Alexei Orlov Discusses How Unconventional Monetary Policies Affect Hedge Funds’ Performance and Factor Exposures in Applied Economics Article

In a recent article published in Applied Economics, Brattle Senior Associate Dr. Alexei Orlov and his coauthor, Dr. Massimo Guidolin of Bocconi University, study how unconventional monetary policy (UMP) announcements by the Federal Reserve and the European Central Bank have affected the performance and factor exposures of the hedge fund (HF) industry and of ten common HF strategies.

Using modified event studies and tests for exogenously as well as endogenously determined structural breaks in the context of a multi-factor model, the authors find that UMPs affect HFs’ performance through significant changes in the betas of conventional HF risk factors for the aggregate HF index as well as for seven of the ten common strategies. The results for the aggregate and style indices are corroborated by an augmented Fama-French five-factor model, tests for breaks in US and Eurozone shadow rates, and analyses of more granular, individual HF data.

Dedicated Short Bias funds, for example, exhibit strongly negative market betas that become less negative or more variable after UMP announcements, consistent with UMP easing reducing downside opportunities and compressing volatility. Equity Market Neutral strategies, despite low unconditional market betas, display pronounced shifts in FX volatility betas around breaks, which reflects UMP’s effect on spreads and currency-linked arbitrage. In general, the direction and the magnitude of beta changes match each strategy’s dependence on risk factors affected by UMP.

The article extends the existing literature by identifying both direct and indirect effects, suggesting that HF factor loadings are part of the transmission channel for UMP. The paper, therefore, complements the macro-finance literature on how policy shocks propagate through capital markets. The authors discuss the implications of these findings for HF managers and investors. The findings also have relevance for litigation centered around measurement of performance and riskiness of HFs.

The full article, “Factor exposures of hedge fund strategies and unconventional monetary policy shocks,” can be found below.