are “market neutral” hedge strongfundsstrong really market neutral.pdf

Are “Market Neutral” Hedge Funds Really Market Neutral? Andrew J. Patton University of Oxford Using a variety of different definitions of “neutrality,” this study presents significant evi- dence against the neutrality to market risk of hedge funds in a range of style categories. I generalize standard definitions of “market neutrality,” and propose five different neutrality concepts. I suggest statistical tests for each neutrality concept, and apply these tests to a database of monthly returns on 1423 hedge funds from five style categories. For the “market neutral” style, approximately one-quarter of the funds exhibit significant exposure to market risk; this proportion is statistically significantly different from zero, but less than the proportion of significant exposures for other hedge fund styles. (JEL G11, G23) 1. Introduction The low correlation between hedge fund returns and market returns is an oft- cited favorable characteristic of hedge funds (Agarwal and Naik 2004; Brown, Goetzmann, and Ibbotson 1999; Fung and Hsieh 2001). Indeed, the term “hedge fund” was coined with reference to the goal of the first such funds, which was to invest in undervalued securities using the proceeds from short-sales of related securities, thereby creating a “market neutral” strategy (Caldwell 1995). The hedge fund industry is one of the fastest-growing sectors of the economy: the value of assets under the management of hedge funds has grown from $50 billion in 1990 to around $1.4 trillion in December 2006, and the market- neutral style of hedge funds is one of the fastest growing styles,1 thus interest in the diversification benefits they offer is great. Hedge funds are often classified according to their self-described investment strategies or styles, and the “equity market neut