Fin Mkts Portfolio Mgmt (2007) 21: 425444

DOI 10.1007/s11408-007-0060-8

The tactical and strategic value of hedge fund

strategies: a cointegration approach
Roland Fss Dieter G. Kaiser

Published online: 24 August 2007

Swiss Society for Financial Market Research 2007

Abstract This paper analyzes long-term comovements between hedge fund strategies and traditional asset classes using multivariate cointegration methodology. Since
cointegrated assets are tied together over the long run, a portfolio consisting of these
assets will have lower long-term volatility. Thus, if the presence of cointegration
lowers uncertainty, risk-averse investors should prefer assets that are cointegrated.
Long-term (passive) investors can benefit from the knowledge of cointegrating relationships, while the built-in error correction mechanism allows active asset managers to anticipate short-run price movements. The empirical results indicate there is
a long-run relationship between specific hedge fund strategies and traditional financial assets. Thus, the benefits of different hedge fund strategies are much less than
suggested by correlation analysis and portfolio optimization. However, certain strategies combined with specific stock market segments offer portfolio managers adequate
diversification potential, especially in the framework of tactical asset allocation.
Keywords Hedge fund strategies Stock markets Tactical and strategic asset
allocation Portfolio optimization Multivariate cointegration analysis
Johansen test
JEL Classification C32 G11 G15

R. Fss ()
Department of Empirical Research and Econometrics, University of Freiburg,
Platz der Alten Synagoge, 79085 Freiburg im Breisgau, Germany
e-mail: roland.fuess@vwl.uni-freiburg.de
D.G. Kaiser
Feri Institutional Advisors GmbH, Haus am Park, Rathausplatz 8-10, 61348 Bad Homburg, Germany
e-mail: dieter.kaiser@feri.de

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R. Fss, D.G. Kaiser

1 Introduction
Over the past decade, the hedge fund universe has grown from a handful of firms
managing a few hundred million dollars to more than 8,000 hedge funds worldwide
managing more than $1 trillion (HFR 2006). As a result, however, hedge funds face
constant scrutiny from investors and researchers.
Behind the torrid growth of the hedge fund universe has been the perceived
diversification benefit hedge funds can provide traditional portfolios because of
their low correlation structure (Brooks and Kat 2002; Morley 2001; Zask 2000;
Planta and Banz 2002; Eling 2006). This article, however, posits that the assumption of correlation analysis as it applies to hedge funds deserves to be reexamined
and reinterpreted. Kat (2003) has argued that correlation coefficients are only reliable
under a normal distribution of variables. Hedge funds tend to exhibit nonzero skewness and/or excess kurtosis (see Kat and Lu 2002; Fss and Kaiser 2007; Galeano and
Favre 2001). Therefore, the lower and upper bounds of a correlation coefficient might
be narrower than 1 (Kat 2003). We contend it is unreliable to claim that hedge funds
have low correlations with stock market indices.
Meanvariance methods are also used to analyze return series (Markowitz 1952).
However, with these types of methods: (1) stationarity is assumed, (2) returns must be
normally distributed, and (3) return correlations between assets must be stable. Since
financial log asset prices are mostly nonstationary (see Nelson and Plosser 1982),
they must be transformed into stationary variables before correlation analysis can be
applied. And, this procedure can result in information loss on long-run components
because it removes the possibility of finding common price trends.
Cointegration methods, on the other hand, work directly on portfolio values and
make no assumption about stationarity of the asset values (Alexander 2001). Therefore, this article draws on the theory of cointegration processes to discern whether
hedge fund strategies exhibit a long-run equilibrium relationship with the time series
of conventional financial asset classes.
Cointegration refers to the fact that financial assets share common stochastic
trends that cause time series to move toward long-term equilibrium after every terminal shock. The built-in error correction mechanism determines how long it will
take to reach equilibrium. The presence of cointegration does not make prices fully
predictable, but it does make it possible for investors to better time their portfolio
holdings (Gregoriou and Rouah 2001).
Cointegration affects both tactical and strategic financial decision making (Lucas
1997). Because of the long-term relationship between cointegrated assets, a portfolio of these assets with weights taken from cointegrating vectors will have lower
long-term volatility. In addition, the error correction mechanism allows active asset
managers to anticipate price movements over the short term. The speed of adjustment
estimated by the error correction model shows the economic relevance of long-term
comovements.
When it takes decades for the asset returns to move toward the common stochastic
trend, the existence of such a trend is of little relevance for an investor with finite
horizon (Kasa 1992). Without cointegration, there is no mean reversion in the price
spread, and uncertainty for active and passive asset managers will be higher. Thus,
risk-averse investors will still prefer cointegrated assets.

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Most studies on cointegrated assets have applied the approach to traditional stock
market portfolios and indices. For example, Bossaerts (1988) developed a test of
cointegration and applied it to five size-based and five industry-based stock portfolios.
His results rejected the null hypothesis of no cointegration at a very high significance
level, thereby providing substantial evidence of cointegration.
Kasa (1992) studied the drivers of equity markets in the US, Japan, England, Germany, and Canada, and found evidence of a single stochastic trend. He used the Johansen test for common trends on monthly and quarterly data from the Morgan Stanley Capital International (MSCI) equity indices from January 1974 through August
1990.
Other studies have examined the interrelationships among regional stock markets to find potential gains from international diversification. For example, Corhay
et al. (1993) found cointegration among stock prices in several European countries
(except Italy, which did not influence the long-term relationship). Arshanapalli and
Doukas (1993) found links between US and European markets (the UK, Germany,
and France) using the bivariate Engle and Granger (1987) approach.
On the other hand, Taylor and Tonks (1989) found no pairwise cointegration between US and UK equity markets, a result reinforced by Kanas (1998) using the multivariate trace statistic, the Johansen approach, and Bierens test. This suggests there
is no cointegration between the US market and any major European equity market.
Another strand of studies has focused on stock market links between emerging
markets and their regional areas. Pan et al. (1999) used the multivariate cointegration
approach and found no evidence of common stochastic trends in the equity markets
of Australia, Hong Kong, Japan, Malaysia, or Singapore. Garret and Spyrou (1999)
investigated the existence of common trends in Latin America and Asia-Pacific equity
markets. They noted some common trends,1 but they did not rule out the possibility
of long-term diversification benefits, because some of the countries do not enter the
regions common trend.
Gregoriou and Rouah (2001) focused on hedge fund investments, examining common stochastic trends between the ten largest hedge funds of different styles and the
equity market indices of the S&P 500, the MSCI World, the Russell 2000, and the
NASDAQ index from January 1991 through December 2000. The authors found evidence of cointegration with the stock market indices for just two of the hedge funds.
They argue that large hedge funds tend to allocate assets over a wide range of investment instruments, such as futures, options, currencies, swaps, and other derivatives.
Therefore, the performance of these hedge funds will not be strongly correlated to
standard benchmarks.
Fss and Herrmann (2005) studied long-term interdependence between hedge
fund strategies and the stock market indices of France, Germany, Japan, North America, and the UK from January 1994 to December 2003. They found no evidence of
common stochastic trends, except for a weak long-term interrelation between hedge
fund strategies and the US stock market.
1 For further studies on the interdependence of emerging markets, especially in Asia and Latin America,

see Hung and Cheung (1995), Chaudhuri (1997), and Chen et al. (2002).

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Both Gregoriou and Rouah (2001) and Fss and Herrmann (2005) use the Engle
and Granger (1987) two-step cointegration approach, which is considered weaker
than the Johansen method. The results of the Johansen test do not depend on the
normalization selected (Hamilton 1994), while, in comparison, the DickeyFuller
(DF) test is numerically dependent upon the precise formulation of the cointegrating
regression.2
Fss et al. (2006) test for the presence of cointegration between hedge funds and
traditional and alternative financial assets. Their empirical results suggest that, for a
traditional portfolio, the hedge fund composite index not only enters the cointegrating
vector, but the returns also react to the common trend. Thus, risk-averse investors with
long-term investment horizons do not increase risk by including hedge funds.
On the other hand, for a portfolio consisting only of alternative assets, hedge funds
share a common trend with NASDAQ-listed companies, small-cap stocks, and real
estate equities. However, only hedge fund and emerging equity returns react significantly to the common trend. The authors conclude that investors with both traditional
and alternative portfolios can benefit from risk diversification.
We interpret the overall absence (existence) of a common stochastic trend in most
of the studies as the existence (failure) of long-run gains from diversification. But to
expand this narrow perspective, we differentiate between tactical and strategic asset
allocation, as per Lucas (1997). Thus, the relevance and the implications of cointegration between asset prices and hedge fund strategies for asset allocation decisions
will depend on the holding period of the investment, the rebalancing frequency of the
portfolio, and investor risk attitude. In contrast to Fss et al. (2006), who represent
the hedge fund universe by an aggregate composite index, we analyze the dynamic
linkages between various hedge fund strategies and traditional asset markets.
The remainder of this article is organized as follows. Section 2 reviews the different asset allocation levels in the context of investment decisions. In Sect. 3, we
discuss stationarity and cointegration more fully, as well as the augmented Dickey
Fuller and Johansen tests and how they affect asset allocation. Section 4 presents our
empirical findings of cointegration relationships between the hedge fund styles and
conventional financial assets. Section 5 concludes.

2 Asset allocation methods

Most finance literature defines three levels of asset allocation: benchmark, strategic,
and tactical. The aim of asset allocation in all cases is to obtain the best possible
risk/return profile for a portfolio. But the three methods use dramatically different
ways to achieve their objectives, which we will examine further in this section.
In benchmark asset allocation (or what is referred to as indexing), the portfolio
manager makes investment decisions according to the asset weights of the benchmark index. Strategic asset allocation, in contrast, is based on a long-term view of
2 Dickey et al. (1991) argue that the results of the EngleGranger cointegration approach may not be

consistent because it is sensitive to the choice of dependent variables. Johansens multivariate cointegration
test is more robust.

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429

Table 1 Asset allocation methods

Source: Dahlquist and Harvey (2001)

performance and usually has a 5 year time horizon. The weights are determined by
long-term forecasts, so there is no need to rebalance the portfolio (see Table 1).
Tactical asset allocation is the process of short-term deviations from the strategic
weights, usually in one month to one quarter increments. Because indexing results
in only slight alterations in portfolio weights, variation in investment weights will
increase with the strategic program. Strategic asset allocation weight changes are
slow and evolving so as to maintain the objective of rebalancing the portfolio within
a year; tactical asset allocation weight changes, in contrast, are highly dynamic.
The use of conditioning information to determine the weights also naturally varies
according to the allocation method. Benchmark allocation requires no conditioning
information at all; in strategic and tactical asset allocation, conditioning information
is generally used. In addition, strategic allocation decisions are sometimes based on
unconditional information by assuming that historical returns are representative of
future returns. In the context of portfolio optimization, using ex post data can lead to
a fixed weight portfolio. On the other hand, Dahlquist and Harvey (2001) note that,
for both tactical and strategic asset allocation, short- and long-term expected returns
induce weight changes unless the conditioning information has no predictive ability.
To establish a consistent and effective investment policy, investors must gauge
the level of future uncertainty by using quantitative models. Time series models are
attractive for this purpose because the future behavior of a times series is explained
by its own past and by the past of related time series. Thus, investors need no (or only
some) prior knowledge about related (exogenous) economic variables.
To be more precise, we focus here on long-term comovements between hedge
funds and financial asset markets, and the effects of short- and long-term planning
horizons. Cointegration will reveal the existence of any long-run equilibrium relationships between hedge funds and other financial series.
The built-in error correction mechanism illustrates how series react to temporary
deviations from long-term equilibrium. Assuming investors are risk-averse, under
strategic asset allocation, they will benefit from being aware of and understanding
cointegrating relationships (e.g., that asset prices will stay together over the long

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term). As Lucas (1997) has noted, cointegrating relationships of financial time series
show less long-term variability, and thus, less long-term risk.
For tactical asset allocation, we can incorporate the reaction to temporary states
of disequilibrium into the calculus. If time series are cointegrated, the error correction mechanism allows the portfolio manager to anticipate some of the near-term
developments. This means that the conditioning information is provided by the adjustment coefficient of the temporary deviations. However, if this process unfolds
over decades, passive long-term investors would be better served by focusing on error correction instead of cointegrating vectors, and active investors could probably
ignore the presence of cointegration.

3 Stationarity and cointegration in a system with hedge funds

In the context of long-run properties of financial time series, researchers have tended
to focus on asset price characteristics, i.e., random walk (unit root) or mean reversion
(trend stationary) processes. For example, if asset prices are mean-reverting, over
time the price level will revert to its trend path (or mean return). This suggests future
returns are predictable from information on past returns.3
In contrast, a random walk supposes any shock to an asset price is permanent, and
there is no tendency for it to revert back. Thus, in a random walk framework, future
returns are unpredictable based on historical observations, and the most recent return
would be the best predictor of future returns.4
Another trait of random walks is that the longer the time horizon, the more likely
it is that prices will wander far from their trend path. In the long run, this boundless
growth in volatility of asset prices characterizes the nonstationarity of random walks,
which in turn has important implications for asset pricing and portfolio allocation
decisions. Of course, for financial decisions on optimal asset allocation, the above
results imply that the correct choice concerning the (non)stationarity property of a
time series is of major relevance.
To evaluate whether hedge fund strategies provide long-term diversification benefits for traditional portfolios, we need to test for the presence of common stochastic
trends. Hence, we need to use cointegration, as defined and developed by Granger
(1981) and Engle and Granger (1987). Cointegration is a property of some nonstationary time series. If two nonstationary time series are cointegrated, a linear combination relationship that is also stationary is said to exist. In the context of portfolio
theory, if the value series of a fixed weight portfolio of assets with nonstationary
prices is stationary, the assets will form a cointegrated set. The set of asset weights
within such a portfolio is called the cointegrating vector.
Cointegration means there is some long-term equilibrium relationship tying the
times series together, despite the fact that short-term departures from equilibrium
3 Consequently, stationarity is based on the assumption that the effect of present shocks in the time series

diminishes or disappears in the distant future. Technically speaking, stationarity means that the time series
exhibits a constant mean, standard deviation, and autocovariance that depend only on the time lag.
4 Hence, in financial literature, the property of nonstationarity often emerges quite naturally as a result of

the assumption of efficient markets and the absence of arbitrage (Lucas 1997).

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431

may also be present. Johansen (1988, 1991), Johansen and Juselius (1990, 1991)
developed the multivariate test for cointegration and the error correction model. The
Johansen procedure is a maximum likelihood estimation of a fully specified error
correction model in transitory form:
Xt = + 1 Xt1 + + k1 Xtk+1 + Xt1 + t

(1)

where Xt exhibits the vector of price changes in period t, is a constant vector,
represents the short-run dynamics, and is the long-run impact matrix, which
will have reduced rank under cointegration.
The number of stationary linear combinations of Xt , the cointegrating vectors is
determined by the rank of this matrix. If is of intermediate rank, 0 < r() =
r < n, so that r linear combinations of nonstationary variables are stationary, and r
cointegrating vectors, or n r stochastic trends, exist. Because the matrix does not
have full rank, two n r matrices and can be factored so that =  , where 
denotes transposition.
Consequently, we rewrite (1) as
Xt = +

k1


i Xti +  Xt1 + t .

(2)

i=1

In this factorization, the r columns of can be defined as cointegrating vectors,

i.e., the linearly independent combinations of Xt that are stationary. is the matrix
of the error correction terms that shows the impact of r cointegrated vectors on Xt .
The ith row of represents the direction and strength of the adjustment process.
Note that the evidence of the error correction mechanism for tactical asset allocation decisions is quite obvious. If Xt is in a transitory state of disequilibrium, e.g.,
 Xt = 0, we can predict some of the future developments of Xt due to the function
of the error correction mechanism (Lucas 1997).
To determine the rank r of estimated matrix , we first calculate the eigenvalues i . The number of significantly nonzero eigenvalues shows the rank of the matrix , and can be evaluated by the trace test and the maximal eigenvalue test. As
Kasa (1992) points out, the two tests differ in their assumptions about the alternative
hypothesis. The trace statistic is the result of testing the restriction r q (q < n)
against the completely unrestricted model r n:
trace = T

n


ln(1 i )

(3)

i=q+1

where T is the sample size and r+1 , . . . , n are the n r smallest squared canonical
correlations.
We refer to the second restricted maximum likelihood ratio test as the maximal
eigenvalue test statistic. The max is found by again testing the null hypothesis of at
most q cointegrating vectors against the alternative of one additional cointegrating
vector (i.e., r q + 1):
max = T ln(1 q+1 )

(4)

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R. Fss, D.G. Kaiser

where 1 , . . . , q are the largest squared correlations. The maximal eigenvalue test
clearly produces more straightforward results.5
These technical explanations allow us to establish a connection to the optimal asset
allocation framework. To illustrate, consider an investor with a quadratic risk aversion
utility function, where the conditional mean and variance of portfolio returns over
the investment horizon matters. Further assume that the vector of log asset prices Xt
follows a VAR process of order one:
Xt = + Xt1 + t ,

with t iid(0, ).

(5)

For = 0, we obtain the standard model with iid returns, while =  in (5)
represents a cointegrated system of asset prices.6 Given a constant holding vector x in
the assets over investment horizon H , the conditional mean and conditional variance
are given, respectively, in (6) and (7):
x  E0 (XH X0 ) =

H
1




x  (I + )s + x  (I + )H I X0 ,

(6)

s=0

x  V0 (XH X0 )x =

H
1


x  (I + )s (I +  )s x.

(7)

s=0

When there is no cointegration ( = 0), we obtain the standard formulations H x 

and H x  x for the mean and variance, respectively, from which the usual Markowitz
(1952) meanvariance analysis follows. When the asset prices are cointegrated ( =
 ), meanvariance analysis still applies, but with different formulas and different
values for conditional moments, which generate a shift in the meanvariance frontier.
Thus, for asset allocation, the relevance of cointegration depends on the holding period of the investment, the portfolios rebalancing frequency, and the investors risk
appetite.
For strategic asset allocation with a static (no-rebalancing) long-term investment
style, as shown above, we construct a portfolio with weights corresponding to cointegrating vectors in  Xt1 . The lower long-term volatility of such portfolios makes
them particularly attractive for highly risk-averse long-term investors. On the other
hand, portfolio managers using tactical asset allocation can anticipate the temporary
deviations of asset prices from long-run equilibrium, and can effectively rebalance
the portfolio using the matrix .

5 To be more precise, if are evenly distributed, the trace statistic tends to have greater power than
max
i
because it considers the range of all n q of the smallest eigenvalues. Comparatively, max tends to
produce better results when i are either large or small (Kasa 1992).
6 For = 0, the eigenvalues of (I + ) lie on the unit circle, and the model in (9) reduces to a pure random

walk with drift.

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433

4 Data and empirical results

Our data include monthly total return indexes in US dollars from December 1993
to December 2005 (there are 145 end-of-month observations in each series).7 Our
hedge fund strategy indices come from Credit Suisse/Tremont. The other financial
asset class indices are represented by the S&P 500 Composite Index, the NASDAQ
Composite (DS calculated), the Wilshire All Growth, the Wilshire All Value, and the
J.P. Morgan Government Bond Index.8
Using hedge fund indices to proxy for hedge fund strategy performance can cause
various biases in the time series. These biases arise from the lack of regulation and
difficulty in estimating prices inherent in the hedge fund structure. Because hedge
funds are not legally required to report return information publicly, managers decide
how and when to present performance information. This can mean that reported values do not reflect actual performance, however. And price estimation can be difficult
because hedge funds invest in instruments that are often not stock exchange oriented.
The most common biases in the literature are survivorship bias, backfilling bias,
selection bias, autocorrelation bias, and the multiperiod bias (Fung and Hsieh 2000).
These biases generally result in overestimating expected returns and underestimating
expected variance, which affects the values of the cointegrating vectors and the error
correction model coefficients. The overall finding of cointegration or no cointegration, however, will still hold. Note that the Credit Suisse/Tremont indices, which are
noninvestable, are affected particularly by the survivorship and instant history biases
(see Lhabitant 2004). Note also that broad-based hedge fund style indexes generally
understate trading style diversity and overstate any risk of style convergence.
4.1 Descriptive statistics
Over our sample period, most of the indices increase continuously, implying a high
rate of return. Table 2 gives the summary statistics for the hedge fund strategies, as
well as for the stock, bond, and index returns.
Note first that the annualized average of continuously compounded returns is the
highest for the global macro and distressed securities strategies (12.70% and 12.61%,
respectively). For the risk-adjusted return (e.g., the simple Sharpe ratio defined as
the coefficient of mean and the standard deviation), the J.P. Morgan bond index and
equity market neutral strategy significantly outperform the others. Comparatively,
only the short-seller strategy has a negative annualized mean return (2.05%), and
high volatility (17.06%).
The S&P 500, NASDAQ, and value stocks outperform most of the hedge fund
strategies for both absolute and risk-adjusted returns. The NASDAQ composite is the
most volatile asset, with an annualized standard deviation of 26.87%.
7 Hakkio and Rush (1991) argue that the length of the time series is more important than the frequency of

the information for discerning the presence of cointegration. Shiller and Perron (1985) and Perron (1989)
support this observation. They find no empirical evidence that changing the frequency of observations
while keeping the sample length fixed influences the results of cointegration testing, as it is mainly a
long-term property.
8 We use the S&P 500 as a proxy for the overall market, especially for the large-cap sector (correlation

of 0.9953). The NASDAQ proxies for new economy firms.

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R. Fss, D.G. Kaiser

Table 2 Times series statistical properties, January 1994December 2005

Indices

Mean

Std. dev.

Skew-

Excess

Sharpe

J.B.

(in % p.a.)

(in % p.a.)

ness

kurtosis

ratio

test

Relative value strategies

102.44a

 ln (convertible arbitrage)

8.259

4.771

1.372

3.090

0.500

 ln (fixed-income arbitrage)

6.089

3.802

3.207

17.122

0.462

 ln (equity market neutral)

9.458

2.919

0.309

0.300

0.935

2.828

7.436

4.220

1.369

6.904

0.509

330.96a

12.609

6.579

3.213

21.357

0.553

 ln (long/short equity)

11.244

2.940

0.027

3.865

0.319

89.64a

 ln (short-sellers)

2.049

17.058

0.610

1.136

0.035

16.67a

8.033

16.687

1.125

6.288

0.139

267.61a

12.695

11.033

0.197

2.882

0.332

50.78a

 ln (S&P 500 composite)

10.007

14.853

0.730

0.919

0.674

17.85a

 ln (NASDAQ composite)

11.412

26.868

0.628

1.181

0.425

17.83a

7.800

18.218

0.885

1.470

0.428

31.78a

10.826

14.582

0.892

2.423

0.742

54.31a

6.018

4.755

0.588

1.081

1.266

15.32a

2,005.8a

Event-driven strategies
 ln (risk arbitrage)
 ln (distressed securities)

2,984.6a

Opportunistic strategies

 ln (emerging markets)
 ln (global macro)
Stock and bond market

 ln (Wilshire growth)
 ln (Wilshire value)
 ln (J.P. Morgan bond)

Based on monthly continuously compounded total returns for 145 observations. a denotes significance at
the 1% level (rejection of the normal distribution). The Sharpe ratio is defined as the coefficient of mean
and standard deviation without adjustment for the risk-free rate

Note that the emerging market strategy has extremely high volatility compared to
its mean return. However, almost all asset classes exhibit asymmetric return patterns
with negative skewness and positive excess kurtosis, except for equity market neutral.
The JarqueBera test shows to what degree returns deviate from a normal distribution. A high value suggests returns do not follow a normal distribution at the 1%
significance level. The results again show substantial variation between the different
asset classes, so using standard deviation as a single measure of risk may alter the
actual performance. Moreover, in a portfolio optimization context, standard deviation is an incomplete measure of risk and it may lead to suboptimal asset allocation
decisions.
Finding the optimal portfolio weights in a meanvariance analysis also requires
that return correlations between assets be stable.9 However, correlation analysis is
only valid for stationary variables. We can make most of the financial data stationary
by taking first differences of the prices or by de-trending the variables. Thus, asset
prices are integrated of order one, but with the disadvantage that valuable information
9 For instance, Lhabitant (2002) found that correlation between most hedge fund indices and between US

and European equity markets is much higher in down markets than in up markets.

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435

Table 3 Contemporaneous correlations between monthly returns January 1994December 2005

Indices

 ln (convertible

 ln (S&P

 ln (NASDAQ

 ln (Wilshire

 ln (Wilshire

 ln (J.P. Mor-

500 comp.)

comp.)

growth)

value)

gan bond)

0.141

0.140

0.112

0.185

0.035

0.037

0.037

0.035

0.051

0.079

0.371

0.275

0.312

0.362

0.106

arbitrage)
 ln (fixed-income
arbitrage)
 ln (equity market
neutral)
 ln (risk arbitrage)

0.460

0.383

0.394

0.547

0.108

 ln (distressed

0.558

0.487

0.492

0.592

0.067

0.600

0.729

0.684

0.515

0.029

0.757

0.814

0.806

0.684

0.127

0.488

0.496

0.479

0.478

0.110

0.230

0.160

0.194

0.228

0.217

securities)
 ln (long/short
equity)
 ln (short-sellers)
 ln (emerging
markets)
 ln (global macro)

can be lost because de-trending eliminates any possibility of detecting common price
trends.
Due to their trading strategies,10 hedge funds are typically nonlinear functions of
traditional markets, so using linear correlation coefficients as a measure of dependence is not reliable (Lhabitant 2004). Using the correlation coefficient as an indicator for dependence among random variables is also problematic, however, because
(1) only linear dependence is measured, and (2) the results are only meaningful if the
multivariate distribution is elliptic (Embrechts et al. 1999, 2002; Kat 2003).
As Table 2 shows, most hedge fund strategies and financial assets have a negative
skewness and/or an excess kurtosis, so the joint distribution is far from being elliptic.
Also, if the distribution is not elliptic, the correlation coefficient does not exhaust
the full interval [1, +1], so it can be much smaller for certain distributions. This
can lead to incorrect findings of very low dependence, even though the variables are
perfectly correlated.11
The cointegration approach is again more suitable because it works directly on
asset prices rather than returns and does not require the assumption of stationarity of
the asset value series.
10 These trading strategies lead to complex hedge fund portfolios including nonlinear assets such as op-

tions, interest rate derivatives, and so on. Such portfolios exhibit both nonnormality fluctuations of the
underlying assets and nonlinear functions in traditional assets.
11 Besides the limitation to two variables, other problems may arise when using the correlation coefficients,

such as spurious correlations and nonresistance against outliers. See Lhabitant (2004) for more about these
problems.

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R. Fss, D.G. Kaiser

Table 3 shows the correlation matrix between the hedge fund strategies and the
various US stock and bond segments. Note that only the monthly returns for the
short-sellers strategy are negatively correlated with the US stock market. Furthermore, the bond index is negatively correlated with risk arbitrage, distressed securities, and emerging markets. We expected that emerging markets would be more
highly correlated, particularly with the stock market indices. The long/short equity
and distressed securities indices are highly positively correlated with the NASDAQ
index.
Despite its problems, correlation and cointegration are related but distinct concepts. High correlation does not imply high cointegration, and higher correlation is
neither necessary nor sufficient for higher cointegration between assets. In fact, cointegrated series can actually have low correlations (Fss and Herrmann 2005).
4.2 Testing for unit roots
Before applying the Johansen cointegration methodology, we test whether the time
series is integrated to the same order, or whether each series requires the same degree
of differencing to achieve stationarity. As Engle and Granger (1987) discuss, a series
is said to be integrated of order d, I (d), if the d times differenced series has a stationary invertible ARMA representation. Tests of stationarity are often characterized
as unit roots. If the hedge fund strategy and the financial market indices data exhibit
a unit root, they are considered integrated, I (1). If asset returns exhibit a random
walk, temporary shocks in the returns persist over time and do not disappear by reverting to the mean. However, such behavior inevitably affects the timing of portfolio
rebalancing (Gregoriou et al. 2001).12
The results of the augmented DickeyFuller (ADF) tests (Dickey and Fuller 1981,
1979; Said and Dickey 1984) reported in Table 4, provide strong evidence that all
series in the levels are nonstationary as suggested by the small values of the ADF
statistics.
However, when we use first differences, the null hypothesis is rejected at the 1%
level for all asset classes except for equity market neutral. Accordingly, the cointegration results for this strategy should be interpreted with caution, because cointegration
analysis requires that the variables be stationary, of the same order, and significant at
the 1% level.
A constant term or drift parameter is present in the return series of hedge funds, as
well as in the S&P 500, except for emerging markets and short-sellers. The constant
term for these series reflects fluctuations around a mean, which may be the result
of overestimating hedge fund returns. Thus, we conclude that all financial series are
nonstationary in levels and stationary in returns. This means that all indices are integrated of order one, I (1), which is a necessary condition in testing for cointegration.
Even though the hedge fund strategies and financial asset prices follow a random
walk, we next investigate how independent the random walk components are. In other
words, cointegration exists when there is a mean reversion in the price spread between
the strategy indices and the traditional asset categories.
12 Gregoriou et al. (2001) note a finding of nonstationarity by the ADF test does not necessarily imply

random walk behavior, since random walks are only one example of nonstationarity.

The tactical and strategic value of hedge fund strategies

437

Table 4 Unit root tests of prices and returns

Indices

Unit root test in level Xt

Unit root test in first difference Xt

ADF

ADF

ADFc

ADFct

ADFc

ADFct

Relative value strategies

Convertible arbitrage

5.416a (2)

2.856 (3)

Equity market neutral

7.843a (0)

2.068 (1)

Fixed-income arbitrage
2.078 (8)

3.445b (7)

1.753 (5)

4.048a (5)

Event-driven strategies
Risk arbitrage

8.939a (0)

2.201 (1)

Distressed securities
Opportunistic strategies
Long/short equity

4.756a (5)

1.270 (6)

Short-sellers

3.45b (1)

Emerging markets

2.403 (7)

Global macro

2.410 (8)

10.70a (0)
3.874a (6)
3.546a (7)

Stock and bond market

S&P 500 comp.

1.915 (0)

NASDAQ comp.

2.11 (10)

Wilshire growth

2.30 (10)

Wilshire value

1.469 (0)

J.P. Morgan bond

12.03a (0)
3.710a (5)
11.29a (0)
10.90a (0)
2.554 (3)

9.399a (1)

All test statistics are augmented DickeyFuller t -tests, where ADFct denotes the ADF statistic with trend
and constant term, ADFc is the ADF statistic with constant term and no trend, and ADF is the ADF statistic
without constant term or trend. For each time series, the appropriate model is chosen by minimizing the
Akaike information criterion (AIC) or the Schwartz criterion (SIC) values. a and b indicate significance
at the 1% and 5% levels (unit root is the null hypothesis) on the basis of the critical values given by
MacKinnon (1996). Lag length is the order of the augmentation needed to eliminate any autocorrelation
in the residuals of the ADF regression. The lag orders in the ADF equations for each time series are
determined by the significance of the coefficient for the lagged terms and are in parentheses

4.3 Testing for cointegration

Because we are interested in the diversification effects of hedge fund strategies, we
incorporate the corresponding indices of the three hedge fund styles into a traditional
stock and bond portfolio. We can thus make inferences about tactical and strategic
asset allocation decisions for a mixed-asset portfolio, and determine whether hedge
funds become substitutes for equity or bond allocation.
We test for cointegration between the financial series and the three style categories
by using the Johansen maximum likelihood (ML) procedure (Johansen 1988, 1991;
Johansen and Juselius 1990). As we noted earlier, standard tests for cointegration
such as the trace and maximal eigenvalue tests are biased toward nonrejection of
the no-cointegration hypothesis when the data are subjected to structural breaks.13
13 According to the CUSUM test, no structural breaks are found for any of the series, but the Chow break-

point test indicates significant structural breaks for the S&P 500, NASDAQ, and growth stocks from No-

438

R. Fss, D.G. Kaiser

Table 5 VAR lag order selection

Lag

Relative value strategies

FPE

5.12E20

5.34E30

4.09E30a

5.52E30

6.25E30

AIC

21.71

44.70

44.98a

44.70

44.62

8.27E17

1.29E25a

1.32E25

1.70E25

2.12E25

17.02

36.26a

35.19

33.90

32.67

Event-driven strategies
FPE
AIC

Opportunistic strategies
FPE

4.33E16

9.19E26a

1.37E25

1.57E25

2.06E25

AIC

9.84

32.11a

31.73

31.63

31.42

Lag
Relative value strategies
FPE

9.28E30

1.12E29

1.55E29

1.88E29

AIC

44.30

44.23

44.07

44.10

FPE

2.77E25

2.67E25

2.94E25

3.77E25

AIC

31.40

30.46

29.41

28.24

FPE

2.87E25

3.81E25

4.31E25

4.38E25

AIC

31.21

31.12

31.27

31.65

Event-driven strategies

Opportunistic strategies

a Indicates lag order selected by the Akaike information criterion (AIC) and the final prediction error (FPE)

However, we decided not to split the time series into subsamples, as the length of the
data series is important for discerning cointegration.
We use the Akaike information and final prediction error criteria to specify the
order of the unrestricted VAR model (see Ltkepohl 1991).
Table 5 shows that both information criteria refer to a VAR model of order k = 2
for a portfolio including relative value strategies (where the lag order is 1 for the
event-driven and opportunistic strategies). Hence, the vector error correction model
(VECM) involves terms in differences k 1 = 1 and k 1 = 0, respectively.
According to the ADF test, the distribution of test statistics from the trace and
maximal eigenvalue tests depends on the deterministic components drift and trend in
the system. Due to the time series used, and in accordance with the results of the unit
root tests, we can ignore linear and quadratic data trends. But we do need to decide
whether to include a constant in the cointegration equation. A constant implies that
the mean of the cointegration relationships between the time series differs from zero.
However, we assume that the log prices of the different asset classes are driven by the
vember 1998 to February 2001, and for emerging markets hedge fund strategies from July 1998 to April
2001. For this time series, the cointegration tests results may not be reliable because parameter stability
becomes questionable over the whole sample period.

The tactical and strategic value of hedge fund strategies

439

Table 6 Johansens maximum likelihood test

H0

Eigenvalues

Trace test trace

Maximal eigenvalue test max

Estimated

5% critical

1% critical

Estimated

5% critical

1% critical

statistics

value

value

statistics

value

value

Relative value strategies (variables: S&P 500, NASDAQ, growth, value, bonds, convertible arbitrage,
fixed-income arbitrage, and equity market neutral)
r =0

0.3223

162.35a

141.20

152.32

55.63a

47.99

53.90

r 1

0.2008

106.72

109.99

119.80

32.05

41.51

47.15

r 2

0.1693

74.68

82.49

90.45

26.52

36.36

41.00

r 3

0.1187

48.15

59.46

66.52

18.06

30.04

35.17

r 4

0.0795

30.09

39.89

45.58

11.84

23.80

28.82

r 5

0.0696

18.25

24.31

29.75

10.32

17.89

22.99

r 6

0.0453

7.93

12.53

16.31

6.63

11.44

15.69

r 7

0.0090

1.30

3.84

6.51

1.30

3.84

6.51

Event-driven strategies (variables: S&P 500, NASDAQ, growth, value, bonds, risk arbitrage, distressed
securities)
0.4421

177.30a

109.99

119.80

84.03a

41.51

r 1

0.2245

93.28a

82.49

90.45

36.61b

36.36

41.00

r 2

0.1405

56.67

59.46

66.52

21.80

30.04

35.17

r =0

47.15

r 3

0.1209

34.87

39.89

45.58

18.56

23.80

28.82

r 4

0.0669

16.31

24.31

29.75

9.97

17.89

22.99

r 5

0.0396

6.34

12.53

16.31

5.82

11.44

15.69

r 6

0.0036

0.51

3.84

6.51

0.51

3.84

6.51

Opportunistic strategies (variables: S&P 500, NASDAQ, growth, value, bonds, long/short equity, shortsellers, emerging markets, global macro)
r =0

0.3739

228.28a

175.77

187.31

67.43a

53.69

59.78
53.90

r 1

0.2665

160.85a

141.20

152.32

44.64

47.99

r 2

0.2277

116.22b

109.99

119.80

37.21

41.51

47.15

r 3

0.1804

79.00

82.49

90.45

28.65

36.36

41.00

r 4

0.1332

50.35

59.46

66.52

20.59

30.04

35.17

r 5

0.0966

29.76

39.89

45.58

14.63

23.80

28.82

r 6

0.0614

15.13

24.31

29.75

9.13

17.89

22.99

r 7

0.0373

6.00

12.53

16.31

5.47

11.44

15.69

r 8

0.0037

0.53

3.84

6.51

0.53

3.84

6.51

a and b indicate that the null hypothesis of no cointegration can be rejected at the 1% and 5% significance

levels, respectively. The trace and max statistics are carried out under the assumption of no deterministic
trend (i.e., without a constant in the cointegrating vector). Critical values for the Johansen test come from
Osterwald-Lenum (1992); r refers to the number of cointegrating vectors in the model

same factors and thus exhibit the same long-term evolution. So we consider a model
with no deterministic component.
Table 6 reports the results for the three different strategies. For the relative value
portfolio, the trace and maximal eigenvalue tests indicate the presence of one cointegration vector at the 1% level. For the event-driven portfolio, the trace indicates

440

R. Fss, D.G. Kaiser

two long-term equilibriums at the 1% significance level, while the max shows two
cointegration equations at the 1% level and two at the 5% level.
For the opportunistic portfolio, the test statistics are significantly higher: The trace
statistic suggests no more than two (three) cointegrating vectors, since we fail to
reject r 2 (r 3) at the 1% (5%) level. The maximal eigenvalue test indicates only
one common stochastic trend at the 1% significance level.
We tested in all cases for the absence of a deterministic trend component by comparing the restricted model without a constant with the unrestricted model with a constant. We applied the following likelihood ratio (LR) test statistic (Johansen 1995):
LR = T

r

i=1


1 i w 2
log
(r)
1


(8)

where i and i are the eigenvalues of the restricted and unrestricted models.
The test results signify the correct specifications with respect to the deterministic
component in all three cointegration relationships.
The existence of one or more common stochastic trend(s) does not imply that all
assets are a driving force in the common trend. It is possible that some of the financial
or hedge fund series do not enter the common stochastic trends. Furthermore, as
we discussed earlier, the relevance of diversification benefits depends on the speed
of adjustment toward the common trend (Kasa 1992). Thus, if returns do not react
significantly to common trends, their existence will only slightly affect the benefits
of diversification.
However, to analyze the nature of the cointegrating vector and the adjustment
coefficients, we perform a formal LR test. Table 7 gives the results from tests of
restrictions on the composition of the cointegrating vector present in each sample,
and tests of restrictions on the reaction of an assets returns to the common trend.
For the event-driven and opportunistic strategies, we set binding restrictions on both
cointegrating vectors simultaneously so that the test statistics are 2 (2) distributed.
Significant values indicate that the specific asset enters at least one common trend.
Results from the relative value strategies reveal that NASDAQ stocks, bonds, and
the equity market neutral strategy do not share a common trend with the remaining
asset prices, and they do not adjust to this cointegrating vector. This implies that riskaverse investors with a long-term investment horizon can lower their level of risk
even with convertible and/or fixed-income hedge fund strategies in their portfolios.
For tactical asset allocation, however, the fixed-income strategy would provide
diversification benefits in the short term, because it also does not react to the existing
common trend. For the event-driven style, we see that only the distressed securities
strategy shares a highly significant common stochastic trend with growth and hightech stocks. The short-term adjustment is merely a result of this strategy. For tactical
and strategic asset allocation, a portfolio consisting of these assets has higher longterm volatility and should be avoided by risk-averse investors.
In contrast, however, active and passive investors can benefit by adding risk arbitrage hedge funds to a conservative equity/bond portfolio. Interestingly, for both
hedge fund styles, bonds do not share a common trend with stock markets and hedge
fund strategies, and thus offer substantial diversification potentials.

The tactical and strategic value of hedge fund strategies

441

Table 7 Testing entering in and adjustment to the relevant cointegrating vector

Relative value strategies
S&P 500 = 0

2 (1) = 6.5074b

S&P 500 = 0

NASDAQ = 0

2 (1) = 2.1382

2 (1) = 5.9494b

NASDAQ = 0

growth cap. = 0

2 (1) = 4.7676b

growth cap. = 0

2 (1) = 6.5170b

value cap. = 0

2 (1) = 6.4080b

value cap. = 0

2 (1) = 3.6031c

bonds = 0

2 (1) = 0.0371

bonds = 0

bonvertible arbitrage = 0

2 (1) = 6.2720b

convertible arbitrage = 0

2 (1) = 3.8029c

fixed-income arbitrage = 0
equity market-neutral = 0

2 (1) = 8.3018b
2 (1) = 0.2629

fixed-income arbitrage = 0
equity market-neutral = 0

S&P 500 = 0

2 (2) = 4.1724

S&P 500 = 0

NASDAQ = 0

2 (2) = 7.8501b

NASDAQ = 0

2 (2) = 2.7378

growth cap. = 0

2 (2) = 11.6103a

growth cap. = 0

2 (2) = 3.1818

value cap. = 0

2 (2) = 5.4879c

value cap. = 0

2 (2) = 4.5550c

bonds = 0

2 (2) = 0.7323

bonds = 0

risk arbitrage = 0

2 (2) = 0.3052

risk arbitrage = 0

distressed securities = 0

2 (2) = 12.5490a

distressed securities = 0

2 (2) = 27.0101a

S&P 500 = 0

2 (2) = 8.5930b

S&P 500 = 0

2 (2) = 7.9169b

NASDAQ = 0

2 (2) = 1.4908

NASDAQ = 0

growth cap. = 0

2 (2) = 4.4413

growth cap. = 0

2 (1) = 2.0557

Event-driven strategies

Opportunistic strategies

value cap. = 0

2 (2) = 9.2109a

value cap. = 0

2 (2) = 6.7589b

bonds = 0

2 (2) = 6.4098c

bonds = 0

2 (2) = 7.1081b

long/short equity = 0

2 (2) = 6.0034b

long/short equity = 0

2 (2) = 17.2960a

short-sellers = 0
emerging markets = 0

2 (2) = 3.0202

short-sellers = 0

2 (2) = 7.2260b

emerging markets = 0

2 (2) = 3.1893

global macro = 0

2 (2) = 4.9844c

global macro = 0

2 (2) = 8.9304b

a , b , and c indicate that the null hypothesis (no entering into and no adjustment to the cointegrating vec-

tor(s)) can be rejected at the 1%, 5%, and 10% significance levels, respectively

In an opportunistic portfolio, conservative assets like the S&P 500, value stocks,
and bonds share common trends with most of the strategies, except for short-sellers.
The emerging market hedge funds do not react to these common trends, but long/short
equity does exhibit highly significant adjustment, which again confirms the results
from Table 3s correlation analysis. This implies that risk-averse investors can lower
long-run volatility by investing according to the cointegrating vectors, while active
managers can benefit from the knowledge of short-term movements in the asset
prices. Investors enhance diversification potential by taking high-tech and growth
stocks into account in their tactical and strategic asset allocation.
Overall, it is obvious that nearly all hedge fund strategies share at least one common trend with certain traditional assets. This information is useful for tactical and
strategic asset allocation, and also for forecasting hedge fund strategy prices.

442

R. Fss, D.G. Kaiser

5 Conclusion
Hedge funds have been considered ideal as a way to diversify more traditional stock
and bond portfolios because of their perceived low correlation with these markets.
This article, however, presents another side of the story. We find that alternative investments may provide diversification benefits, but low correlation is hardly the reason. We note that hedge fund returns are significantly nonnormal, which makes correlation analysis unsuitable. In this context, standard deviation does not fully reveal
the risk structure, and the correlation coefficient might have different limits.
We confirm the existence of cointegration between US stock markets and hedge
fund strategy indices. We used the Johansen cointegration test to examine common
stochastic trends that move groups of hedge fund indices and US stock market indices
to common equilibrium after each terminal shock. Our results can be used within a
framework of tactical decision making and strategic planning. Because cointegration
lowers uncertainty, risk-averse investors should prefer cointegrated assets, and indeed, most recent research has concluded that non-cointegrated assets are better for
portfolio diversification.
In contrast, however, we find that risk-averse investors may sometimes prefer cointegrated assets because of lower uncertainty about their movements as a group. And
the built-in error correction mechanism allows active investors to anticipate shortterm price movements more effectively. Our empirical results suggest that the equity
market neutral, risk arbitrage, and short-seller strategies do not enter the cointegrating vectors. In addition, fixed-income arbitrage and emerging markets do not react
to these common trends in the short term. There also seems to be a higher long-term
codependence between conservative assets (the S&P 500, value stocks, and bonds)
and the relative value and opportunistic strategies. NASDAQ and growth stocks, however, exhibited long-term relationships with event-driven strategies to a greater extent,
particularly with distressed securities.
Overall, we conclude that the long-term diversification benefits of hedge fund
strategies are much less significant than correlation analysis and portfolio optimization techniques have previously suggested. However, certain strategies, combined
with specific stock segments, can offer portfolio managers adequate diversification
potential, especially within a tactical asset allocation framework.
Acknowledgements The authors thank the two anonymous referees for their constructive criticism and
their helpful suggestions on the manuscript. Any remaining errors are, of course, our own.

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Roland Fss is lecturer at the department of Empirical Research and Econometrics and assistant professor at the department of Finance and Banking at the University of Freiburg, Germany. He holds a Diploma in Business Administration
from the University of Applied Science in Lrrach, a Diploma and a Ph.D. degree
in Economics from the University of Freiburg. His research interests are in the
field of applied econometrics, alternative investments as well as international and
real estate finance. Roland Fss has authored numerous articles in finance journals
as well as book chapters.

Dieter G. Kaiser is a Director Alternative Investments at FERI Institutional Advisors GmbH in Bad Homburg, Germany where he is responsible for portfolio
management and the selection of event driven and commodity hedge funds. From
2003 to 2007 he was responsible for institutional research and business development at Benchmark Alternative Strategies GmbH in Frankfurt. He has written
numerous articles on Alternative Investments that have been published in both,
academic and professional journals and is the author and editor of seven books.
Dieter G. Kaiser holds a B.A. in Business Administration from the University of
Applied Sciences Offenburg, an M.A. in Banking and Finance from the Frankfurt
School of Finance and Management, and a Ph.D. in Finance from the University
of Technology Chemnitz.