Econometric Issues in Modeling Returns and Managerial Efficiency in the Hedge Fund Industry

The main focus of this paper is to explore the potential econometric im-provements that can be achieved in estimating hedge fund returns. Specifically, we examine the effects of incorporating the following three adjustments to estimating managerial efficiency; (1) a selection bias adjustment model, (2) a nonlinear specification; and (3) a fixed effect model. Diagnostic tests confirm the importance of these adjustments in modeling hedge fund return. We propose a model that incorporates all three issues while retaining simplicity and computational efficiency. Using hedge fund data over the period 1996-2008, our basic results show that when selectivity, nonlinearity, and fund heterogeneity are taken into account, a more robust estimate of the effect of key variables has on hedge fund return can be obtained and the overall explanatory power of the model can be improved