Time-Varying Risk Exposure of Hedge Funds: Regime-Switching Approach

Abstract

This article aims to investigate risk exposure of hedge funds using switching regime beta models. This approach allows to analyze hedge fund tail event behavior and in particular the changes in hedge fund exposure conditional on different states of various risk factors. Up to this point, most of the studies on hedge fund performance have been based either on (i) the classical linear factor model applied to mutual funds, (ii) non-parametric models or (iii) linear factor models with option-like factors. In this paper, in line with the asset pricing perspective proposed by Bekaert and Harvey (1995, 2002), we suggest to analyze the exposure of hedge fund indexes with a parametric factor model based on regime switching, where non-linearity in the exposure is captured by factor loadings that are state dependent. The regime switching approach is able to identify when the market risk factor is characterized by normal, up-market and crisis conditions, and the state dependent factor loading is able to capture the exposure of hedge fund indexes to the market risk factor in these different states. We find that in the normal state of the market, the exposure to risk factors could be very low but as soon as the market risk factor captured by S&P500 moves to a crisis state characterized by negative returns and high volatility, the exposure of hedge fund indexes to the S&P500 and other risk factors may change significantly. We further extend the regime switching model to allow for non-linearity in residuals and show that switching regime models are able to capture and forecast the evolution of the idiosyncratic risk factor in terms of changes from a low volatility regime to a distressed state that are not directly related to market risk factors. In particular, our analysis shows that the convertible bond arbitrage distress observed in 2005 is not related to a particular regime of the market index or some other systemic risk factor, but to a switch in the volatility of the idiosyncratic risk factor in this strategy.