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Fin Mkts Portfolio Mgmt (2007) 21: 425–444

DOI 10.1007/s11408-007-0060-8

The tactical and strategic value of hedge fund
strategies: a cointegration approach
Roland Füss · Dieter G. Kaiser

Published online: 24 August 2007
© Swiss Society for Financial Market Research 2007

Abstract This paper analyzes long-term comovements between hedge fund strategies and traditional asset classes using multivariate cointegration methodology. Since
cointegrated assets are tied together over the long run, a portfolio consisting of these
assets will have lower long-term volatility. Thus, if the presence of cointegration
lowers uncertainty, risk-averse investors should prefer assets that are cointegrated.
Long-term (passive) investors can benefit from the knowledge of cointegrating relationships, while the built-in error correction mechanism allows active asset managers to anticipate short-run price movements. The empirical results indicate there is
a long-run relationship between specific hedge fund strategies and traditional financial assets. Thus, the benefits of different hedge fund strategies are much less than
suggested by correlation analysis and portfolio optimization. However, certain strategies combined with specific stock market segments offer portfolio managers adequate
diversification potential, especially in the framework of tactical asset allocation.
Keywords Hedge fund strategies · Stock markets · Tactical and strategic asset
allocation · Portfolio optimization · Multivariate cointegration analysis ·
Johansen test
JEL Classification C32 · G11 · G15

R. Füss ()
Department of Empirical Research and Econometrics, University of Freiburg,
Platz der Alten Synagoge, 79085 Freiburg im Breisgau, Germany
D.G. Kaiser
Feri Institutional Advisors GmbH, Haus am Park, Rathausplatz 8-10, 61348 Bad Homburg, Germany


R. Füss, D.G. Kaiser

1 Introduction
Over the past decade, the hedge fund universe has grown from a handful of firms
managing a few hundred million dollars to more than 8,000 hedge funds worldwide
managing more than $1 trillion (HFR 2006). As a result, however, hedge funds face
constant scrutiny from investors and researchers.
Behind the torrid growth of the hedge fund universe has been the perceived
diversification benefit hedge funds can provide traditional portfolios because of
their low correlation structure (Brooks and Kat 2002; Morley 2001; Zask 2000;
Planta and Banz 2002; Eling 2006). This article, however, posits that the assumption of correlation analysis as it applies to hedge funds deserves to be reexamined
and reinterpreted. Kat (2003) has argued that correlation coefficients are only reliable
under a normal distribution of variables. Hedge funds tend to exhibit nonzero skewness and/or excess kurtosis (see Kat and Lu 2002; Füss and Kaiser 2007; Galeano and
Favre 2001). Therefore, the lower and upper bounds of a correlation coefficient might
be narrower than ±1 (Kat 2003). We contend it is unreliable to claim that hedge funds
have low correlations with stock market indices.
Mean–variance methods are also used to analyze return series (Markowitz 1952).
However, with these types of methods: (1) stationarity is assumed, (2) returns must be
normally distributed, and (3) return correlations between assets must be stable. Since
financial log asset prices are mostly nonstationary (see Nelson and Plosser 1982),
they must be transformed into stationary variables before correlation analysis can be
applied. And, this procedure can result in information loss on long-run components
because it removes the possibility of finding common price trends.
Cointegration methods, on the other hand, work directly on portfolio values and
make no assumption about stationarity of the asset values (Alexander 2001). Therefore, this article draws on the theory of cointegration processes to discern whether
hedge fund strategies exhibit a long-run equilibrium relationship with the time series
of conventional financial asset classes.
Cointegration refers to the fact that financial assets share common stochastic
trends that cause time series to move toward long-term equilibrium after every terminal shock. The built-in error correction mechanism determines how long it will
take to reach equilibrium. The presence of cointegration does not make prices fully
predictable, but it does make it possible for investors to better time their portfolio
holdings (Gregoriou and Rouah 2001).
Cointegration affects both tactical and strategic financial decision making (Lucas
1997). Because of the long-term relationship between cointegrated assets, a portfolio of these assets with weights taken from cointegrating vectors will have lower
long-term volatility. In addition, the error correction mechanism allows active asset
managers to anticipate price movements over the short term. The speed of adjustment
estimated by the error correction model shows the economic relevance of long-term
When it takes decades for the asset returns to move toward the common stochastic
trend, the existence of such a trend is of little relevance for an investor with finite
horizon (Kasa 1992). Without cointegration, there is no mean reversion in the price
spread, and uncertainty for active and passive asset managers will be higher. Thus,
risk-averse investors will still prefer cointegrated assets.

They noted some common trends. North America. They found no evidence of common stochastic trends. (2002). Taylor and Tonks (1989) found no pairwise cointegration between US and UK equity markets. Hong Kong. except for a weak long-term interrelation between hedge fund strategies and the US stock market. Corhay et al. His results rejected the null hypothesis of no cointegration at a very high significance level. This suggests there is no cointegration between the US market and any major European equity market. and Bieren’s test. Garret and Spyrou (1999) investigated the existence of common trends in Latin America and Asia-Pacific equity markets. The authors found evidence of cointegration with the stock market indices for just two of the hedge funds. Another strand of studies has focused on stock market links between emerging markets and their regional areas. which did not influence the long-term relationship).1 but they did not rule out the possibility of long-term diversification benefits. Therefore. Japan. or Singapore. the Johansen approach. examining common stochastic trends between the ten largest hedge funds of different styles and the equity market indices of the S&P 500. On the other hand. He used the Johansen test for common trends on monthly and quarterly data from the Morgan Stanley Capital International (MSCI) equity indices from January 1974 through August 1990. the Russell 2000. Bossaerts (1988) developed a test of cointegration and applied it to five size-based and five industry-based stock portfolios. and found evidence of a single stochastic trend. such as futures. and other derivatives. currencies. especially in Asia and Latin America. the performance of these hedge funds will not be strongly correlated to standard benchmarks. Japan. Germany. thereby providing substantial evidence of cointegration. Other studies have examined the interrelationships among regional stock markets to find potential gains from international diversification. swaps. the MSCI World. Malaysia. Germany. see Hung and Cheung (1995). Pan et al. Japan. Füss and Herrmann (2005) studied long-term interdependence between hedge fund strategies and the stock market indices of France. Gregoriou and Rouah (2001) focused on hedge fund investments. and France) using the bivariate Engle and Granger (1987) approach. options. For example. (1993) found cointegration among stock prices in several European countries (except Italy. Kasa (1992) studied the drivers of equity markets in the US. England.The tactical and strategic value of hedge fund strategies 427 Most studies on cointegrated assets have applied the approach to traditional stock market portfolios and indices. Arshanapalli and Doukas (1993) found links between US and European markets (the UK. and the NASDAQ index from January 1991 through December 2000. because some of the countries do not enter the region’s common trend. 1 For further studies on the interdependence of emerging markets. and the UK from January 1994 to December 2003. . a result reinforced by Kanas (1998) using the multivariate trace statistic. They argue that large hedge funds tend to allocate assets over a wide range of investment instruments. (1999) used the multivariate cointegration approach and found no evidence of common stochastic trends in the equity markets of Australia. Germany. and Canada. For example. Chaudhuri (1997). and Chen et al.

D. Thus. Section 5 concludes. we analyze the dynamic linkages between various hedge fund strategies and traditional asset markets. The aim of asset allocation in all cases is to obtain the best possible risk/return profile for a portfolio. in contrast. . 2 Asset allocation methods Most finance literature defines three levels of asset allocation: benchmark. for a traditional portfolio.G. and real estate equities. (2006) test for the presence of cointegration between hedge funds and traditional and alternative financial assets. and tactical. The remainder of this article is organized as follows. risk-averse investors with long-term investment horizons do not increase risk by including hedge funds. which we will examine further in this section. 3. we differentiate between tactical and strategic asset allocation. we discuss stationarity and cointegration more fully. The results of the Johansen test do not depend on the normalization selected (Hamilton 1994). the Dickey–Fuller (DF) test is numerically dependent upon the precise formulation of the cointegrating regression. small-cap stocks. The authors conclude that investors with both traditional and alternative portfolios can benefit from risk diversification. (1991) argue that the results of the Engle–Granger cointegration approach may not be consistent because it is sensitive to the choice of dependent variables.2 Füss et al. Section 4 presents our empirical findings of cointegration relationships between the hedge fund styles and conventional financial assets. in comparison. But to expand this narrow perspective. hedge funds share a common trend with NASDAQ-listed companies. Strategic asset allocation. Section 2 reviews the different asset allocation levels in the context of investment decisions.428 R. In benchmark asset allocation (or what is referred to as indexing). the hedge fund composite index not only enters the cointegrating vector. the rebalancing frequency of the portfolio. as per Lucas (1997). We interpret the overall absence (existence) of a common stochastic trend in most of the studies as the existence (failure) of long-run gains from diversification. (2006). for a portfolio consisting only of alternative assets. In contrast to Füss et al. However. Kaiser Both Gregoriou and Rouah (2001) and Füss and Herrmann (2005) use the Engle and Granger (1987) two-step cointegration approach. the relevance and the implications of cointegration between asset prices and hedge fund strategies for asset allocation decisions will depend on the holding period of the investment. which is considered weaker than the Johansen method. On the other hand. strategic. while. In Sect. But the three methods use dramatically different ways to achieve their objectives. Johansen’s multivariate cointegration test is more robust. and investor risk attitude. is based on a long-term view of 2 Dickey et al. as well as the augmented Dickey– Fuller and Johansen tests and how they affect asset allocation. Füss. only hedge fund and emerging equity returns react significantly to the common trend. who represent the hedge fund universe by an aggregate composite index. but the returns also react to the common trend. the portfolio manager makes investment decisions according to the asset weights of the benchmark index. Thus. Their empirical results suggest that.

we focus here on long-term comovements between hedge funds and financial asset markets. variation in investment weights will increase with the strategic program. Strategic asset allocation weight changes are slow and evolving so as to maintain the objective of rebalancing the portfolio within a year. so there is no need to rebalance the portfolio (see Table 1). that asset prices will stay together over the long . conditioning information is generally used. they will benefit from being aware of and understanding cointegrating relationships (e. Time series models are attractive for this purpose because the future behavior of a times series is explained by its own past and by the past of related time series. To be more precise. investors need no (or only some) prior knowledge about related (exogenous) economic variables. The use of conditioning information to determine the weights also naturally varies according to the allocation method. for both tactical and strategic asset allocation. in contrast. Thus. strategic allocation decisions are sometimes based on unconditional information by assuming that historical returns are representative of future returns. The weights are determined by long-term forecasts. Because indexing results in only slight alterations in portfolio weights. tactical asset allocation weight changes. usually in one month to one quarter increments. In the context of portfolio optimization. In addition. and the effects of short. are highly dynamic.The tactical and strategic value of hedge fund strategies 429 Table 1 Asset allocation methods Source: Dahlquist and Harvey (2001) performance and usually has a 5 year time horizon. using ex post data can lead to a fixed weight portfolio. short. investors must gauge the level of future uncertainty by using quantitative models.and long-term expected returns induce weight changes unless the conditioning information has no predictive ability. On the other hand. Tactical asset allocation is the process of short-term deviations from the strategic weights. under strategic asset allocation.. The built-in error correction mechanism illustrates how series react to temporary deviations from long-term equilibrium.g. To establish a consistent and effective investment policy. Cointegration will reveal the existence of any long-run equilibrium relationships between hedge funds and other financial series.and long-term planning horizons. Benchmark allocation requires no conditioning information at all. in strategic and tactical asset allocation. Dahlquist and Harvey (2001) note that. Assuming investors are risk-averse.

the error correction mechanism allows the portfolio manager to anticipate some of the near-term developments. In the long run.G. in financial literature. as defined and developed by Granger (1981) and Engle and Granger (1987). The set of asset weights within such a portfolio is called the cointegrating vector. stationarity means that the time series exhibits a constant mean. random walk (unit root) or mean reversion (trend stationary) processes. i.e. the above results imply that the correct choice concerning the (non)stationarity property of a time series is of major relevance. the assets will form a cointegrated set. This suggests future returns are predictable from information on past returns. we need to test for the presence of common stochastic trends. we can incorporate the reaction to temporary states of disequilibrium into the calculus.4 Another trait of random walks is that the longer the time horizon. Technically speaking. the property of nonstationarity often emerges quite naturally as a result of the assumption of efficient markets and the absence of arbitrage (Lucas 1997). and active investors could probably ignore the presence of cointegration. Cointegration is a property of some nonstationary time series. for financial decisions on optimal asset allocation. if the value series of a fixed weight portfolio of assets with nonstationary prices is stationary. cointegrating relationships of financial time series show less long-term variability. future returns are unpredictable based on historical observations. and thus.430 R. Of course. stationarity is based on the assumption that the effect of present shocks in the time series diminishes or disappears in the distant future. which in turn has important implications for asset pricing and portfolio allocation decisions. 3 Stationarity and cointegration in a system with hedge funds In the context of long-run properties of financial time series. D. we need to use cointegration. a random walk supposes any shock to an asset price is permanent. As Lucas (1997) has noted. Füss. Hence. To evaluate whether hedge fund strategies provide long-term diversification benefits for traditional portfolios. despite the fact that short-term departures from equilibrium 3 Consequently. the more likely it is that prices will wander far from their trend path. in a random walk framework. If two nonstationary time series are cointegrated. For tactical asset allocation. Thus. For example. 4 Hence. and autocovariance that depend only on the time lag. passive long-term investors would be better served by focusing on error correction instead of cointegrating vectors. In the context of portfolio theory. and the most recent return would be the best predictor of future returns. a linear combination relationship that is also stationary is said to exist. This means that the conditioning information is provided by the adjustment coefficient of the temporary deviations. this boundless growth in volatility of asset prices characterizes the nonstationarity of random walks. . Kaiser term). over time the price level will revert to its trend path (or mean return). researchers have tended to focus on asset price characteristics. if asset prices are mean-reverting. If time series are cointegrated. and there is no tendency for it to revert back.3 In contrast.. less long-term risk. Cointegration means there is some long-term equilibrium relationship tying the times series together. standard deviation. if this process unfolds over decades. However.

0 < r(Π) = r < n.e. The λmax is found by again testing the null hypothesis of at most q cointegrating vectors against the alternative of one additional cointegrating vector (i. . two n × r matrices α and β can be factored so that Π = αβ  . The trace statistic is the result of testing the restriction r ≤ q (q < n) against the completely unrestricted model r ≤ n: λtrace = −T n  ln(1 − λ˜ i ) (3) i=q+1 where T is the sample size and λ˜ r+1 . i. Consequently. r ≤ q + 1): λmax = −T ln(1 − λ˜ q+1 ) (4) . exist.The tactical and strategic value of hedge fund strategies 431 may also be present. The Johansen procedure is a maximum likelihood estimation of a fully specified error correction model in transitory form: Xt = μ + Γ1 Xt−1 + · · · + Γk−1 Xt−k+1 + ΠXt−1 + εt (1) where Xt exhibits the vector of price changes in period t. The number of significantly nonzero eigenvalues shows the rank of the matrix Πˆ . α is the matrix of the error correction terms that shows the impact of r cointegrated vectors on Xt . . Γ represents the short-run dynamics. Johansen (1988. Because the matrix does not have full rank. If Π is of intermediate rank. the two tests differ in their assumptions about the alternative hypothesis.. . We refer to the second restricted maximum likelihood ratio test as the maximal eigenvalue test statistic. μ is a constant vector. To determine the rank r of estimated matrix Πˆ . The number of stationary linear combinations of Xt . and r cointegrating vectors. which will have reduced rank under cointegration. Note that the evidence of the error correction mechanism for tactical asset allocation decisions is quite obvious. or n − r stochastic trends.. β  Xt = 0. and Π is the long-run impact matrix. the r columns of β can be defined as cointegrating vectors. The ith row of α represents the direction and strength of the adjustment process. As Kasa (1992) points out. If Xt is in a transitory state of disequilibrium. e.. and can be evaluated by the trace test and the maximal eigenvalue test. 1991) developed the multivariate test for cointegration and the error correction model. the cointegrating vectors is determined by the rank of this matrix. where  denotes transposition. we first calculate the eigenvalues λ˜ i . . Johansen and Juselius (1990. we rewrite (1) as Xt = μ + k−1  Γi Xt−i + αβ  Xt−1 + εt .e. (2) i=1 In this factorization. the linearly independent combinations of Xt that are stationary. so that r linear combinations of nonstationary variables are stationary. 1991).g. λ˜ n are the n − r smallest squared canonical correlations. we can predict some of the future developments of Xt due to the function of the error correction mechanism (Lucas 1997).

432 R. while Π = αβ  in (5) represents a cointegrated system of asset prices.6 Given a constant holding vector x in the assets over investment horizon H . with εt ∼ iid(0. Further assume that the vector of log asset prices Xt follows a VAR process of order one: Xt = μ + ΠXt−1 + εt . for asset allocation. the conditional mean and conditional variance are given. Comparatively. (5) For Π = 0. the portfolio’s rebalancing frequency. respectively.G. but with different formulas and different values for conditional moments. (6) s=0 x  V0 (XH − X0 )x = H −1  x  (I + Π)s Ω(I + Π  )s x. The maximal eigenvalue test clearly produces more straightforward results. and can effectively rebalance the portfolio using the matrix α. The lower long-term volatility of such portfolios makes them particularly attractive for highly risk-averse long-term investors. which generate a shift in the mean–variance frontier. To illustrate. For strategic asset allocation with a static (no-rebalancing) long-term investment style. the eigenvalues of (I + Π ) lie on the unit circle. the relevance of cointegration depends on the holding period of the investment. consider an investor with a quadratic risk aversion utility function. from which the usual Markowitz (1952) mean–variance analysis follows. in (6) and (7): x  E0 (XH − X0 ) = H −1    x  (I + Π)s μ + x  (I + Π)H − I X0 . Ω). λmax tends to produce better results when λi are either large or small (Kasa 1992). When the asset prices are cointegrated (Π = αβ  ). Kaiser where λ˜ ∗1 . we obtain the standard formulations H x  μ and H x  Ωx for the mean and variance. as shown above.5 These technical explanations allow us to establish a connection to the optimal asset allocation framework. where the conditional mean and variance of portfolio returns over the investment horizon matters. (7) s=0 When there is no cointegration (Π = 0). λ˜ ∗q are the largest squared correlations. . . On the other hand. the trace statistic tends to have greater power than λ max i because it considers the range of all n − q of the smallest eigenvalues. and the model in (9) reduces to a pure random walk with drift. . D. . respectively. . if λ are evenly distributed. and the investor’s risk appetite. mean–variance analysis still applies. we obtain the standard model with iid returns. portfolio managers using tactical asset allocation can anticipate the temporary deviations of asset prices from long-run equilibrium. 5 To be more precise. 6 For Π = 0. Thus. Füss. we construct a portfolio with weights corresponding to cointegrating vectors in β  Xt−1 .

however. 4. Note also that broad-based hedge fund style indexes generally understate trading style diversity and overstate any risk of style convergence. especially for the large-cap sector (correlation of 0. The NASDAQ proxies for “new economy” firms. will still hold. and the multiperiod bias (Fung and Hsieh 2000).. as it is mainly a long-term property. selection bias. respectively). Table 2 gives the summary statistics for the hedge fund strategies. The overall finding of cointegration or no cointegration. and index returns.87%. The NASDAQ composite is the most volatile asset. implying a high rate of return.9953). are affected particularly by the survivorship and instant history biases (see Lhabitant 2004).8 Using hedge fund indices to proxy for hedge fund strategy performance can cause various biases in the time series.06%). as well as for the stock. The other financial asset class indices are represented by the S&P 500 Composite Index. and value stocks outperform most of the hedge fund strategies for both absolute and risk-adjusted returns. And price estimation can be difficult because hedge funds invest in instruments that are often not stock exchange oriented. Note first that the annualized average of continuously compounded returns is the highest for the global macro and distressed securities strategies (12. Because hedge funds are not legally required to report return information publicly.P. the simple Sharpe ratio defined as the coefficient of mean and the standard deviation). They find no empirical evidence that changing the frequency of observations while keeping the sample length fixed influences the results of cointegration testing.61%. The most common biases in the literature are survivorship bias. the Wilshire All Value.05%). Morgan Government Bond Index.g.P. only the short-seller strategy has a negative annualized mean return (−2. the NASDAQ Composite (DS calculated). however. which affects the values of the cointegrating vectors and the error correction model coefficients. with an annualized standard deviation of 26. 7 Hakkio and Rush (1991) argue that the length of the time series is more important than the frequency of the information for discerning the presence of cointegration. which are noninvestable. This can mean that reported values do not reflect actual performance.70% and 12. backfilling bias. autocorrelation bias. The S&P 500. These biases generally result in overestimating expected returns and underestimating expected variance. For the risk-adjusted return (e. Comparatively. most of the indices increase continuously. These biases arise from the lack of regulation and difficulty in estimating prices inherent in the hedge fund structure. bond. NASDAQ. and high volatility (17. the J.The tactical and strategic value of hedge fund strategies 433 4 Data and empirical results Our data include monthly total return indexes in US dollars from December 1993 to December 2005 (there are 145 end-of-month observations in each series). Shiller and Perron (1985) and Perron (1989) support this observation.1 Descriptive statistics Over our sample period. 8 We use the S&P 500 as a proxy for the overall market. and the J. Morgan bond index and equity market neutral strategy significantly outperform the others. Note that the Credit Suisse/Tremont indices. . the Wilshire All Growth. managers decide how and when to present performance information.7 Our hedge fund strategy indices come from Credit Suisse/Tremont.

372 3.687 −1.300 0.213 21.B.) (in % p. Thus.027 3.826 14. Moreover. Füss.628 1.) ness kurtosis ratio test Relative value strategies 102.058 0.369 6.78a  ln (S&P 500 composite) 10.509 330.309 0.436 4.005.049 17.412 26. but with the disadvantage that valuable information 9 For instance.609 6.771 −1.007 14. Finding the optimal portfolio weights in a mean–variance analysis also requires that return correlations between assets be stable.332 50. standard deviation is an incomplete measure of risk and it may lead to suboptimal asset allocation decisions.85a  ln (NASDAQ composite) 11.9 However.207 17.288 0.125 6.865 0.800 18.197 2.582 −0.P. so using standard deviation as a single measure of risk may alter the actual performance. Morgan bond) Based on monthly continuously compounded total returns for 145 observations.244 2. .78a 10.83a 7.940 −0. correlation analysis is only valid for stationary variables.31a 6. However. We can make most of the financial data stationary by taking first differences of the prices or by de-trending the variables.462  ln (equity market neutral) 9.259 4.755 −0.892 2.357 0.139 267.919 0.136 −0.a.695 11.919 0. January 1994–December 2005 Indices Mean Std.428 31. The Sharpe ratio is defined as the coefficient of mean and standard deviation without adjustment for the risk-free rate Note that the emerging market strategy has extremely high volatility compared to its mean return.67a 8.018 4.610 1.266 15.868 −0.32a 2.033 −0. The results again show substantial variation between the different asset classes. Lhabitant (2002) found that correlation between most hedge fund indices and between US and European equity markets is much higher in down markets than in up markets. almost all asset classes exhibit asymmetric return patterns with negative skewness and positive excess kurtosis.44a  ln (convertible arbitrage) 8.885 1. dev.a.425 17.434 R.882 0.035 16.674 17.61a 12.458 2.742 54. asset prices are integrated of order one.470 0.802 −3.553  ln (long/short equity) 11. in a portfolio optimization context. The Jarque–Bera test shows to what degree returns deviate from a normal distribution.6a Opportunistic strategies  ln (emerging markets)  ln (global macro) Stock and bond market  ln (Wilshire growth)  ln (Wilshire value)  ln (J.984.181 0.64a  ln (short-sellers) −2.319 89.500  ln (fixed-income arbitrage) 6.081 1.033 16. A high value suggests returns do not follow a normal distribution at the 1% significance level.853 −0. except for equity market neutral.122 0.218 −0.220 −1.579 −3. a denotes significance at the 1% level (rejection of the normal distribution).8a Event-driven strategies  ln (risk arbitrage)  ln (distressed securities) 2.935 2. D.090 0.423 0. (in % p.089 3.828 7.G.96a 12.730 0. Skew- Excess Sharpe J.588 1. Kaiser Table 2 Times series statistical properties.904 0.

106 arbitrage)  ln (fixed-income arbitrage)  ln (equity market neutral)  ln (risk arbitrage) 0.035 0.806 −0.558 0.029 −0. +1]. As Table 2 shows.035 0.729 0.684 0.684 0.488 0. Kat 2003).487 0.383 0.362 0.371 0.478 −0. Due to their trading strategies. 2002.228 0.108  ln (distressed 0.141 0. This can lead to incorrect findings of very low dependence.547 −0. most hedge fund strategies and financial assets have a negative skewness and/or an excess kurtosis. so using linear correlation coefficients as a measure of dependence is not reliable (Lhabitant 2004). Mor- 500 comp. 11 Besides the limitation to two variables.515 0.312 0. so it can be much smaller for certain distributions. Using the correlation coefficient as an indicator for dependence among random variables is also problematic.460 0.112 0.037 0.037 0. Also.10 hedge funds are typically nonlinear functions of traditional markets.492 0.592 −0.230 0.051 0.160 0.496 0.757 −0.814 −0.110 0.140 0. the correlation coefficient does not exhaust the full interval [−1.600 0.479 0.) growth) value) gan bond) 0. other problems may arise when using the correlation coefficients.394 0.) comp.11 The cointegration approach is again more suitable because it works directly on asset prices rather than returns and does not require the assumption of stationarity of the asset value series.067 0. Such portfolios exhibit both nonnormality fluctuations of the underlying assets and nonlinear functions in traditional assets. so the joint distribution is far from being elliptic. 10 These trading strategies lead to complex hedge fund portfolios including nonlinear assets such as op- tions. however. 1999.185 0.079 0.194 0. because (1) only linear dependence is measured. and (2) the results are only meaningful if the multivariate distribution is elliptic (Embrechts et al. .275 0. and so on.217 securities)  ln (long/short equity)  ln (short-sellers)  ln (emerging markets)  ln (global macro) can be lost because de-trending eliminates any possibility of detecting common price trends.P. such as spurious correlations and nonresistance against outliers.The tactical and strategic value of hedge fund strategies 435 Table 3 Contemporaneous correlations between monthly returns January 1994–December 2005 Indices  ln (convertible  ln (S&P  ln (NASDAQ  ln (Wilshire  ln (Wilshire  ln (J. interest rate derivatives. if the distribution is not elliptic. even though the variables are perfectly correlated. See Lhabitant (2004) for more about these problems.127 0.

such behavior inevitably affects the timing of portfolio rebalancing (Gregoriou et al. we conclude that all financial series are nonstationary in levels and stationary in returns. which is a necessary condition in testing for cointegration. Kaiser Table 3 shows the correlation matrix between the hedge fund strategies and the various US stock and bond segments. if the d times differenced series has a stationary invertible ARMA representation. since random walks are only one example of nonstationarity. we next investigate how independent the random walk components are. Furthermore. 4. 12 Gregoriou et al. particularly with the stock market indices. as well as in the S&P 500. which may be the result of overestimating hedge fund returns. 1979. because cointegration analysis requires that the variables be stationary. Even though the hedge fund strategies and financial asset prices follow a random walk. I (d). However. of the same order. If asset returns exhibit a random walk. Tests of stationarity are often characterized as unit roots.2 Testing for unit roots Before applying the Johansen cointegration methodology. I (1). and emerging markets. High correlation does not imply high cointegration. As Engle and Granger (1987) discuss. D. The long/short equity and distressed securities indices are highly positively correlated with the NASDAQ index. A constant term or drift parameter is present in the return series of hedge funds. We expected that emerging markets would be more highly correlated.436 R. the null hypothesis is rejected at the 1% level for all asset classes except for equity market neutral. temporary shocks in the returns persist over time and do not disappear by reverting to the mean.G. provide strong evidence that all series in the levels are nonstationary as suggested by the small values of the ADF statistics. distressed securities. a series is said to be integrated of order d. Despite its problems. or whether each series requires the same degree of differencing to achieve stationarity. . This means that all indices are integrated of order one. The constant term for these series reflects fluctuations around a mean. Füss.12 The results of the augmented Dickey–Fuller (ADF) tests (Dickey and Fuller 1981. and higher correlation is neither necessary nor sufficient for higher cointegration between assets. However. (2001) note a finding of nonstationarity by the ADF test does not necessarily imply random walk behavior. correlation and cointegration are related but distinct concepts. I (1). If the hedge fund strategy and the financial market indices data exhibit a unit root. Accordingly. In other words. when we use first differences. cointegrated series can actually have low correlations (Füss and Herrmann 2005). In fact. and significant at the 1% level. Thus. we test whether the time series is integrated to the same order. cointegration exists when there is a mean reversion in the price spread between the strategy indices and the traditional asset categories. they are considered integrated. the bond index is negatively correlated with risk arbitrage. Said and Dickey 1984) reported in Table 4. 2001). except for emerging markets and short-sellers. the cointegration results for this strategy should be interpreted with caution. Note that only the monthly returns for the short-sellers strategy are negatively correlated with the US stock market.

270 (6) Short-sellers −3.11 (10) Wilshire growth −2.403 (7) Global macro −2.874a (6) −3. ADFc is the ADF statistic with constant term and no trend.856 (3) Equity market neutral −7.03a (0) −3.P. but the Chow break- point test indicates significant structural breaks for the S&P 500. The lag orders in the ADF equations for each time series are determined by the significance of the coefficient for the lagged terms and are in parentheses 4. and growth stocks from No- .753 (5) −4.70a (0) −3.445b (7) −1.29a (0) −10.3 Testing for cointegration Because we are interested in the diversification effects of hedge fund strategies. and determine whether hedge funds become substitutes for equity or bond allocation. −1.The tactical and strategic value of hedge fund strategies 437 Table 4 Unit root tests of prices and returns Indices Unit root test in level Xt Unit root test in first difference Xt ADF ADF ADFc ADFct ADFc ADFct Relative value strategies Convertible arbitrage −5. For each time series.410 (8) −10. and ADF is the ADF statistic without constant term or trend.201 (1) Distressed securities Opportunistic strategies Long/short equity −4.30 (10) Wilshire value −1. no structural breaks are found for any of the series. where ADFct denotes the ADF statistic with trend and constant term. As we noted earlier. Lag length is the order of the augmentation needed to eliminate any autocorrelation in the residuals of the ADF regression.469 (0) J. NASDAQ. a and b indicate significance at the 1% and 5% levels (unit root is the null hypothesis) on the basis of the critical values given by MacKinnon (1996).939a (0) −2.078 (8) −3. Johansen and Juselius 1990). the appropriate model is chosen by minimizing the Akaike information criterion (AIC) or the Schwartz criterion (SIC) values.554 (3) −9. we incorporate the corresponding indices of the three hedge fund styles into a traditional stock and bond portfolio.915 (0) NASDAQ comp. −2.546a (7) Stock and bond market S&P 500 comp. standard tests for cointegration such as the trace and maximal eigenvalue tests are biased toward nonrejection of the no-cointegration hypothesis when the data are subjected to structural breaks.90a (0) −2. Morgan bond −12. We can thus make inferences about tactical and strategic asset allocation decisions for a mixed-asset portfolio.068 (1) Fixed-income arbitrage −2.048a (5) Event-driven strategies Risk arbitrage −8. 1991.399a (1) All test statistics are augmented Dickey–Fuller t -tests. We test for cointegration between the financial series and the three style categories by using the Johansen maximum likelihood (ML) procedure (Johansen 1988.756a (5) −1.13 13 According to the CUSUM test.45b (1) Emerging markets −2.843a (0) −2.416a (2) 2.710a (5) −11.

D.19E−26a 1.98a −44.94E−25 3.87E−25 3.71 −44. the cointegration tests results may not be reliable because parameter stability becomes questionable over the whole sample period.19 −33.70 −44.73 −31. But we do need to decide whether to include a constant in the cointegration equation.38E−25 AIC −31. For this time series. Hence. Due to the time series used. Kaiser Table 5 VAR lag order selection Lag 0 1 2 3 4 Relative value strategies FPE 5.12E−29 1. as the length of the data series is important for discerning cointegration.27E−17 1.27 −31.07 −44.G.438 R.46 −29.09E−30a 5. respectively.32E−25 1.30 −44.88E−29 AIC −44.23 −44. However. We use the Akaike information and final prediction error criteria to specify the order of the unrestricted VAR model (see Lütkepohl 1991).67 Event-driven strategies FPE AIC Opportunistic strategies FPE 4.55E−29 1.26a −35.77E−25 2.12 −31.33E−16 9.65 Event-driven strategies Opportunistic strategies a Indicates lag order selected by the Akaike information criterion (AIC) and the final prediction error (FPE) However.57E−25 2. we assume that the log prices of the different asset classes are driven by the vember 1998 to February 2001.29E−25a 1. we decided not to split the time series into subsamples.63 −31.42 5 6 7 8 Lag Relative value strategies FPE 9.52E−30 6.21 −31.12E−25 −17.77E−25 AIC −31.25E−30 AIC −21. Füss.84 −32.90 −32. we can ignore linear and quadratic data trends.37E−25 1. and in accordance with the results of the unit root tests.81E−25 4.24 FPE 2.70 −44.40 −30.06E−25 AIC −9. A constant implies that the mean of the cointegration relationships between the time series differs from zero.02 −36.10 FPE 2. the distribution of test statistics from the trace and maximal eigenvalue tests depends on the deterministic components drift and trend in the system. and for emerging markets hedge fund strategies from July 1998 to April 2001. .67E−25 2. the vector error correction model (VECM) involves terms in differences k − 1 = 1 and k − 1 = 0.28E−30 1. According to the ADF test.62 8.11a −31.12E−20 5. Table 5 shows that both information criteria refer to a VAR model of order k = 2 for a portfolio including relative value strategies (where the lag order is 1 for the event-driven and opportunistic strategies).34E−30 4.70E−25 2.31E−25 4.41 −28.

51 3.59 30.00 82.61b 36.31 5.36 41.75 10.28a 82.51 3.80 84.0036 0.89 22.77 187.58 18. growth.87 39.20 152.72 109..58 14.90 r ≤1 0.75 9.17 r ≤5 0.97 17.64 47.0966 29.0696 18.99 119.1693 74.84 6.99 53.65 36.e.17 r =0 47.69 r ≤8 0.30a 109.53 16.04 35.31 5. growth.84 6.0090 1.76 39. without a constant in the cointegrating vector).28a 175.0669 16. So we consider a model with no deterministic component.53 3.31 29.00 r ≤3 0.20 152.00 r ≤4 0.15 r ≤3 0.90 r ≤1 0.04 35.2245 93.45 28.44 15.80 28.69 r ≤7 0.35a 141.30 3. For the event-driven portfolio.52 20. convertible arbitrage.0614 15.68 82.53 16.63a 47.69 59. The λtrace and λmax statistics are carried out under the assumption of no deterministic trend (i. r refers to the number of cointegrating vectors in the model same factors and thus exhibit the same long-term evolution.1187 48.00 12.34 12.2008 106.84 23.32 17.31 67.03a 41. risk arbitrage.63 11.69 r ≤6 0.80 28.00 r ≤2 0.52 18.13 17.22b 109. growth. Table 6 reports the results for the three different strategies.25 24.51 Opportunistic strategies (variables: S&P 500.67 59.84 6.36 41.82 r ≤4 0.80 30.56 23.89 22.53 16.51 a and b indicate that the null hypothesis of no cointegration can be rejected at the 1% and 5% significance levels.15 59.51 47.52 36.63 23.75 9.49 90.58 11.82 r ≤6 0.53 3.15 r ≤3 0.30 3.51 r ≤1 0.3223 162.99 119.15 r ≤2 0.89 45.35 59.46 66.The tactical and strategic value of hedge fund strategies 439 Table 6 Johansen’s maximum likelihood test H0 Eigenvalues Trace test – λtrace Maximal eigenvalue test – λmax Estimated 5% critical 1% critical Estimated 5% critical 1% critical statistics value value statistics value value Relative value strategies (variables: S&P 500. emerging markets.84 6. NASDAQ.49 90.1209 34. value.82 r ≤5 0.51 Event-driven strategies (variables: S&P 500.99 119.93 12.1405 56.32 55.84 6. respectively.4421 177. long/short equity.13 24.84 6. bonds.31 29. Critical values for the Johansen test come from Osterwald-Lenum (1992).99 r ≤7 0.80 32.32 44. NASDAQ.1804 79. NASDAQ. value.0396 6.44 15.3739 228. bonds.51 1.51 0. For the relative value portfolio.46 66.78 53.99 r ≤5 0.04 35.31 29.85a 141.46 66. distressed securities) 0. value. the trace and maximal eigenvalue tests indicate the presence of one cointegration vector at the 1% level.44 15.31 6.17 r ≤4 0. global macro) r =0 0. bonds.89 45.36 41.21 41.51 47.80 28. fixed-income arbitrage.89 22.89 45.0037 0.99 r ≤2 0.45 26.1332 50.06 30. the λtrace indicates .80 37.45 36.2277 116.0795 30.99 r ≤6 0. and equity market neutral) r =0 0. shortsellers.0453 7.2665 160.09 39.0373 6.31 24.51 0.47 11.05 41.43a 53.82 11.49 90.52 21.

. D. This implies that riskaverse investors with a long-term investment horizon can lower their level of risk even with convertible and/or fixed-income hedge fund strategies in their portfolios. to analyze the nature of the cointegrating vector and the adjustment coefficients. if returns do not react significantly to common trends. It is possible that some of the financial or hedge fund series do not enter the common stochastic trends. because it also does not react to the existing common trend. however. The test results signify the correct specifications with respect to the deterministic component in all three cointegration relationships. the relevance of diversification benefits depends on the speed of adjustment toward the common trend (Kasa 1992). their existence will only slightly affect the benefits of diversification. we see that only the distressed securities strategy shares a highly significant common stochastic trend with growth and hightech stocks. however. Füss. and tests of restrictions on the reaction of an asset’s returns to the common trend. as we discussed earlier. active and passive investors can benefit by adding risk arbitrage hedge funds to a conservative equity/bond portfolio. we set binding restrictions on both cointegrating vectors simultaneously so that the test statistics are χ 2 (2) distributed. and they do not adjust to this cointegrating vector. Significant values indicate that the specific asset enters at least one common trend. Thus. while the λmax shows two cointegration equations at the 1% level and two at the 5% level. Results from the relative value strategies reveal that NASDAQ stocks. For the opportunistic portfolio. the test statistics are significantly higher: The trace statistic suggests no more than two (three) cointegrating vectors. The maximal eigenvalue test indicates only one common stochastic trend at the 1% significance level. The short-term adjustment is merely a result of this strategy. bonds do not share a common trend with stock markets and hedge fund strategies. In contrast. The existence of one or more common stochastic trend(s) does not imply that all assets are a driving force in the common trend. For tactical asset allocation. Kaiser two long-term equilibriums at the 1% significance level. bonds. For the event-driven style.440 R. For the event-driven and opportunistic strategies. Table 7 gives the results from tests of restrictions on the composition of the cointegrating vector present in each sample. and the equity market neutral strategy do not share a common trend with the remaining asset prices. We applied the following likelihood ratio (LR) test statistic (Johansen 1995): LR = T r  i=1  1 − λˆ i w 2 log ∼ χ (r) 1 − λˆ ∗  (8) i where λˆ i and λˆ ∗i are the eigenvalues of the restricted and unrestricted models. We tested in all cases for the absence of a deterministic trend component by comparing the restricted model without a constant with the unrestricted model with a constant. Furthermore. for both hedge fund styles. the fixed-income strategy would provide diversification benefits in the short term. Interestingly. and thus offer substantial diversification potentials. a portfolio consisting of these assets has higher longterm volatility and should be avoided by risk-averse investors. we perform a formal LR test. since we fail to reject r ≤ 2 (r ≤ 3) at the 1% (5%) level.G. For tactical and strategic asset allocation. However.

The tactical and strategic value of hedge fund strategies 441 Table 7 Testing entering in and adjustment to the relevant cointegrating vector Relative value strategies βS&P 500 = 0 χ 2 (1) = 6. which again confirms the results from Table 3’s correlation analysis. except for short-sellers.1893 βglobal macro = 0 χ 2 (2) = 4.4908 αNASDAQ = 0 − βgrowth cap.4080b αvalue cap. = 0 χ 2 (1) = 6. = 0 χ 2 (1) = 4.1081b βlong/short equity = 0 χ 2 (2) = 6.7323 αbonds = 0 − βrisk arbitrage = 0 χ 2 (2) = 0.0371 αbonds = 0 − βbonvertible arbitrage = 0 χ 2 (1) = 6. Investors enhance diversification potential by taking high-tech and growth stocks into account in their tactical and strategic asset allocation.5170b βvalue cap. = 0 χ 2 (1) = 6.5930b αS&P 500 = 0 χ 2 (2) = 7.5490a αdistressed securities = 0 χ 2 (2) = 27.2629 αfixed-income arbitrage = 0 αequity market-neutral = 0 − βS&P 500 = 0 χ 2 (2) = 4. respectively In an opportunistic portfolio. .4413 αgrowth cap.2720b αconvertible arbitrage = 0 χ 2 (1) = 3.0101a βS&P 500 = 0 χ 2 (2) = 8. The emerging market hedge funds do not react to these common trends. and bonds share common trends with most of the strategies. conservative assets like the S&P 500. = 0 − χ 2 (1) = 2. 5%. it is obvious that nearly all hedge fund strategies share at least one common trend with certain traditional assets.9304b a . = 0 χ 2 (2) = 4.4098c αbonds = 0 χ 2 (2) = 7. = 0 χ 2 (2) = 11.7378 βgrowth cap. b . This implies that risk-averse investors can lower long-run volatility by investing according to the cointegrating vectors.1818 βvalue cap. and c indicate that the null hypothesis (no entering into and no adjustment to the cointegrating vec- tor(s)) can be rejected at the 1%.9844c αglobal macro = 0 χ 2 (2) = 8.3052 αrisk arbitrage = 0 − βdistressed securities = 0 χ 2 (2) = 12. = 0 χ 2 (1) = 3.5074b αS&P 500 = 0 βNASDAQ = 0 χ 2 (1) = 2. and 10% significance levels. Overall.4879c αvalue cap.9494b αNASDAQ = 0 − βgrowth cap.1724 αS&P 500 = 0 − βNASDAQ = 0 χ 2 (2) = 7.1382 χ 2 (1) = 5. = 0 χ 2 (2) = 4. value stocks.8501b αNASDAQ = 0 χ 2 (2) = 2. but long/short equity does exhibit highly significant adjustment. = 0 χ 2 (2) = 5.0557 Event-driven strategies Opportunistic strategies βvalue cap.2260b αemerging markets = 0 χ 2 (2) = 3.2960a βshort-sellers = 0 βemerging markets = 0 χ 2 (2) = 3.2109a αvalue cap.5550c βbonds = 0 χ 2 (2) = 0.0202 αshort-sellers = 0 − χ 2 (2) = 7. This information is useful for tactical and strategic asset allocation. while active managers can benefit from the knowledge of short-term movements in the asset prices.0034b αlong/short equity = 0 χ 2 (2) = 17.7589b βbonds = 0 χ 2 (2) = 6.9169b βNASDAQ = 0 χ 2 (2) = 1. and also for forecasting hedge fund strategy prices.8029c βfixed-income arbitrage = 0 βequity market-neutral = 0 χ 2 (1) = 8.7676b αgrowth cap. = 0 χ 2 (2) = 9.3018b χ 2 (1) = 0.6103a αgrowth cap. = 0 χ 2 (2) = 6. = 0 χ 2 (2) = 3.6031c βbonds = 0 χ 2 (1) = 0.

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