Testing Nonlinear Dependence in the Hedge Fund Industry

This paper proposes a parsimonious approach to test nonlinear dependence on the conditional mean and variance of hedge funds with respect to several market factors. My approach introduces nonlinear dependence by means of empirically relevant polynomial functions of the factors. For comparison purposes, I also consider multifactor extensions of tests based on piecewise linear alternatives. I apply these tests to a database of monthly returns on 1071 hedge funds. I find that nonlinear dependence on the mean is highly sensitive to the factors that I consider. However, I obtain a much stronger evidence of nonlinear dependence on the conditional variance. JEL: C12, C32, C22 Copyright The Author 2011. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.