely in an upward-trending bull episode over the 11-year sample period examined. Hence,
the signs of the factor loadings for the three directional equity strategies are consistent with
the intuition in this regard.
14
Figure 4: Hedge Fund Sibling Strategies & Common Factors
tral hedge fund strategy in particular. In fact, the "non-directional" style of the
latter strategy is the antithesis of the "directional" or market-timing style of
the short bias and equity long/short strategies. Although market-timing hedge
funds are not the subject of this paper, the relationship of these two sibling
strategies to a common (market-timing) factor is well illustrated by Figure 1.
Proceeding in a similar fashion, inspection of Figure 4 reveals a common
sensitivity shared by the Convertible Arbitrage, Fixed Income Arbitrage and
Distressed Debt hedge fund styles (bolded vectors) to what we posit (i.e. sub-
ject to subsequent empirical verication) is an alternative location choice fac-
tor; namely, a buy-and-hold strategy in the credit asset class. Distressed Debt
hedge funds invest in the debt of companies who might typically be restructur-
ing in the aftermath of bankruptcy proceedings, but signicantly may also bet
non-directionally in the sense of "taking arbitrage positions within a companys
capital structure, typically by purchasing a senior debt tier and short-selling
common stock, in the hopes of realizing returns from favourable shifts in the
spread between the two tiers" (see [2]). Prevailing interest rate exposure is typi-
cally hedged out leaving the strategy exposed therefore to either an improvement
15
or otherwise in the creditworthiness of the target company.
Convertible Arbitrage funds typically hedge out prevailing equity and inter-
est rate exposure, often leaving the strategy exposed to the credit risk of the
issuing company. In fact, anecdotal reports suggest that CB Arb funds have
generated most of their returns in recent years from a long-only buy-and-hold
exposure to the credit asset class
10
. A location choice factor in the credit asset
class will allow us to empirically test that conjecture. Fixed Income Arbitrage
funds typically bet on anticipated widening / narrowing of term spreads along
the default-free yield curve (hedging out duration and convexity risk for exam-
ple) but may also bet on anticipated favourable movements in the quality spread
between corporate investment grade and government yields of comparable ma-
turity. In all three strategies one might therefore reasonably expect to see a
common sensitivity to the credit asset class. Indeed Figure 4 clearly shows
the strategies to have signicant positive loadings to the second factor, infor-
mation which might therefore be reasonably interpreted as implying potential
buy-and-hold exposures for these strategies to a credit location choice factor.
Before proceeding with the analysis a few comments on the relatively un-
correlated nature of the system are in order. The specic variances for the
majority of strategies indicate a very limited collective ability of the common
factors to explain individual variation in the system. In contrast, the Broad
Hedge Fund Index strategy (which is an asset-weighted portfolio of the sector-
based hedge fund strategies listed in Table 1) displays a specic variance value
which indicates that the likely disparate dominant factors which are driving the
returns of individual strategies are collectively manifest in the broad index.
3 Explanatory Variable Data
Based on the data screening insights derived in the previous section, in this sec-
tion we provide a brief description of the various explanatory variable datasets
used in the regression analyses of Sections 5 and 6. For the cases where our
regressor variable data has not been direcftly observable, we also provide a de-
scription of the methodologies used to construct the relevant regressor variable
time-series.
3.1 Fixed Income Datasets
In order to properly attribute the performance of xed-income oriented hedge
funds we dierentiate between our selection of traditional "location choice" and
alternative "trading strategy" factors. For the Fixed Income Arbitrage sector
for example, in the former case we chose the Lehman US MBS mortgage-backed
10
We show later in a simple linear regression that the convertible arbitrage strategy appears
to have been largely vega-neutral over the sample period - that is, in the aggregate and based
on short-term implied volatility (VIX) as the relevant proxy for vega risk. We also show the
strategy to have been largely equity market-neutral but to have had some residual exposure
to gamma risk, most probably reecting a simple delta-hedging risk-management strategy in
the underlying equity market.
16
securities index in order to reect the trading activities of relative value hedge
funds in this market. In addition, we included the Lehman Global Treasury
Index to reect the global remit of xed-income hedge funds. In each of these
cases, the empirical intent was to examine the extent (or otherwise) of traditional
buy-and-hold investment styles in the respective markets. For the trading
strategy factors on the other hand, we used a set of implicit statistical factors
which are intended to capture in a parsimonious fashion the return-generating
characteristics of the proprietary trading and risk-management practices which
are manifest in hedge fund returns; namely, low-volatility, absolute (in this
context, meaning market-neutral) returns. The rationale for including these
statistical factors, and their construction methodologies, are explained in more
detail in the following sections.
3.1.1 Libor Swap Data
In deciding on an appropriate set of risk-factors to regress the Fixed Income
Arbitrage returns against, we interpreted the output of a factor analysis of
hedge fund returns in Section 2 (Figure 4) to justify why we should investigate
both the credit asset class as a potential "location choice" return-generating
factor, along with an implicit "trading strategy" factor; namely, (changes in)
the slope of an appropriate reference yield curve. The latter factor can be
reasonably proxied by the second-highest eigenvalue orthogonal factor extracted
from a principal components analysis (PCA) of the historical variation in the
benchmark zero curve. This factor is known to drive the twists that can
change the slope of the zero yield curve and represents a very real exposure for
relative-value oriented xed income arbitrage funds with ceterus paribus bullish
or bearish expectational views on the steepening of the yield curve between
various maturity reference points
11
.
Figure 5 below shows both the individual and the cumulative variability in
the US Libor zero curve explained by the rst three largest-eigenvalue prin-
cipal components. The principal components analysis was performed on the
standardised daily changes in the zero yields over the sample period April 1997
through April 2007. While the rst factor accounted for just under 84% of
total variation, the second factor accounted for a signicant 11% of the global
variation in the system. Both factors have the standard interpretation of shift
and twist factors, respectively.
11
At the start of 1998 Long Term Capital Management was reported to have had a notional
value position of c. $697 Billion in swaps (see Edwards [3]), much of it in the form of US yield
curve swaps which exchanged the dierence between a specied Libor yield and a specied
constant-maturity Treasury (CMT) yield. The short spread trade was in eect a relative value
bet on the slope of the yield curve, which in LTCMs case (receive Libor / pay CMT) would
pay o if spreads narrowed over the contract period. In contrast to LTCMs expectations
of narrowing yield spreads however, over the course of August and September yield spreads
dramatically widened in the face of a market stampede to more liquid and higher-quality xed
income securities.
17
Figure 5: Parallel Shift & Slope Factors in US Libor Zero Curve 1997-2007
Given the dynamically hedged nature of xed income relative value strate-
gies, we therefore also investigate the explanatory power of a parallel shift "trad-
ing strategy" factor in order to assess the extent of the strategys "P&L" sensi-
tivity to this factor. However, in contrast with the extant yield curve literature,
we uniquely use the correlation matrix of changes in the forward (par) swap
rate curve rather than in the benchmark zero yield curve as the input to our
PCA routine. We show below that forward swap rate curves are the funda-
mental market benchmarks used in the marking calculations for the xed legs
of forward-starting swaps (and for European-exercise swaptions). Moreover,
proprietary xed income traders will use swaps to either acquire a favourable
exposure
12
to anticipated interest rate changes or to hedge a pre-existing (e.g.
bond portfolio) interest rate exposure. As they are cheaper but have the same
level of interest rate exposure
13
, xed income arbitrage funds are more likely to
12
As shown in the following footnote, the xed leg of a spot-starting swap has initially (and
subsequently) a longer duration than the oating leg. If the Libor-Swap zero curve rises
(falls) as anticipated this will lower (increase) the xed leg more than that of the oating leg,
thus raising (lowering) the mark-to-market value of the swap to the buyer (i.e. the holder of
a payer swap who is short the xed-leg and long the oating-leg) and lowering (raising) the
value of the swap to the seller (i.e. the holder of a receiver swap who is long the xed-leg and
short the oating-leg ).
13
For a notional principal ., a plain vanilla interest swap with maturity date Tm can be
priced at generic time t as the dierence between the xed and oating legs of the swap. It
can be shown that the swap can be equivalently priced as the dierence between a date Tm
maturing coupon bond (default-free) paying the swap xed rate 1 (annually) and a discount
18
trade interest rate swaps rather than coupon-paying Treasuries for interest-rate
risk management purposes. Finally, mindful of the dynamical nature of xed
income market-neutral hedge fund strategies, we deliberately eschewed the use
of a total return index such as the Lehman Swap Total Return Index beause of
the passive buy-and-hold investment style implied by a strategy which tracks
such an index.
Figure 6: Shift & Twist Factors in Forward Swap Rate Curve Apr-97 to
Nov-05
Figure 6 shows the familiar term-dependency or shape of the factor loadings
for the rst two principal components extracted from a principal components
bond maturing on the start date of the swap 1(t. T
0
):
SW1t = ..

n
X
i=1
1

i
360
1(t. T
i
) +1(t. Tm)
!
..1(t. T
0
)
where T
i
denotes the payment dates on the xed leg and
i
denotes the actual/360 day count
fraction between xed leg payment dates.
When the swap is spot -starting (t = T
0
) we get
SW1t = ..

n
X
i=1
1

i
360
1(t. T
i
) +1(t. Tm)
!
.
noting that the right-most term in the pricing formula is duration-neutral, being simply a
constant. The advantage of using the swap for hedging purposes therefore is that it is priced
much cheaper than the embedded 1 coupon-paying bond while having the same duration.
19
analsyis of the forward par swap rate curve over the sample period April 1997
through November 2004. Our analysis shows that the rst two components
dominate in explaining the global variation in the reference forward swap rate
curve over the sample period examined, with the rst factor accounting for just
under 90% and the second factor accounting for 10% of the variation in the
system.
We provide in the following a brief description of the methodology and the
data used to derive the time series of forward swap rate curves used in the
principal components analsyis. First, we dene the date-t value of a forward-
starting payer swap contract, which commences at the forward-date T
l
and
terminates at date T
L
with t < T
l
< T
L
. and which makes payments at the
dates T
j
. , = | + 1. .... 1. Assuming a $-unit principal or notational amount
and xed payments made at the rate 1, if 1(t. T) denotes the date-t value of a
zero-coupon bond with maturity T. then the value of a forward-starting payer
swap (i.e. long the oating leg and short the xed leg) \
pay
l;L
(t) may be imputed
from the following relationship for a newly-issued swap
\
pay
l;L
(t) = \
flo
l;L
(t) \
fix
l;L
(t) = 1(t. T
l
) 1(t. T
L
) 1
L
X
j=l+1

j1
1(t. T
j
) .
where \
flo
l;L
(t) is the value of the oating side of the swap; \
fix
l;L
(t) is the value of
the xed side of the swap; and
j1
is the market convention for the daycount
fraction for the swap payment at date T
j
. We then dene the forward (par)
swap rate n
l;L
(t) to be the xed rate at which the date t value of the newly
issued forward-starting swap contract is zero, i.e.
n
l;L
(t) =
1(t. T
l
) 1(t. T
L
)
P
L
j=l+1

j1
1(t. T
j
)
=
1(t. T
l
) 1(t. T
L
)
1
l+1;L
(t)
(2)
where the notation 1
l+1;L
(t) denotes the present value of a basis point - i.e. the
increase in the value of the xed leg in the swap if the swap rate increases.
The forward swap rate curves we have used in this study are constructed
from a daily time-series (January 1997 through November 2005) of imputed
forward swap rates extracted from the US $ Libor / Swap market (Datastream).
Because of their greater usage for risk-management purposes we choose the set
of 6 month, 1 year, 1.5 year, ..., 10 year (i.e. in 1/2 year forward increments)
forward-starting contracts with a xed underlying swap length of 1 year
14
. A
forward swap rate curve for trade date t is then formed by augmenting the
front end of the set of imputed forward swap rates with the swap rate on a spot
starting 1-year swap.
14
To impute the forward swap rate time-series corresponding to this set of forward starting
swap contracts, we rst generated for each trade date in the series the Libor-Swap zero curve
using quoted Libor rates and relevant maturity xed rates on spot starting swaps. Since
it was necessary to have available the imputed 1.5-year, 2.5-year,..., 9.5-year zero rates, the
corresponding spot swap rates were determined by implementing a spline interpolation of the
spot-starting 1-year, 2-year,..., 10-year swap (xed) rates. For each trade date we then used
the bootstrapped zero curve to compute the required-maturity discount bond prices used in
Eqn. 2 to impute the daily time-series of forward swap rates.
20
Figure 7: Forward Par Swap Rate Curve Dynamics Autumn 1998
We show in Figure 7 that the US $ forward par swap curve was relatively at
and downward trending during August and into September 1998. However, just
as the market repercussions of the Russian debt crisis were most dramatically
initially reected in the August returns for the Distressed Debt hedge fund
sector (-12.45%), the changing fortunes of xed-income oriented relative value
hedge funds were subsequently implicitly manifested in the movements in the
US Libor swap market
15
during September and October. Having displayed a
downward trend over August, during September and into October the forward
swap curve can be seen to shift sharply upwards and steepen out along the term
structure, reecting the general widening of both term and quality spreads in
the post Russian debt crisis period. Figure 7 shows clearly the well-known
parallel shift and twisting (i.e. steepening) factors that are known to drive
most of the observed variation in interest rate term structures. As the xed
rates quoted on newly-issued forward-staring swaps rose sharply
16
, the swap
books of proprietary xed-income hedge funds would have been directly and
15
It is well known that swap spreads (over Treasury) inuence the spreads on commercial
mortgage-backed securities (CMBS) because of the prevailing use of interest rate swaps to
hedge CMBS positions by market participants (see [4] p. 212). This was very evident during
Autumn 1998 when credit and liquidity shocks drove both swap spreads and CMBS spreads
to historically high levels. We explain in Section 3.1.3 how hedge funds have exploited their
relative value acumen in conjunction with their trading and risk-management expertise to
become big participants in the mortage-backed securities markets.
16
As the reference Libor-Swap zero curve began to shift up sharply in early October 1998,
21
signicantly aected. Given the prevailing use of interest rate swaps by hedge
funds in hedging general interest rate exposure, we feel that it is more relevant
to extract statistical factors from a principal components analysis of variations
in the forward swap curve rather than the zero yield curve.
Our empirical objective is to look for evidence of a statistically-signicant
return-generating factor in the case of relative value strategies with an unhedged
exposure to the twist factor, and for evidence of a potential hedging factor to
detect evidence of duration-neutrality (i.e. a hedged exposure to the parallel
shift factor). However, in light of the swap-based hedging propensity of hedge
funds who trade the mortgage-backed securities markets (see Section 3.1.3 fol-
lowing), it must be said that the net exposure to the "twist" factor must await
empirical verication until our discussion of regression results in Section 4.2.
3.1.2 Interest Rate Swaption Volatility Data
In order to account for possible non-linear dependencies between the returns on
predominantly US-based non-directional xed-income strategies and the under-
lying xed income asset class, or conversely in order to detect the neutrality
of the strategy to interest rate volatility, we extracted a proxy for the (interest
rate) market volatility term structure from a US Libor payer-swaptions dataset
downloaded from Datastream. We show in Section 3.1.3 below that mortgage-
backed securities arbitrageurs do seek to hedge out interest rate volatility in
order to lock-in excess risk-adjusted spreads on these securities. For these funds
to be truly regarded as relative value vehicles, the cost of being long the implied
volatility in the interest rate options used for hedging interest rate volatility risk
should be less than the value received from being structurally short the "implied
volatility received from homeowners"
17
. As with the exposure to the "twist"
factor in the previous section, however, the net exposure of the Fixed Income
Arbitrage sector to a "vega" factor, and the incremental explanatory power of
such a factor, is a subject for empirical verication in Section 4.2.
The data set comprised swaptions quotes on a selection of daily observations
over the period June 1997 through November 2005 (equating to 102 monthly-
equivalent trade dates). Maintaining a degree of consistency with the forward
swap rate dataset described in the previous section, the swaptions data represent
at-the-money-forward quotes for 6-month, 1-year, 2-year, 3-year, 4-year and 5-
year forward contracts written on underlying swap contracts of 1 year length in
all cases. Quotes are given with the typical market convention of Black implied
volatilities as embedded in Eqn. 3 following
1o
t
= 1
l+1;L
(t) [n
l;L
(t) (d
1
) 1 (d
2
)] (3)
because of their longer duration the xed legs on outstanding spot and forward starting swaps
would have decreased by proportionately more than the oating legs. The xed rate quotes
for newly issued swaps would therefore have needed to have been increased sharply at this
time so as to maintain equality between the xed and oating legs on newly issued swaps.
17
If market interest rate volatility rises, then the risk of an increase in prepayment speeds
will increase. Other things being equal, this will lower the market value of the MBS security
held long by the hedge fund (i.e. assuming the MBS was initially underpriced), indicating
that the hedge fund is therefore structurally short "interest rate vega".
22
where
d
1
=
ln[n
l;L
(t) 1] +
1
2
o (T
l
t)
o

T
l
t
.
d
2
= d
1
o
p
T
l
t.
n
l;L
(t) is the currently observable forward swap rate (dened in Eqn. 2) for
a payer swap commencing on date T
l
and ending on date T
L
, o = o
Black
T
l
;T
L
is
the Black implied volatility of the (lognormally-distributed) forward swap rate,
and the present value of a basis point 1
l+1;L
(t) is dened as in Eq. (2). For
a xed-length underlying swap, our swaptions dataset therefore constitutes a
reasonable proxy for the forward swap rate market volatility term structure.
The informational content of this extensive swaptions dataset can however
be parsimoniously reduced into a small number of common explanatory factors
using the same principal components analysis (PCA) procedure used in Section
3.1.1 above.
Figure 8: PCA Analysis of Log-Dierences in ATMF Swaption Implied
Volatilities Jun97 - Nov05
The maturity characteristics of the rst two principal components (which
collectively account for 93% global fraction of the total variance of changes in
the swap volatilities) are illustrated in Figure 8. The PCA was performed
on the monthly log-dierences of the at-the-money-forward (ATMF) swaption
implied volatility dataset (see [9]). Figure 8 shows that both factors have
23
standard parallel shift and tilt interpretations with the rst factor accounting
for roughly 77% of the global variation in this term structure system.
3.1.3 Mortgage Backed Security Dataset
In order to examine the predominantly domestic (i.e. US) exposure of relative
value strategies to the mortgage backed securities (MBS) markets
18
over the
sample period examined, we used the Lehman US Aggregate Index. This in-
dex includes the Lehman US Treasury Index, the US Investment Grade Credit
Index (covering the investment-grade corporate bond market) and indices for
MBS, ABS (asset-backed securities) and CMBS (commercial mortgage backed
securities). The aggregate index has become the dominant xed income bench-
mark used by investment practitioners to measure and evaluate the investment
performance of xed income portfolios.
Relative value strategies are the dominant hedge fund style in the MBS
and CMBS markets and as a result of aggressive leveraging, hedge funds have
become big participants. The fundamental investment style is to arbitrage
perceived mispricing of securities by isolating the "excess risk-adjusted spread"
by in turn hedging out all other risk exposures such as falling interest rate /
prepayment risk, changes in the slope of the yield curve, interest rate volatility
as well as negative convexity. We believe that the aforementioned index and its
subcomponents therefore contain potentially signicant information about the
nature of the return-generating process underlying the Fixed Income Arbitrage
and Convertible Arbitrage hedge fund sectors in particular.
3.1.4 Lehman Global Treasury Index
In order to examine the extent (or otherwise) of a passive buy-and-hold invest-
ment style which might be present in the Fixed Income Arbitrage sector, we in-
cluded a location choice factor which also reects the global remit of xed-income
hedge funds; namely, the Lehman Global Treasury Index. The index includes
local currency-denominated sovereign debt of non-emerging market countries
(including the G-7 countries and other major and global issuers as dened in
the index), in which all issues are xed-rate and non-convertible.
3.2 Credit Dataset
In choosing datasets for the credit asset class we emphasise that the relevant risk
factor in each case corresponds to a location choice style factor which is germane
to the proclaimed investment style of the hedge fund sector under investigation.
18
Long Term Capital Management were one of the rst big hedge funds to trade this market
in 1994 when they placed short bets on the spread between interest only (IO) passthrough
securities and principal only (PO) securities converging. At the time IOs had fallen sharply
in value due to the surge of US mortgage renancings that followed in the wake of falling
mortgage rates. Believing the fall was in excess of the fair value predicted by internal models,
Long Term accumulated a leveraged IO position estimated at $2 Billion (see [7]) while it
hedged out the underlying interest rate exposure by purchasing Treasuries.
24
Besides implying a generic buy-and-hold investment strategy in the credit asset
class, this implies that for all three hedge fund strategies examined, we needed
to include both the domestic (i.e. US) credit market as well as the possible
global high-yield exposures of the sectors.
3.2.1 Investment Grade Credit Index
In order to capture the inuence on returns of both a domestic investment grade
corporate credit factor, and of a global sovereign-debt risk factor, we selected the
Lehman Global Credit Index. The index includes investment grade and high-
yield credit securities extracted from the Lehman Global Aggregate and Global
High Yield indices. We feel that this index constitutes an appropriate location
choice factor to use for the Convertible Arbitrage hedge fund sector, which (on
the basis of the factor analysis in Figure 4 earlier) we a priori posit involves
a passive buy-and-hold strategy in the global credit asset class. NEED TO
REWRITE TO INCORPORATE INSIGHTS FROM P. 285 IN LHABITANT.
3.2.2 Global High Yield Bond Index
To isolate the possible inuence of a distressed debt risk factor on Distressed
Debt hedge fund returns we used the Lehman Global High Yield Index (LGHY).
The LGHY index integrates the non-investment grade portions of the Lehman
Emerging Markets Index with the US High Yield Index, the Pan-European
High Yield Index and also (since July 1999) the CMBS High Yield Index. Ac-
cordingly, we feel that this index is an appropriate return generating factor to
include in our evaluation of the international credit market exposures of the
xed income hedge fund sectors examined. As in the case of all of the Lehman
indices cited above, the LGHY data are represented as excess (over 1-month US
Libor) monthly log-returns and are therefore interpretable as risk-premia for
the purposes of our factor-based performance evaluation analysis.
25
Monthly Returns on Lehman Global High Yield Index
The August-September 1998 "credit market crash" is clearly evident in the
returns data in Figure 3.2.2, as it was earlier in the returns of various hedge
fund sectors (including Distressed Debt and Global / Macro) presented in Table
1.
3.3 Equity Dataset
Although all of the strategies which are the empirical focus of this paper are
xed income oriented, the Convertible Arbitrage sector does have an indirect
exposure to underlying equity markets through the embedded warrant of the is-
suing company. In light of the predominantly US-based market for convertibles
we therefore focused on the US stock market for evidence of a return-generating
(or hedge) factor present in the returns on this strategy over the sample period.
3.3.1 S&P500 Index
As a proxy for the equity market in which US convertible issuers trade, we
chose the S&P500 large capitalisation total returns index. The convertible
arbitrage strategy typically delta-hedges the underlying stock market exposure
of the purchased (i.e. buy-and-hold) convertibles. However, the strategy does
not necessarily dynamically hedge against rapidly changing equity prices and so
may be a priori expected to display residual gamma exposure. Consequently,
26
the reader should be aware that a priori this may disguise the empirical evidence
in support of the strategys delta neutrality.
3.3.2 VIX Volatility Index
Mindful of the non-linear dependency of many hedge fund strategies to tradi-
tional asset classes, the use of the VIX index
19
can be viewed as a proxy for
the informational content embedded in a panel of short-dated S&P500 index
options. Consequently, the index oers the promise of detecting the embedded
warrant-attributable non-linear dependency between the returns on the Con-
vertible Arbitrage hedge fund sector and on the US equity market.
4 Maximum Likelihood -Stable Estimation
As shown in Table 1 earlier, the c stable distribution can model the negative
skewness and excess kurtosis that characterise hedge fund return distributions.
The use of the distribution in Finance became popular in the 1960s (see ) but
interest waned thereafter. This decline in interest was due not only to the
relative mathematical complexity, and the considerable computational power
needed to implement the distribution in practical complications, but was also
due to the success of the Black-Scholes-Merton Gaussian approach to Finance
theory which was developed at the same time. We refer the reader to Ap-
pendix C for details of the maximum likelihood estimation procedure applied
to hedge fund return distributions. In Appendix C we show the asymptotic
distributional properties of the estimator as applied to the estimation of the
factor loadings or slope coecients. We rst report regression results ob-
tained using a standard ordinary least squares (OLS) estimator. We then check
our results for robustness using the maximum likelihood alpha-stable estimator
(MLE/c-stable).
4.1 Extended Linear Factor Model
In the style of Sharpe [8] and Fung & Hsieh [5] we use a factor model (Eqn.
1 earlier) in an attempt to explain the return-generating processes underlying
each sibling strategy in the xed-income family of hedge fund styles discussed
in Section 2.2.
1
t;HF
= c +
X
k
/
k
1
kt
+c
t
We use the term "extended" for our linear model in order to dierentiate our ap-
proach from traditional performance evaluation studies. As mentioned in both
the Introduction and in Section 2, the dynamic trading and risk-management
strategies adopted by both the "non-directional" and "hybrid" class of strategies
19
The monthly VIX values, which measure short-term volatility expectations for the
S&P500 equity market, are de-annualised to monthly-equivalent values for consistency with
all other data.
27
requires that we use germane regressor variables in order that we can meaning-
fully report on the statistical signicance of the trading strategy factor loadings
in each case. Consequently, both the number (/) and the choice of factors (1
k
)
vary for the particular strategies in accordance with the case-by-case rationale
provided in Section 3 earlier.
4.2 OLS Results and Analysis
For the three hedge fund sectors examined we provide estimates of Jensens
alpha and the various factor loadings based on our estimation of the extended
linear factor model using an ordinary least squares estimator. For each model,
we also present the R
2
value along with the F test goodness-of-t statistic
(notwithstanding the normality constraint on the residuals) and associated p-
value for the full model to test the null that all the factor coecients, not
including the constant term, are simultaneously zero.
4.2.1 Fixed Income Arbitrage
The estimated factor loadings and standard errors, along with simple goodness-
of-t statistics are presented in Table 3 following.
Fixed Income Arbitrage [OLS Estimator]
Risk Factors 1
k
1. 2. 3. 4. 5. 6.
Int. Rate Volatility
US Agg. Global Global FPSR Curve Term Structure
Index High Yield Treasury Shift Twist Shift
b
/
k
-.013 .20 -.01 0.00 0.00 0.00
t
stat
-.13 5.73 -.73 -1.19 1.13 -1.40
b c = .00374 (4.49% annualised) t
stat
= 3.37
1
2
= 33.2%
1 test statistic ~.
2
6;143
= 7.8
j-value= 0.00
1
2

= 31.8% (i.e. without Col. 6 risk factor)

b c

= 4.08% annualised (i.e. without Col. 6 risk factor) t

stat
= 3.13
Table 3: OLS Results Fixed Income Arbitrage Hedge Fund Sector
Columns 4. and 5. represent factor proxies for parallel shift and twist factors
in the US forward swap rate curve described in Section 3.1.1 earlier. The data
used in the regression analysis are the rst-dierenced factor score time-series for
the 1st and 2nd principal components extracted from a principal components
analysis of standardised monthly changes in the aforementioned swap curve.
28
They may therefore be regarded as "conditioning information" factors which can
inuence the dynamic trading and hedging responses of hedge fund managers in
a dynamically changing marketplace. The column 6. factor contains the rst-
dierenced factor score time-series for just the 1st principal component extracted
from a PCA analysis of standardised changes in the Libor swap volatility term
structure (i.e. the set of option-implied volatilies for options on underlying
1-year swap contracts maturing 6 months out, 1Y out, 2Y, . . . , up to 5Y out)
explained in Section 3.1.2 earlier. As with the interpretation of the factors
represented in Columns 4. and 5., this risk factor may similarly be viewed as a
conditioning information factor which can inuence changes in the proprietary
trading and hedging tactics of hedge fund managers in response to anticipated
changes in market volatility.
The most signicant inference to take from Table 3 is that by adding the
factor proxy for shifts in the benchmark market volatility term structure to
our set of regressor variables, the increase in the alpha of approximately 41
basis points is attributable to the skill of the (average) hedge fund manager
20
.
This is a not insignicant amount given the low-volatility nature of the return-
generating process underlying this strategy. In reality, relative value hedge
funds will dynamically shift their portfolio allocations and/or re-balance their
hedges as markets move. We conclude therefore that this incremental gain in
alpha is attributable specically to the proprietary trading and hedging expertise
of the hedge fund managers who trade in this sector.
That is not to say, however, that the strategy is a "true alpha generator".
Table 3 clearly shows that the strategy has a signicant positive loading to the
Global High Yield credit risk factor. When not included as a factor in the
regression analysis the R
2
value drops to just 2.75% and the associated Jensens
alpha drops to 3.84% annualised. Accordingly, we nd that the sectors average
compensation for being exposed to a buy-and-hold strategy in the credit asset
class amounts to a signicant 65 basis points. Signicantly, this nding conrms
the intuition discussed in relation to Figure 4 earlier concerning the proposition
that a credit market "location choice" factor is present in the return-generating
process for this strategy.
20
In order to rationalise this dierence, consider that on the left hand side of the regression
the excess returns reect both long (through long option hedges) and short (exposure to rising
MBS prepayment speeds) exposures to interest rate volatility as a result of the strategys
proprietary arbitraging of mortgage backed securities. On the right hand side the strategys
passive short exposure to interest rate volatility is picked up by the US Aggregate Index
(Column 1) which includes a MBS sub-index. By including the interest rate volatility factor
(i.e. adding back Column 6) we are in eect allowing the regression to pick up a balanced
exposure to interest rate vega, commensurate with left hand side exposure. The 41 basis point
dierence in Jensens alpha constitutes the component of "relative value" which is therefore
protected from adverse interest rate volatility movements and is correctly attributable to
manager skill - i.e. to a proprietary hedging competency in this instance. More generally,
this is a signicant nding as it justies the use of "trading strategy" factors in correctly
attributing fund performance to manager skill.
29
4.2.2 Convertible Arbitrage
The risk factors, the estimated factor loadings and standard errors, and a num-
ber of simple goodness-of-t statistics are presented in Table 4 following.
Convertible Arbitrage [OLS Estimator]
Risk Factors 1
k
1. 2. 3. 4. 5.
US Agg Global Equity Factors Global
Index Treasury Market Volatility High Yield
b
/
k
.124 -.02 0.07 0.05 0.11
t
stat
.75 -.10 2.34 2.01 2.74
c = .0039 (4.69% annualised) t
stat
= 3.3
1
2
= 11.88%
1 test statistic ~.
2
5;143
= 3.64
j-value= 0.004
Table 4: OLS Results Convertible Arbitrage Hedge Fund Sector
Columns 1. and 2. contain the excess monthly log-returns data for the
Lehman indices described earlier. Column 3 contains the excess monthly log-
returns data for the US stock market (S&P500 index) while Column 4 is a
germane proxy for capturing non-linear dependencies between returns on strat-
egy and on the underlying US stock market. The time-series for this index is in
the form of log relative index levels and is included to capture the strategys
exposure to short-term vega.
Our analysis of Table 4 shows that Jensens alpha is signicant at 4.68%
annualised. As might be expected given the dynamic delta-hedging nature
of the strategy the estimated stock market loading is low at +0.07. What
this probably reects is a deliberate exposure to gamma risk whereby the
high convexity of typical convertible securities results in the position not be-
ing delta-hedged frequently enough to be neutral to larger than normal, rapid
changes in the underlying stock market. Interestingly, the strategys loading
to the volatility factor is +0.06 which suggests that vega risk was also largely
hedged or balanced out over the sample period examined. Although this may
appear initially to be counter-intuitive given the long-volatility exposure of the
embedded warrant, many large hedge funds would have been sellers of vega
(in eect, hedging out or balancing out the volatility exposure of the strategy)
in the aftermath of Autumn 1998
21
. Moreover, vega has a second-order ef-
21
In the aftermath of the rescue of Long Term Capital Management in 1998, many hedge
funds took advantage by using variance swaps to sell realised volatility at high implied levels.
30
fect on option prices and so would not be expected to be a major factor in the
return-generating process for this strategy anyway.
Table 4 shows that the strategy has a signicant but moderate positive load-
ing to the Global High Yield credit risk factor. Given the propensity of
convertible arbitrageurs to largely (but not completely
22
) hedge out credit risk
through the use of asset swaps, this is perhaps not too surprising. On the face
of it, the OLS results seem to support the anecdotal view that the Convert-
ible Arbitrage sector has generated positive returns over the latter half of the
sample period largely on the back of favourable movements in the credit asset
class. Mindful of the institutional under-pricing practices in the US convertibles
market at the time and the proprietary nature of the trading and hedging mod-
els used by the early generations of convertible arbitrageurs, it appears likely
that the strategy over the early years of the sample period was predominantly
generating alpha returns. In more recent years however as these competitive ad-
vantages were eroded and more funds adopted the strategy, it would appear that
the strategy began to systematically take on directional risk, particularly in the
international and domestic credit markets. In eect, convertible arbitrageurs
became proprietary traders in the search for acceptable returns. However, we
provide further insights on this nding and inference in Section 4.3 when we use
the alpha-stable maximum likelihood estimator to quantify the extent to which
the loading on the credit risk factor shown in Table 4 masks an underlying
sensitivity to a systematic (negative) skewness risk factor.
4.2.3 Distressed Debt
The risk factors, the estimated factor loadings and a number of simple goodness-
of-t statistics are presented in Table 5 following.
The estimates reported in Table 5 show the strategy to have a very signicant
loading to the US stock market factor in particular. The sample correlation
with returns on the S&P500 index was +0.546, and along with the respective
sample standard deviations back up this calculation of sample beta. In con-
trast, and perhaps surprisingly, the estimated Global High Yield factor loading
There was no shortage of distressed buyers from structured nance houses willing to buy at
historically high levels, who were structurally short vega through sales of guaranteed equity-
linked products to retail investors and who were showing signicant mark-to-market losses on
the embedded Call options in these products.
22
Convertible arbitrageurs largely hedge out credit risk by selling the convertible security to
a credit investor at a signicant discount to market - in eect the oor value of the straight
bond security taking into account the credit spread on the bond. The discount is paid for by
the credit investor giving the convertible arbirageur a call on the convertible at a strike oor
level which would require a very signicant improvement in the creditworthiness of the issuer
for the call on the convertible to be exercised. In such an event, the arbitrageur would call
the convertible, making good the credit investors leg of the asset swap with a tighter credit
spread. In eect, both parties stand to gain from the improvement in the creditworthiness of
the issuer - with most but not all of the gain accruing to the credit investor.
31
Distressed Debt [OLS Estimator]
Risk Factors 1
k
1. 2. 3. 4.
Global Global Equity US Agg.
High Yield Treasury Market Index
b
/
k
.04 .11 2.68 0.18
t
stat
0.77 0.47 7.61 0.97
b c = .0157 (18.81% annualised) t
stat
= 9.32
1
2
= 33%
1 test statistic ~.
2
4;143
= 17.24
j-value= 0.00
Table 5: OLS Results Fixed Income Arbitrage Hedge Fund Sector
was statistically insignicant at +0.04 and had a negligible eect on the estima-
tion of alpha in the regressions. Given the R
2
of c. 33% for the regression model
this would lead one to agree with anecdotal reports that the strategy largely
hedges out exposure to the credit asset class per se and instead derives its re-
turns from astute non-directional betting on anticipated favourable movements
in spread dierentials between the returns of senior debt and common equity
securities in target companies. In fact, the goodness-of-t F-test for the full
model indicates that the hypothesis that all coecients are zero (other than the
constant) can be soundly rejected. Again, given the largely neutral exposure to
the global credit asset class, this is strong evidence in support of the hypothesis
that the strategy does generate excess, risk-adjusted returns which are due to
manager skill; namely, superior security selection (i.e. relative value acumen)
and proprietary trading and risk-management expertise.
4.3 MLE / Alpha-stable Results and Analysis
For the three hedge fund sectors examined we provide in the following Tables
the results of the maximum likelihood regression analyses using a log-density
function which can properly account for non-normality eects in the residuals.
4.3.1 Fixed Income Arbitrage
Table 6 shows that by not properly accounting for non-normality in the
return distribution (and hence in the residuals), the reduction in the estimated
Jensens alpha (denoted b c
J
in Table 6) to 2.89% relative to the OLS estimate
suggests that the dierential of 160 basis points may have been incorrectly
attributed to manager skill. However, the robustness of this claim must for the
moment await further empirical investigation as explained below.
32
Fixed Income Arbitrage [MLE c-Stable Estimator]
Risk Factors 1
k
1. 2. 3. 4. 5. 6. Alpha-Stable
Int. Rate Vol Parameters
US Agg. Global Global FPSR Curve Term Structure b c
b

b
c
Index High Yield Treasury Shift Twist Shift (SE) (SE) (SE)
b
/
k
-.004 .039 -.007 .00 .00 .00 1.47 -1.0 0.00
o1 .05 .026 i i i i (.128) (*) (.00)
7
stat
-.08 1.5 i i i i 11.4 * 13.2
b c
J
= .0024 (2.89%) annualised 7
stat
= 1.23
1
2
- 32%
Max. Log Likelihood = 327
Table 6: MLE Performance Evaluation Results : Fixed Income Arbitrage
In light of the fact that the estimated value for the skewness parameter
(
b
) falls on its lower permitted boundary, the traditional maximum likelihood
approach to calculating standard errors of the estimates is not valid. When
the maximum of the likelihood function is on the boundary of the log-likelihood
space it is not possible to invert the Hessian to estimate condence intervals as
the Hessian may not be positive denite. Hence standard errors are not easily
calculated using the traditional information matrix approach. As an alternative
to manual manipulation of the optimisation algorithm to overcome this problem,
in the interim we propose to estimate the parameter space conditional on the
assumption that the true value of beta = -1.0 and estimate condence intervals
using a simulation methodology.
Before proceeding we also draw the readers attention to the fact that the
skewness parameter measures the relative weight of the negative and positive
heavy tails in the stable distribution. A beta of -1 implies that the negative
tail is heavy and that the positive tail decays exponentially (like a normal dis-
tribution). An estimated value of
b
= 1.0 would imply a large systematic
downside risk with no corresponding upside and so would imply a substantial
compensatory risk premium for systematic negative skewness exposure, if this
was indeed a true feature of the returns distribution for the strategy. The 160
basis point dierential cited above does appear to support the latter hypoth-
esis. Had the strategy been signicantly longer-lived than the sample period
1994-2005, a legitimate concern would be that the small sample was picking
up a few extreme values which happened to be negative, for example Autumn
1998 when convergence trades diverged rather than converged due to the post
credit crash ight to quality in global xed income markets, whereas a larger
sample might have picked up some positive extremes. Nonetheless, the strategy
as we have known it since the early 1990s does appear to have an underlying
return generating process which includes a systematic non-normality risk factor
which in turn has empirically manifested as a heavily negatively skewed returns
33
distribution over the sample period.
4.3.2 Convertible Arbitrage
Convertible Arbitrage [MLE c-Stable Estimator]
Risk Factors 1
k
Alpha-Stable
1. 2. 3. 4. 5. Parameters
US Agg. Global Equity Factors Global b c
b

b
c
Index Treasury Market Volatility High Yield (SE) (SE) (SE)
b
/
k
.07 .12 .02 .017 .03 1.41 -.59 .006
o1 .098 .123 .021 .021 .035 (.125) (.175) (.00)
7
stat
.71 .99 1.08 .78 .88 11.3 -3.38 10.5
b c
J
= .00264 (3.16% annualised) 7
stat
= 1.28
1
2
= 11.9%
Max. Log Likelihood = 415
Table 7: MLE Performance Evaluation Results : Convertible Arbitrage
As with the Fixed Income Arbitrage results, Table 7 shows that by not
properly accounting for non-normality in the return distribution, the increase
in Jensens alpha to 4.69% in the OLS case suggests that 153 basis points has
been incorrectly attributed to manager skill. However, the robustness of this
claim must again for the moment await further empirical verication.
4.3.3 Distressed Debt
Distressed Debt [MLE c-Stable Estimator]
Risk Factors 1
k
1. 2. 3. Alpha-Stable
Lehman Lehman US Parameters
Global Global Equity b c
b

b
c
High Yield Treasury Market (SE) (SE) (SE)
b
/
k
.009 .34 1.85 1.83 -1.0 0.008
o1 .04 .10 .30 (.082) * (.00)
7
stat
.21 3.26 6.10 22.3 * 15.4
b c
J
= .0137 (16.40% annualised) . 7
stat
= 9.06
1
2
= 33% +
Max. Log Likelihood = 8,417
Table 8: MLE Performance Evaluation Results : Distressed Debt
34
As with the other hedge fund indices examined, Table 8 shows the residuals
to have a good t to an alpha-stable distribution, with the skewness () pa-
rameter indicating a particular heavy negative skew in the distribution. The
estimate for the kurtosis (c) parameter also suggests a somewhat fat-tailed
residuals distribution. The factor loading estimates are qualitatively similar to
the OLS estimates in Table 5 earlier, with two notable exceptions. The load-
ing on the Global Treasury factor shows a notable increase in both level and
signicance from the standard OLS regressions.
Most signicantly, however, the annualised Jensens alpha estimate is some
2.41% lower than in the case where non-normality in the returns and residuals
was not accounted for in the regression framework. By properly accounting for
non-normality eects in the regression framework, rather than through an addi-
tional set of regressor variables, we provide evidence that the risk-premium for
systematic (negative) skewness in particular is signicant. Conversely, by not
accounting properly for a negative skewness factor when the return distribution
is heavily negatively skewed, Jensens alpha is overstated by a substantial 241
basis points. Although this component of excess return is attributable to risk-
taking rather than to manager skill, the major portion of excess risk-adjusted
returns nonetheless appear to be attributable to manager skill, thus conrming
the conclusions drawn from the OLS regression results earlier.
5 Conclusions and Future Research
In this paper we evaluated hedge fund performance when returns are non-normal
and display non-linear dependencies with underlying asset classes. We focused
in particular on the non-directional and hybrid classes of xed-income strate-
gies; convertible arbitrage, xed income arbitrage and distressed debt where
relative-value trading is the dominant style. We constructed a germane array
of implicit statistical risk factors which were designed to parsimoniously capture
the dynamic trading and risk-management strategies followed by relative value
hedge funds, as well as the non-linear dependencies of returns on traditional as-
set classes. We found that hedge fund returns in this non-directional sibling
class of strategies can be attributed to a mix of "alpha" and "beta" factors.
Signicantly, we provided strong evidence to conrm the intuition that by
not properly accounting for non-normality eects in the regression framework,
a signicant fraction of hedge fund returns can be incorrectly attributed to
manager skill in certain cases. Nonetheless, our results suggest that the major
proportion of the absolute returns generated by these hedge funds is justiably
attributable to the relative value acumen and the proprietary trading and risk-
management expertise of fund managers. These relative-value strategies it
would appear generate both "alpha" and "beta" returns for their investors.
The maximum-likelihood alpha-stable estimator is well suited for capturing
the value-at-risk implications of return distributions with fat tails and negatively
skewed characteristics. We propose to advance this research in the near term
with a value-at-risk study of hedge fund returns when the return distribution is
35
well-tted by an alpha-stable distribution such as that used in this study.
36
6
References
[1] Bank of New York (2006).
[2] Credit Suisse First Boston / Tremont Hedge Fund Database.
www.hedgeindex.com.
[3] Edwards, F. R., 1999, "Hedge Funds and the Collapse of Long-Term Capital
Management," Journal of Economic Perspectives, 13, 189-210.
[4] Fabozzi, F., 2006, "The CMBS Market, Swap Spreads and Relative Value".
[5] Fung, W. and D.A. Hsieh, 1997, "Empirical Characteristics of Dynamic
Trading Strategies," Review of Financial Studies, 10, 275-302.
[6] Fung, W. and D.A. Hsieh, 1999, "A Primer on Hedge Funds," Journal of
Empirical Finance, 6, 309-331.
[7] Lowenstein, R., 1998, "When Genius Failed," Fourth Estate, London.
[8] Sharpe, W.F., 1997, "Asset Allocation: Management Style and Perfor-
mance Measurement," Journal of Portfolio Management, 18, 7-19.
[9] Skiadopoulos, G., Hodges, S. and Clewlow, L., 1998, "The dynamics of
implied volatility surfaces," Financial Options Research Centre Preprint
1998/86, Warwick Business School, University of Warwick.
[10] National Pension Reserve Board
37
A AMaximumLikelihood Estimator for -Stable
Return Distributions
B Regression with non-normal -Stable Errors
Consider the standard regression model
n
i
=
k
X
j=1
r
ij

j
+-
i
. i = 1. . . . . (4)
where n
i
is an observed dependent variable, the r
ij
are observed independent
variables,
j
are unknown coecients to be estimated and -
i
are identically and
independently distributed. Equation 4 may be written in matrix form as
n = A +- (5)
where
n =
0
B
B
B
@
n
1
n
2
.
.
.
n
N
1
C
C
C
A
. A =
0
B
B
B
B
B
@
r
11
r
12
. . . r
1k
r
21
r
22
. . . r
2k
.
.
.
.
.
.
.
.
.
.
.
.
r
N1
r
N2
. . . r
Nk
1
C
C
C
C
C
A
. =
0
B
B
B
@

2
.
.
.

k
1
C
C
C
A
. - =
0
B
B
B
@
-
1
-
2
.
.
.
-
N
1
C
C
C
A
(6)
The standard OLS estimator of is
^

OLS
= (A
0
A)
1
A
0
n (7)
Thus
^

OLS
= (A
0
A)
1
A
0
- (8)
Thus in the simplest case where A is predetermined
^

OLS
is a linear sum
of the elements of -. If the elements of - are independent identically distributed
non-normal c-stable variables then
^

OLS
has an c-stable distribution. The
variance of -
i
does not even exist. Thus standard OLS inferences are not valid.
([?]) prove the following properties of the asymptotic t-statistic
1. The tails of the distribution function are normal-like at
2. The density has innite singularities [1 r[

at 1 for 0 < c < 1 and

= 1. When 1 < c < 2 the distribution has peaks at 1.
3. As c 2 the density tends to normal and the peaks vanish
When 1 < c < 2 the OLS estimates are consistent but converge ar a rate of
:
1

1
rather than :

1
2
in the normal case.
38
[?, ?, ?] shows that, subject to certain conditions, the maximum likelihood
estimates of the parameters of an c-stable distribution have the usual asymp-
totic properties of a Maximum Likelihood estimator. They are asymptotically
normal, asymptotically unbiased and have an asymptotic covariance matrix
:
1
1(c. . . c)
1
where 1(c. . . c) is Fishers Information. [?] examines linear
regression in the context of c-stable distributions paying particular attention to
the symmetric case. Here the symmetry constraint is not imposed. Assume
that -
i
= n
i

P
k
j=1
r
ij

j
is c-stable with parameters c. . . 0. If we denote
the c-stable density function by :(r. c. . . c) then we may write the density
function of -
i
as
:(-
i
. c. . . c) =
1

n
i

P
k
j=1
r
ij

. . 1. 0
!
. (9)
the Likelihood as
1(-. c. . .
1
.
2
. . . . ) =

n n
Y
i=1
:

n
i

P
k
j=1
r
ij

. . 1. 0
!
. (10)
and the Loglikelihood as
|(-. c. . .
1
.
2
. . . . ) =
n
X
i=1

:log() + log

n
i

P
k
j=1
r
ij

. . 1. 0
!!!
=
n
X
i=1
c(^-
i
).
(11)
The maximum likelihood estimators are the solutions of the equations
0|
0
m
=
n
X
i=1
c
0
(^-
i
)r
im
= 0. : = 1. 2. . . . . /
n
X
i=1

c
0
(^-
i
)
^-
i
^ -
i
r
im
= 0. : = 1. 2. . . . . /
n
X
i=1

c
0
(^-
i
)
^-
i
(n
1

k
X
j=1
r
ij

j
)r
im
= 0. : = 1. 2. . . . . /
n
X
i=1

c
0
(^-
i
)
^-
i
(n
i

k
X
j=1
r
ij

j
)r
im
= 0. : = 1. 2. . . . . /
n
X
i=1

c
0
(^-
i
)
^-
i
n
i
r
im
=
n
X
i=1

c
0
(^-
i
)
^-
i
k
X
j=1
r
ij

j
(12)
39
If \ is the diagonal matrix
\ =
0
B
B
B
B
B
B
@

0
(^"1)
^"1
0 . . . 0
0

0
(^"2)
^"2
. . . 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 . . .

0
(^"n)
^"n
1
C
C
C
C
C
C
A
. (13)
Using the notation in equation (6)we may write equation (12) in matrix format.
A
0
\n = (A
0
\A)
^
(14)
or if A
0
\A is not singular
^
= (A
0
\A)
1
A
0
\n (15)
Thus the maximum likelihood regression estimator has the format of a Gen-
eralized Least Squares estimator in the presence of heteroscedasticity where
the variance
23
of the error term -
i
is proportional to

0
("i)
"i
. The eect of the
Generalized Least Squares adjustment is to give less weight to larger obser-
vations. Figure ?? compares the weighting pattern derived from equation (13)
for c-stable processes with c = 1.2 and 1.6 with those of a standard normal
distribution. For compatibility purposes the c-stable curves are drawn with
= 1

2. As expected the normal distribution gives equal weights to all obser-

vations. The estimator for c-stable processes gives higher weights to the center
of the distribution and extremely small weights to extreme values. This eect
increases as c is reduced.
This result explains the results obtained by [?] who completed a Monte
Carlo study of the use of truncated means as measures of location in c-stable
distributions. They found
When c = 1.1 the .25 truncated
24
means are still dominant for all
n. For c = 1.3 and c = 1.5 the .50 truncated means are generally
best, and when c = 1.9 the distributions of the .75 truncated means
are uniformly less disperse than those of other estimators. Finally,
when the generating process is Gaussian (c = 2) the mean is the
best estimator. Of course it is also minimum-variance, unbiased
in this case.
The shape of the weight curves in the skewed case is shown in gure (??).
The weights are based on the same c-stable distributions as those in gure ??
except that is now 0.1. The most surprising aspect of the weighting systems
is the negative weights given to small positive observations. Again the eects
are more pronounces as c is reduced.
23
This is only an analogy. The vatiance of the error term does not exist
24
A j truncated mean retains 100j% of the data. Thus a .25 truncated mean is an average
of the central 25% of the data
40
C Asymptotic Distributional Properties of the
MaximumLikelihood Estimator with -Stable
Errors
This will be completed to show the asymptotic distributional properties of the
estimator. In particular, we will show the information matrix to be the inverse
of the Hessian of the LLF at the solution and show how various goodness of
t tests are possible with this estimator, for example, Lagrangian Multiplier,
Likelihood Ratio.
41