Spanning Tests for Assets with Option-Like Payoffs: The Case of Hedge Funds

Abstract

We propose a new performance evaluation method which allows for investors with skewness preference, i.e., prudent investors. Applied to hedge funds, our method yields different conclusions compared to standard tests, especially in the recent subsample, for younger funds, and compared to mutual funds. We also derive a performance measure, prudent alpha, which generalizes simple alphas to prudent investors. For hedge funds, the difference between simple and prudent alphas is economically significant and positively related with withdrawal restrictions but unrelated to managerial incentives. For simulated option strategies, prudent alpha is better able to assess performance than existing option-based factor models.