“Hedge Fund R2 What’s under the Hood?” by Nicolas P.B. Bollen
Nicolas P.B. Bollen
Returns of individual hedge funds generally feature low correlation with both risk factors and style factors, consistent with the goal of offering an alternative investment. We identify "low R2" hedge funds for which the optimal factor model R2 is insignificantly different from zero. Low R2 funds feature lower volatility, higher Sharpe ratios, and higher alphas than other funds. However, a proportional hazard rate model indicates that low R2 funds feature an increased probability of subsequent fund failure. These results indicate that low R2 funds may pose an important risk to investors who select funds based on prior performance.