The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers

Hedge fund strategies typically generate option-like returns. Linear-factor models using benchmark asset indices have difficulty explaining them. Following the suggestions in Glosten and Jagannathan (1994), this article shows how to model hedge fund returns by focusing on the popular “trend-following” strategy. We use lookback straddles to model trend-following strategies, and show that they can explain trend-following funds’ returns better than standard asset indices. Though standard straddles lead to similar empirical results, lookback straddles are theoretically closer to the concept of trend following. Our model should be useful in the design of performance benchmarks for trend-following funds.