The past five years have witnessed a dramatic increase in managed futures products whose managers (commodity trading advisors) trade primarily in futures and options markets and which are available to the retail public as well as hedge funds whose managers invest in both cash and futures markets simultaneously and which are structured primarily for pool investment and not for public sale. Despite this growth, funds invested in managed futures and hedge fund products are estimated to be less than 1% of the over 3 trillion dollar mutual fund industry.
One reason for the relatively low level of investment in managed futures and hedge funds is that, as for traditional investments such as stocks and bond funds, investors require both a theoretical basis for their investment in nontraditional investments as well as supporting empirical results. For stock and bond funds, both single factor and multi-factor theoretical models and empirical tests of return formation exist. For instance, Sharpe [1992] used over fifteen global stock and bond indices to explain the return structure of U.S. equity funds. Elton, Gruber, and Blake [1995] used fundamental economic variables to describe the cross sectional returns of U.S. bond funds.
Theoretical models as well as empirical tests of stock and bond return formation, however, may neither fully explain the theoretical basis nor the empirical factors explaining returns to managed futures or hedge funds. Schneeweis [1996] and Fung and Hsieh [1996] point out that hedge fund traders and manage futures commodity trading advisors (CTAs) have different investment styles and opportunities than traditional stock and bond fund managers. These include the ability to trade in multiple markets, take long and short positions, and use varying degrees of leverage.
As important while futures and option markets exist in a zero sum gain, that is, daily gains must equal daily losses for market participants, academic research [Schneeweis, 1996; Chan et al., 1996] has shown that the existence of arbitrage returns, convenience yields, and returns to providing liquidity as well as the existence of trending markets due to institutional and market trading characteristics provide a source of postive return/risk tradeoff for CTA and hedge fund managers.
Little research, however, exists on the actual market or trading factors that explain the performance of managed futures investments or hedge funds. Previous research has concentrated on either a simple benchmark consisting of the average return of all public funds [Irwin et al., 1994] or a more complex Baysian risk-adjusted beta based CTA benchmark [Schneeweis et al., 1997]. However little research exists on the sources, or factors, that underly these CTA based benchmark returns or the individual public commodity funds/CTAs themselves. Mitev [1995] used traditional factor analysis to explain the differential factors explaining commodity trading advisor returns, however, no attempt was made to strictly identify explainatory variables consistent with those factors.
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Multi-Factor Models in Managed Futures, Hedge Fund and Mutual Fund Return Estimation
