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Return Based Style Factors and Value-at-Risk of Asia-Focused Hedge Funds

In the past decade, Asia’s superior secular growth rates have attracted global investors’ strong interest also for capital allocation in Asia focused hedge funds. The expansion of the sector of such funds results in over 1,000 hedge funds now focusing on Asian markets. This represents over 15 percent of the total number of funds in the global industry. Although Asia-focused funds are characteristically smaller, accounting only for 4.9 percent of total industry assets, the fast growth of the Asia-focused hedge fund industry over the past years has also drawn the attention of the research community.

A number of studies have been conducted on hedge fund performance and risk management. Often, in these studies, hedge funds, as an alternative investment, are compared with traditional asset classes in terms of performance (Ackermann et al. (1999), Brown et al. (1999), Liang (1999), Agarwal and Naik (2004), etc.). Some of the results suggest that hedge fund can outperform equity markets due to investment skills of hedge fund managers (Brown et al. (1999), Liang (1999)), while other results cast doubt on the persistence of outperformance of the hedge funds (Ackermann et al. (1999), Agarwal and Naik (2004)). From a risk management perspective, hedge funds are exposed to market risk, liquidity risk and credit risk (Amenc, et. al. (2002)). The performance and risk analysis of hedge funds may also be underestimated due to presence of various biases in hedge fund indices (Fung and Hsieh (2000)). There are several difficulties as it comes to investigating the performances and risks of the hedge fund industry. The short data history of hedge fund available makes it difficult to compare the returns with those of traditional asset classes. Also dynamic and less transparent investment strategies applied by hedge fund managers make it difficult to capture the effective style components for hedge funds. Finally, there is nonlinearity in returns exhibited by hedge funds when they are regressed on returns of traditional asset classes.

In order to explore the risk exposures of hedge funds, many researchers have attempted to map the returns onto a set of external factors. Dor, Jagannathan, and Meier (2003) modify Sharpe’s return based style analysis (1988) in order to examine the effective style of hedge funds. Hereby, the return based style analysis using traditional asset classes is augmented by index options to characterize the risk in hedge funds. Fung and Hsieh (2004) propose an asset based style factor model that can explain up to 80 percent of the monthly variation in hedge fund portfolios. Teo (2009) augments the factor model of Fung and Hsieh (2004) with broad Asian equity indexes to study Asian focused hedge funds.

This paper aims to contribute to the literate in several dimensions. First, we make use of the return based style analysis framework suggested by Dor, Jagannathan, and Meier (2003) in order to identify the effective style factors for Asia-focused hedge funds. To our knowledge, next to Teo (2009) this is one of the first empirical studies applying this technique to the Asian hedge fund industry. Teo (2009) performs a principal component analysis of Equity Long/Short hedge funds grouped by investment region and identifies two additional equity asset based factors for the explanation of Asia-focused hedge fund returns: the Asia ex Japan equity market index and Japan market equity index. Similarly, we augment the factors by including the Asia ex Japan equity index, Japan equity index and the Asia emerging market index in the return based style analysis to better explain variation in Asia-focused hedge funds. In this paper, the HFRI Emerging Markets: Asia ex-Japan Index is chosen to represent the universe of Asia-focused hedge funds. Further, we identify three fixed-income styles and five equity styles as the underlying risk factors for Asia-focused hedge funds.

Second, we include hypothetical out-of-the money call and put options on a subset of equity styles in order to model the nonlinear exposures of Asia-focused hedge funds. Several studies on hedge funds show that hedge fund returns exhibit option-like features (Glosten and Jagannathan (1994), Mitchell and Pulvino (2001) and Fung and Hsieh (2001)). Hedge fund managers trade dynamically and are not limited by investing in a specific class of asset only. Hence the nonlinear payoff of a hedge fund may result from explicitly investing in derivatives or implicitly trading dynamically. In order to include the nonlinearity in hedge fund returns in the return base style analysis, the literature suggests to use actively traded index options as nonlinear factors for the mapping of hedge fund returns, see e.g. Agarwal and Naik (2004), Teo (2009). Other studies suggest to augment the return of traditional asset classes with the returns of the synthetic options on these traditional asset classes (Loudon et al (2006)). In this paper, we choose the latter approach: including hypothetical out-of-the money call and put options, we are able to identify a relationship between out-of-the money put and call option positions and returns from Asia-focused hedge funds. It is reasonable to assume that these positions are constructed by Asia-focused hedge fund managers through active trading strategy in order to hedge the risk exposure from equity markets.

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Return Based Style Factors and Value-at-Risk of Asia-Focused Hedge Funds