Identifying the sources of hedge fund returns through factor models

In the fifth of a series of articles on hedge fund performance measurement, Edhec looks at the use of explicit macro-factor models, implicit factor models, option portfolios and hedge fund indices in identifying sources of hedge funds return

Explicit macro-factor models

In explicit macro-factor models, observable market risk factorsare included in a model through a discretionary choice. The mis-specification risks are non-negligible.

To avoid correlation between the returns of the different asset class factors, Agarwal and Naik (2000a) select variables through a stepwise regression. As mentioned by the authors, "The stepwise method involves entering the independent variables into the discriminant function one at a time, based on