WORKING PAPER
William Fung
Principal, Paradigm, LDC
David A. Hsieh
Fuqua School of Business, Duke
University, Durham, NC 27708
Abstract
Sharpe (1992) proposed an asset class factor model for performance attribution and style analysis of mutual fund managers. The elegance of Sharpe's (1992) intuition was demonstrated empirically by showing that only a limited number of major asset classes was required to successfully replicate the performance of an extensive universe of U.S. mutual funds.
The success of this approach is due to the fact that most mutual fund managers have investment mandates similar to traditional asset managers with relative return targets. They are typically constrained to hold assets in a well defined number of asset classes and are frequently limited to little or no leverage. Therefore, they are likely to generate returns which tend to be highly correlated to the returns of standard asset classes. Consequently, stylistic differences between managers are primarily due to the assets in their portfolios, which are readily captured in Sharpe's (1992) "style regressions."
In this paper, we propose an extension to Sharpe's (1992) model for analyzing investment management styles. The objective is to have an integrated framework for analyzing traditional managers with relative return targets, as well as alternative managers with absolute return targets such as hedge fund managers and commodity trading advisors (CTAs). These alternative managers tend to generate returns which are not correlated to those of standard asset classes. Consequently, the original Sharpe (1992) model must be modified to capture stylistic differences between these alternative managers.
Our work is based on the intuition that manager's returns can be characterized more generally by three key determinants: the returns from assets int he manager's portfolios, their trading strategy, and their use of leverage. In Shapre's (1992) model, the focus was on the first key determinant, the "location" component of return, which tells us the asset categories the manager invests in. Our model extends Sharpe's approach by incorporating factors that reflect "how a manager trades" --- the strategy component of return, and the use of "leverage" --- the quantity component of return. Adding new factors to Sharpe's (1992) model allows us to accommodate managers that employ dynamic, leveraged trading strategies. It is these additional factors that provide insight on the strategic difference between "relative return" versus "absolute return" investment styles. Just as Sharpe's model provides insight to the asset mix decision when only relative return styles are considered, the extended model provides a framework for analyzing the asset mix decision with an absolute return target. In addition, we provide empirical evidence on whether an absolute return investment style adds value beyond the traditional relative return investment styles.
Our date consist of 3,327 U.S. mutual funds from Morningstar and 533 hedge funds/CTAs from a unique data base never analyzed heretofore. We find that the dominant mutual fund styles can be characterized as buy-and-hold mixes of asset classes. In contrast, hedge fund managers and CTA's have five dominant investment styles. Two of them can be characterized as buy-and-hold strategies, while the remaining three can be characterized as dynamic trading strategies, due to hedge fund managers' dynamic use of leverage as well as the time varying nature of their "investment location." By adding these three style factors to Sharpe's (1992) model, we can improve the model's performance significantly.
In a sense, the results confirm the intuition behind classifying hedge fund managers and CTA's as alternative managers. An important implication is that diversification can be achieved by blending the traditional "relative return" investment approach to "absolute return" investment styles. Our extended style analysis model provides a framework for analyzing this choice.