Assessing and Valuing the Non-Linear Structure of Hedge Fund Returns

Several studies have put forward that hedge fund returns exhibit a nonlinear relationship with equity market returns, captured either through constructed portfolios of traded options or piece-wise linear regressions. This paper provides a statistical methodology to unveil such non-linear features with the returns on any selected benchmark index. We estimate a portfolio of options that best approximates the returns of a given hedge fund, account for this search in the statistical testing of the contingent claim features, and test whether the identified non-linear features have a positive value. We find that not all indexes for categories of funds exhibit significant non-linearities, and that only a few strategies as a group provide significant value to investors. Our methodology helps identify individual funds that provide value in an otherwise poorly performing category