Saturday, March 24, 2007

Seven factors that capture most of hedge funds' returns

The Economist magazine just published an article that talked about "synthetic" hedge funds, or replicating hedge fund returns using factor models. The original research cited can be found here. (For those of you who want a primer on factor models, I have written an article on this topic previously.) The seven factors are (are you ready?):

1) excess return on the S&P 500 index;
2) a small minus big factor constructed as the difference of the Wilshire small and large
capitalization stock indices;
3) excess returns on portfolios of lookback straddle options on currencies;
4) excess returns on portfolios of lookback straddle options on commodities;
5) excess returns on portfolios of lookback straddle options on bonds;
6) the yield spread of the US ten year treasury bond over the three month T-bill, adjusted for the duration of the ten year bond;
7) the change in the credit spread of the Moody's BAA bond over the 10 year treasury bond, also appropriately adjusted for duration.

According to the researchers, factors 3)-5) are constructed to replicate the maximum possible return to trend-following strategies on their respective underlying assets.

See, it is not that difficult to run a hedge fund after all!


NA said...

These are some of the strategies GS and MER will probably be utilizing in their HF clones.

Have you ever tried any Ernie?

Also, what is your opinion that- Crude Oil, $WTIC, is trading at 64ish but USO in early 50s? A co-integrating trade with long USO short Crude futures or not? Hmm seems interesting and weird as to why the disparity.

Ernie Chan said...

I personally have only tried the small-large cap factor. But as I mentioned in some previous articles, these factor models, even with as many as seven factors, are more suited for strategies that hold longer term than what a trader like myself would.

Yes, I don't completely understand why USO is rising slower than crude. Of course, USO includes other oil products such as gasoline, nat gas, etc. So if those aren't rising as fast as crude, USO won't either.

Ernie Chan said...

Actually I was wrong in my previous comments on USO. Even though USO can theoretically hold gasoline and heating oil contracts, currently it only holds crude oil futures and some US treasuries. The reason why its price is below that of spot crude oil price is due to the oil futures market in contango right now. Every time we roll over the oil futures to the next nearest contract, we lose money because the next contract is more expensive than the current one. USO has to keep rolling over every month to reflect the spot price. But this is no different than if you hold crude oil futures yourself.

The only way to avoid losing money in a contango market is if you actually own some storage tanks of crude oil -- but then you have to pay for storage.