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As can be seen from table 1, all hedge fund strategies fell short of their long-term average performance in January. Three out of five strategies even posted negative returns. These poor results, which are in sharp contrast to the good performance of Q4 2004, were mainly due to an unfavourable environment, especially in the equity markets.
The disappointing returns might be explained by the exposure of hedge fund strategies to a set of risk factors. Some of them are common to all strategies. The stock market decline
(-2.53% for the S&P 500), together with the historically low level of implied volatility for these markets (12.82 for the VIX contract, ie, the lowest level since November 1995), and the end of the decrease in credit risk (a 17.20% decrease since August 2004) not only hampered the performance of directional (eg, long/short equity, CTA global) and semi-directional (eg, event-driven) strategies directly, but also contributed to a hostile environment for non-directional strategies (eg, convertible arbitrage). Other factors specifically affected one or more strategies. In particular, directional- and semi-directional strategies and the equity market neutral strategy, which traditionally hold long positions in small caps, suffered from the low premium paid to these stocks (the outperformance of the S&P 600 small-cap index over the S&P 500 index was 0.19% in January as opposed to 0.97% on average for 2004).
Fortunately, the long/short equity strategy was able to take advantage of the low level of credit risk and the slight outperformance of growth stocks over value stocks to limit their losses. In the same vein, semi-directional strategies and the equity market neutral strategy benefited from the rise in short-term interest rates and the flattening of the yield curve (the term spread was equal to 1.66% in January – the narrowest since August 2001), to achieve positive performance. It is worth noting that equity market neutral was the only strategy in January to obtain a return close to its long-term average return.
Mathieu Vaissié is a research engineer with Edhec Risk and Asset Management Research Centre based in Paris

Edhec methodology adopted
We used the Edhec Alternative Indices to measure the performance of hedge fund strategies and their exposure to major risk factors. These indices of indices have the merit of being more representative and more stable by construction than the hedge fund indices available on the market (see www.edhec-risk.com for more details). With hedge fund strategies showing significant extreme risks, we decided to present three risk-adjusted performance indicators that take this specific feature into account. The modified Sharpe ratio, for example, involves replacing the volatility in the denominator of the traditional sharpe ratio with the modified value-at-risk. The Sortino ratio divides the excess return of an asset over a prespecified threshold (the minimum acceptable return is equal to 2.5% in our case), by the downside risk of this asset. Finally, the Omega ratio involves dividing the probability weighted average return of an asset over a pre-specified threshold by the probability weighted average return of this asset below the same threshold.
For the sake of clarity, we only reported correlation coefficients when factors appeared to be significant. These factors were identified as follows. In an attempt to highlight their true economic exposures to risk factors, we first corrected the hedge fund strategies’ historical return series for auto-correlation, following the iterative unsmoothing procedure introduced in Okunev and White (2004). We subsequently regressed hedge fund returns onto every single risk factor, and selected the ones showing coefficients that were significant at a 95% confidence level. We finally calculated the correlation coefficient of hedge fund strategies with the selected factors.

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