Atl Econ J (2010) 38:377–378

DOI 10.1007/s11293-010-9230-6

Hedge Fund Returns, Kalman Filter,

and Errors-in-Variables

François-Éric Racicot & Raymond Théoret

Published online: 18 May 2010

# International Atlantic Economic Society 2010

Many studies on hedge fund returns are formulated in a static framework, resorting
to a multifactor model using mimicking portfolios or benchmarks accounting for the
style of different hedge fund strategies. While classical linear regressions represent a
parsimonious approach to the modeling of hedge fund strategies, time-invariant
factor loadings might be misleading (Berkelaar, Kobor, and Kouwenberg, The VaR
Modeling Handbook, 2009). Actually, hedge fund strategies are essentially dynamic
processes. Since conditional models appear promising to explain portfolio managers
dynamic strategies, we study in this paper how conditional alphas and betas react to
financial market variables such as market risk premium, interest rate, market
volatility, or macroeconomic variables related to the business cycle (Racicot and
Théoret, Journal of Wealth Management, 2007).
An interesting assumption tested in the literature (Swinkels and van der Sluis,
Working Paper, Tilburg University, 2001; Bollen and Whaley, Working Paper,
Vanderbilt University, 2006; Racicot and Théoret, Journal of Wealth Management,
2008) is the conjecture that the conditional alpha and beta follow a random walk.
Actually, those parameters might also react to conditioning financial market or
macroeconomic news. Using the Kalman filter setting, our study explores the
reaction of HFR indices conditional alpha and beta to financial market variables,
especially interest rates, market risk premia, and squared market risk premia, a proxy
for volatility. Our results show that the alphas of most of the indices computed over
strategies are not very sensitive to financial market variables. A pure recursive
process seems, therefore, more relevant for the alpha. The data generating process of
the alpha is thus more similar to a random walk process than to a conditional model,

F.-É. Racicot (*)

Department of Administrative Sciences, University of Quebec-Outaouais (UQO), Gatineau, QC,
Canada
e-mail: francoiseric.racicot@uqo.ca

R. Théoret
Department of Finance, University of Quebec-Montréal (UQAM), Montréal, QC, Canada
e-mail: raymond.theoret@uqam.ca
378 F. Racicot, R. Théoret

a result in line with the market efficiency hypothesis. The alpha does not appear
manageable. On the contrary, the conditional beta is much more sensitive to market
conditions, and seems therefore much more manageable than the alpha, in line with
the on-going theories on the endogeneity of risk. We find that the estimated beta
follows a cycle driven by financial market conditions. Finally, we also propose a
possible extension of our dynamic model to account for the presence of
measurement errors in the setting of the Kalman filter. Our work is based on our
previous contribution (Racicot and Théoret, Journal of Derivatives & Hedge Funds,
2008, Journal of Asset Management, 2009) on measurement errors theory, which
proposes a theoretically viable solution using the augmented Hausman artificial
regression with time-varying coefficients.
In a theoretical perspective, it is quite easy to account for errors in the explanatory
variables. It suffices to transform a standard regression model into an artificial
Hausman regression one. In our particular case, our basic model can be extended to
account for errors-in-variables. The following equation obtains:


rpt
rft ¼ at þ b1t rmt
rft þ b2 SMBt þ b3 HMLt þ f1 w b 1t þ f2 w
b 2t þ f3 w
b 3t þ et ;
where the time-varying parameters, relying on conditional information, are given by:
at ¼ at
1 þ 8 1 rt
1 þ 8 2 mktt
1 þ 8 3 mktt
1
2
þ "t ; and

b1t ¼ b1;t
1 þ 8 4 rt
1 þ 8 5 mktt
1 þ 8 6 mktt
1

2
þ vt
and where w b ¼ x
bx and bx ¼ Z ðZ 0 Z Þ
1 Z 0 x. Z is an instrumental variables matrix
which uses as instruments the cumulants or the higher moments of order two and
three of the explanatory variables. The variables w b it account for the potential
correlation between the explanatory variables and the error term et .
To implement the computation of this procedure, we use a computer code which
runs in EViews and developed by the authors which can be found in Racicot and
Théoret (Journal of Wealth Management, 2008). As argued previously, the time-
varying coefficients can also be explained by some factors. The coefficients model
could also be expanded by incorporating a Markov switching regime (Billio,
Getmansky and Pelizzon, The VaR Implementation Handbook, 2009) in a Kalman
filter framework accounting for measurement errors. We leave these and other
potential generalizations of that model for future work.

Acknowledgements We would like to thank Jose Mario Montero Lorenzo and the participants at the
68th conference of the International Atlantic Economic Society (IAES) held in Boston, Massachusetts,
USA on October 2009.