EQIRA: Empirical and Quantitative Investment Research and Analysis

The Top 10 Factors Driving Hedge Fund Returns

Abstract: Hedge funds have the ability to exploit pricing inefficiencies across a very diverse set of asset classes and securities using a variety of techniques. It therefore shouldn’t come as a surprise that their returns draw from a greater number of risk factors than traditional investments. In this post, we look at the 10 most significant risk factors driving hedge fund returns.


Considering the breadth of strategies in the hedge fund universe, it’s difficult to come up with a completely objective measure of significance. The list below is subjective, but we’ve done our best to keep it grounded in empirical evidence.

We’ve performed our factor-based analysis on 14 of our hedge fund strategy indexes, which together provide suitable benchmarks for the vast majority of hedge funds in existence. In doing so, we’ve used statistical and machine learning techniques to identify a factor structure for each index, then looked at the percentage of index risk explained by each factor.

Some factors contribute to many strategies. Others contribute to only a handful. Our list strives to strike a balance between factors that have modest, but widespread contributions and those that have large contributions, but only to a limited number of strategies.

We occasionally report factor returns. It’s important to note that when we do so, we provide excess returns scaled to a 10% expected annual volatility. The factor’s actual market return may have been higher or lower, depending upon its riskiness. Our risk-adjustment standardizes volatility across factors, allowing for easier comparisons.

Without further delay, here’s our list of the 10 most significant risk factors in hedge funds today.

10. Emerging Market Equity Spread

Factor Definition: long emerging market equities, short developed market equities
Most Prominent In: Emerging Markets and, to a lesser extent, Global Macro

Many strategies have at least a modest exposure to emerging equities, but only a handful derive a substantial portion of their risk from sources unique to emerging stocks. That’s probably a good thing, since this factor has struggled to provide a compelling return. Over the last 20 years, it’s notched a risk-adjusted annualized return of either 0.57% or 1.42% per year depending upon whether it’s using individual equities or equity indexes. It’s been particularly hard hit in recent years, with annualized returns below -7% since late 2010. One bonus, however, is that it held its ground in the two most recent bear markets, remaining flat over the 2008 financial crisis and actually gaining during the 2000-2002 bear market. As you’d probably expect, emerging markets-focused hedge funds provide the greatest exposure to the factor.

9. Illiquidity

Factor Definition: lagged strategy returns
Most Prominent In: Distressed Securities, Credit, Convertible Arbitrage, Relative Value

There are many ways to measure liquidity. We like to do so by regressing on lagged strategy returns. The size of the coefficient for these lagged returns tells a lot about the strategy’s liquidity. A high coefficient implies that large returns are realized over multiple periods, which suggests that the underlying securities are not liquid enough to immediately adjust to new information. A coefficient near zero implies the opposite, that markets are liquid enough to incorporate new information quickly. While exposure to illiquidity may allow strategies to earn positive risk premiums, it also puts them at greater risk of declining precipitously during credit crunches, bear markets and other times of stress. Illiquidity is widespread in fixed income investments. Strategies using primarily exchange-traded instruments tend to have little exposure to liquidity factors.

8. Equity Size

Factor Definition: long small cap equities, short large cap equities
Most Prominent In: Event Driven, Equity Short-Bias, Equity Long/Short, Distressed Securities

Equity size is one of the longest-studied return anomalies in finance, having served an integral role in the original Fama-French three-factor model. The long-term outperformance of small caps over large caps is well documented, and strategies leveraging this factor hope to capture this premium. Over the past 20 years, small cap equity returns have exceeded large cap equity returns by 0.93% per year and small cap index returns have exceeded large cap index returns by a slightly smaller 0.49%. Unfortunately, these premia have collapsed in recent years, producing negative returns over the last one, three, and five years, which has certainly affected the performance of several equity-based hedge fund strategies.

7. Short Volatility and Variance

Factor definitions: short variance swaps, short volatility index futures, short index puts/long cash, short index calls/long index
Most Prominent In: Merger Arbitrage, Fixed Income Arbitrage, Relative Value, Convertible Arbitrage, Equity Market Neutral, Distressed Securities

Short volatility and variance factors tend to provide high returns relative to their standard deviations. They have asymmetric return profiles, producing profits most of the time, but losing significantly when things go wrong due to their extraordinary amounts of tail risk. If the factors are managed well, they can furnish a portfolio with considerable extra income. If managed poorly, they can produce crippling losses. They have historically generated much higher risk-adjusted returns than has equity beta. Hedge funds often gain exposure through options, variance swaps or futures. They need not hold equities or equity derivatives, however. Arbitrage strategies, for example, often display significant exposure because they are highly sensitive to liquidity, which is strongly correlated with equity tail risk. In fact, several of the strategies showing the most exposure to these factors are not explicitly equity-oriented.

6. Developed Market Equity Spread

Factor Definition: long developed market equities, short US equities
Most Prominent In: Emerging Markets, Equity Long/Short, Event Driven, Merger Arbitrage, Global Macro

A large percentage of hedge funds invest internationally, so it’s not surprising that so many strategies provide exposure to this factor. Unfortunately, the factor is not very profitable. Over the past 20 years, it’s produced risk-adjusted annualized returns of -1.86% or -0.01% per year depending upon whether it’s constructed using individual equities or equity indexes. Although the factor’s returns have been modest, they have tended to remain stable during bear markets, which gives the factor some value. It’s more useful as a portfolio diversifier than as a return enhancer, however.

5. Commodity Beta

Factor Definition: the excess return of a diversified basket of commodity futures
Most Prominent In: Commodities, Global Macro, Equity Market Neutral

Over the past decade, investors have increasingly turned to commodities as a source of diversification. It’s not surprising then that there are a host of hedge funds poised to meet this demand. Again, however, we find that diversification comes with a price. Our commodity beta factor has lost 0.76% per year on a risk-adjusted basis over the past 20 years. Furthermore its negative returns have accelerated in the past several years. The factor is down 4.68% and 8.66% per year over the past ten and five years, respectively, and down 18.94% over the last 12 months.

4. High Yield Credit Spread

Factor Definition: long high yield credit spreads, short investment grade credit spreads
Most Prominent In: Credit, Relative Value, Distressed Securities, Fixed Income Arbitrage, Event Driven

We define our high yield credit spread factor a bit differently than the rest of the world. As opposed to a spread between high yield bonds and government bonds, we use a spread between high yield bonds and investment grade bonds. This gives a better idea of the return and risk involved in moving out further along the corporate credit risk spectrum, which investors often do in hopes of excess return. Unfortunately, we find that investors aren’t well compensated for this risk. Using US securities, our factor has produced a risk-adjusted -0.19% per year loss over the last 20 years. The international version has earned 1.02% more per year over the last 15 years, but this too, is a relatively small premium. Both factors have performed very poorly during bear markets and each has experienced a drawdown of at least 50% in the last 20 years.

3. Investment Grade Credit Spread

Factor Definition: long investment grade bonds, short government bonds
Most Prominent In: Convertible Arbitrage, Fixed Income Arbitrage, Credit, Relative Value, Distressed Securities, Event Driven

Investment grade spreads haven’t provided any better of a risk/reward trade-off than have high yield spreads. When we construct our spread factor using total market US investment grade bonds and total market US Treasuries, we find that the spread has lost 0.93% per year over the past 20 years. If we standardize maturities we can do a bit better: when using 5-year corporate bonds and 5-year Treasuries, the loss narrows to 0.06% per year. Still, that’s left investors with no compensation for the risk they’ve borne. The factor has a steeper maximum drawdown than our US equity beta factor, and, on a risk-adjusted basis, lost more than equities in the 2008 financial crisis. One bright spot, however, is with short-term bonds. It appears that investment grade bonds with maturities ranging from one to three years materially outperform Treasuries with comparable maturities. Unfortunately, this anomaly disappears with longer maturities.

2. Strategy-Specific (Idiosyncratic) Risk / Alpha

Factor Definition: idiosyncratic risk (the portion of a strategy’s risk that cannot be explained by its factor exposures)
Most Prominent In: Managed Futures, Commodities, Merger Arbitrage, Equity Market Neutral, Global Macro

Hedge fund investors should lament the fact that idiosyncratic risk is not the number one hedge fund risk factor. It is what they are supposedly paying for, after all. Instead we find that most hedge fund strategies produce only small amounts of idiosyncratic risk, instead deriving most of their variance from non-unique risk factors. Admittedly, certain strategies have provided considerable amounts of unique risk. Managed Futures, Commodities and Merger Arbitrage have generated the most over the past 10 years, according to our models. It’s important to note that we are talking about idiosyncratic risk here as opposed to idiosyncratic return, i.e., the standard deviation of the strategy’s unique risk, as opposed to its mean. Although higher risk often leads to higher return, this is not necessarily the case. It’s possible for a strategy to provide a high idiosyncratic return with little unique risk and a small idiosyncratic return with considerable unique risk.

1. Equity Beta

Factor Definition: the excess return of a diversified basket of equities
Most Prominent In: Equity Short-Bias (negative exposure), Equity Long/Short, Event Driven, Merger Arbitrage, Emerging Markets

Investors turning to hedge funds for diversification should be disappointed to find that equity beta represents the largest source of hedge fund risk. It’s really not even close. Equity beta explains more than double the amount of hedge fund risk than the next most significant non-alpha factor. If there’s any consolation it’s in the fact that US equity beta has provided the second highest risk-adjusted return over the last 20 years of all the non-alpha factors on this list, trailing only short volatility and variance.

Closing Thoughts

Investors should find this list concerning. Very few of the factors included have generated strong risk-adjusted returns. Most have provided little diversification during equity market drawdowns. And almost all of them can be easily constructed using inexpensive, highly liquid, exchange-traded index products.

We cannot lump all hedge funds together in one bucket, however. Our analysis is based on hedge fund index factor exposures, not those of individual hedge funds. There are some great funds out there, whose returns are comprised mostly of high reward factors and idiosyncratic risk. Unfortunately they are not always the largest and most widely known. Perhaps the real value of our analysis is that it underscores the need for multi-factor analysis. Using single factor CAPM models, or even the Fama-French Three-Factor Model, can exclude significant sources of systematic risk. Doing so will artificially inflate the attractiveness of funds that rely on easily accessible, low cost alternative risk factors.

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