The purpose of this thesis is to contribute to the literature on hedge fund
performance and risk analysis. The thesis is divided into three major chapters that apply novel factor model (Chapter 2) and return replication approaches (Chapter 3) as well as using hedge fund holdings information to
examine the disposition effect (Chapter 4).
Chapter 2 focuses on the implementation of an efficient Signal Processing technique called Independent Component Analysis, in order to try to
identify the driving mechanisms of hedge fund returns. We propose a new
algorithm to interpret economically the independent components derived
by the data. We use a wide dataset of financial linear and non-linear factors and apply the classification given by the independent component factor
models to form optimal portfolios of hedge funds. The results show that our
approach outperforms the classic factor models for hedge funds in terms of
explanatory power and statistical significance, both in and out of sample.
Additionally the ICA model seems to outperform the other models in asset
allocation and portfolio construction problems.
In chapter 3 we use an effective classification algorithm called Support
Vector Machines in order to classify and replicate hedge funds. We use
hedge fund returns and exposures on the Fung and Hsieh factor model in
order to classify the funds as the self declared strategies differ significantly in the majority of cases from the real one the funds follow. Then we replicate
the hedge fund returns with the use of the Support Vector Regressions and
we conduct: external replication using financial and economic factors that
affect hedge fund returns.
Finally in chapter 4 we examine whether hedge funds exhibit a disposition effect in equity markets that leads to under-reaction to news and return
predictability. The tendency to hold losing investments too long and sell
winning investments too soon has been documented for mutual funds and
retail investors, but little is known about whether holdings of sophisticated
institutional investors such as hedge funds exhibit such irrational behaviour.
We examine the previously unexplored differences in the disposition effect
and performance between hedge and mutual funds. Our results show that
hedge funds' equity portfolio holdings are consistent with the disposition effect
and lead to stronger predictability than that induced by mutual funds'
disposition effect during the same sample period. A subsample analysis reveals that this is due to a relatively more pronounced moderation in the
disposition-induced predictability in mutual fund holdings, which may, for
example, be related to managers learning from their past suboptimal behaviour documented by earlier studies
