Abstract
The CAPM model comes up short when explaining the superior performance of hedge funds in the past. This article argues that the Markowitz mean-variance criterion underpinning the traditional CAPM may fail to capture systematic features characterizing hedge fund performance. The two-moment market model is extended to a higher-moment model to accommodate coskewness and cokurtosis. The authors note that the higher-moment approach is more appropriate for capturing the non-linear relation between hedge fund and market returns and accounting for the specific risk-return payoffs of each hedge fund investment strategy. The key result is that the two-moment pricing model on a stand alone basis may be misleading and may wrongly indicate insufficient compensation for the investment risk.
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