We suggest an empirical model of investment strategy returns which elucidates
the importance of non-Gaussian features, such as time-varying volatility,
asymmetry and fat tails, in explaining the level of expected returns.
Estimating the model on the (former) Lehman Brothers Hedge Fund Index data, we
demonstrate that the volatility compensation is a significant component of the
expected returns for most strategy styles, suggesting that many of these
strategies should be thought of as being `short vol'. We present some
fundamental and technical reasons why this should indeed be the case, and
suggest explanation for exception cases exhibiting `long vol' characteristics.
We conclude by drawing some lessons for hedge fund portfolio construction.Comment: 22 pages, 5 figures, 3 table