Journal of Banking & Finance 32 (2008) 2471–2481

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Journal of Banking & Finance

journal homepage: www.elsevier.com/locate/jbf

Detecting structural breaks and identifying risk factors in hedge fund returns:
A Bayesian approach
Loukia Meligkotsidou a, Ioannis D. Vrontos b,*
a
Department of Mathematics, University of Athens, Athens, Greece
b
Department of Statistics, Athens University of Economics and Business, Athens, Greece

a r t i c l e i n f o a b s t r a c t

Article history: Extending previous work on asset-based style factor models, this paper proposes a model that allows for
Received 11 February 2008 the presence of structural breaks in hedge fund return series. We consider a Bayesian approach to detect-
Accepted 16 May 2008 ing structural breaks occurring at unknown times and identifying relevant risk factors to explain the
Available online 28 May 2008
monthly return variation. Exact and efficient Bayesian inference for the unknown number and positions
of the breaks is performed by using filtering recursions similar to those of the forward–backward algo-
JEL classification: rithm. Existing methods of testing for structural breaks are also used for comparison. We investigate
G11
the presence of structural breaks in several hedge fund indices; our results are consistent with market
G12
C11
events and episodes that caused substantial volatility in hedge fund returns during the last decade.
Ó 2008 Elsevier B.V. All rights reserved.
Keywords:
Bayesian inference
Forward–backward algorithm
Hedge funds
Market events
Risk factors
Structural breaks

1. Introduction The characteristics of hedge funds, as well as the lack of trans-

Hedge funds have received a vast amount of attention over the
last decade. They are alternative investment vehicles for high net-
worth individuals and institutional investors that are privately or-
ganized, administrated by professional investment managers. Typ-
ically, hedge fund managers set absolute return targets to be
achieved independently from the market conditions. For this rea-
son, the managers can follow highly dynamic, complex trading
strategies which are not restricted to the use of leverage, short-
selling and derivatives. They have great flexibility in the types of
securities they hold and the types of positions they take. Hedge
funds can take large, often extreme, positive and negative positions
in bonds, currencies and other asset classes. They are not required
to disclose their positions in specific securities, and they can
change these positions frequently. These characteristics allow for
investment strategies that differ significantly from traditional reg-
ulated investments; see, for example, Fung and Hsieh (1997) who
studied the empirical characteristics of hedge funds.
parency of their managerial activities, make difficult the evaluation
of their performance. The complexity of hedge fund strategies ex-
poses their portfolios to a plethora of economic risk factors and
raises the possibility of model misspecification, since there exists
no generally accepted model (Vrontos et al., 2008). On the other
hand, due to the special features of hedge funds, their return-gen-
erating process may exhibit a high degree of non-normality, fat
tails and skewness (Amin and Kat, 2003; Kouwenberg and Ziemba,
2007) and be characterized by nonlinearities (Fung and Hsieh,
2004). The nonlinear generating process of hedge fund returns
can be associated with many market events having occured over
the last decades.1 Clearly, a model that is able to capture hedge fund
return behaviour under different market conditions is required.
There exist various hedge fund strategies which exhibit differ-
ent statistical properties, different risk-return characteristics and
therefore different exposures to market risk factors. Risk exposures
are likely to be time-varying, since they are expected to change

* Corresponding author. Tel.: +30 210 8203927.
E-mail addresses: meligots@math.uoa.gr (L. Meligkotsidou), vrontos@aueb.gr
(I.D. Vrontos).
1
Edwards (1999); Brown et al. (2000); Brunnermeier and Nagel (2004) described
and studied hedge fund behaviour during well-known financial events, such as the
collapse of Long-Term Capital Management, the Asian currency crisis and the
Technology and Internet bubble, respectively.

0378-4266/$ - see front matter Ó 2008 Elsevier B.V. All rights reserved.
doi:10.1016/j.jbankfin.2008.05.007
2472 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481
with changes in market conditions. Risk factor models can be con-
structed with the aim to identify the factors that affect returns,
measure risk adjusted performance and manager’s skill, and take
into account the specific features of hedge fund returns; dynamic
strategies, nonlinear nature, and occurrence of market events. A
class of models which can capture nonlinearities and changes in
risk exposure due to market events is the class of break-point risk
factor models. Fung and Hsieh (2004) proposed a model for fund of
hedge funds returns, linear to seven asset-based style (ABS hereaf-
ter) factors, with dynamic coefficients. They identified two struc-
tural breaks in the series using a modified CUSUM test. Fung
et al. (forthcoming) extended this work using a modified Chow
(1960) test for identifying structural breaks.
Models that allow for structural breaks are appealing for mod-
eling hedge fund returns, since they can capture the changes in risk
exposures due to the adjustments of hedge fund portfolios which
naturally follow market events. They can also capture nonlineari-
ties and changes in the variance across time; assuming different
segment-specific variances is an alternative way of modeling
time-varying volatilities, rather than modeling the volatility di-
rectly (for example, using GARCH models as in Giamouridis and
Vrontos, 2007; Vrontos et al., 2008). In this study we aim at detect-
ing the presence of multiple structural breaks in hedge fund return
series and at inferring their number and their positions. Further-
more, it is of interest to investigate whether different strategies
are subject to different or common breaks, i.e. what is the relation
of the number and the time of the breaks among different strate-
gies? We are also interested in examining whether there exist sig-
nificant differences in the risk adjusted performance (‘alphas’), the
risk exposures (‘betas’) and the volatilities among the different seg-
ments in the break-point model. Finally, we aim at identifying the
risk factors which are most likely to affect hedge fund indices.
Motivated by and extending previous work on break-point fac-
tor models (Fung and Hsieh, 2004; Fung et al., forthcoming) we use
ABS factors to construct a risk factor model in which the factor
loadings are allowed to change over time through a series of struc-
tural breaks of unknown number and occurrence times. We follow
a Bayesian approach to modeling multiple breaks which has sev-
eral interesting features. Firstly, all the unknown quantities in
the model are treated as parameters. Therefore, the joint posterior
distribution summarizes all the available information about the
number and the positions of the breaks as well as about the model
parameters. Furthermore, the uncertainty associated with the posi-
tions of the breaks is conveyed by their posterior distribution,
which can be asymmetric or even bimodal. The latter may reflect
market uncertainty about the exact date that a structural change,
associated with some episode or crisis, occurred. Under the classi-
cal approach, point estimates of the positions of the breaks can be
obtained, which are then attached to market events having oc-
curred at times close to the positions of the breaks (see Fung and
Hsieh, 2004), while only approximate, symmetric confidence inter-
vals can be computed for the break-dates (Bai and Perron, 2003).
Finally, under the Bayesian approach, variable selection can be eas-
ily incorporated in the model comparison exercise by simply
extending the set of competing models to include model specifica-
tions with different sets of factors.
Our Bayesian approach is based on a set of recursions recently
introduced by Fearnhead (2006), which are similar to those of
the forward–backward algorithm. The forward recursion is used
to calculate the marginal likelihoods of the break-point models,
provided that the segment-specific model parameters can be inte-
grated with respect to their prior distributions. These marginal
likelihoods can be used for inference on the number of breaks in
a Bayesian model comparison setting. The backward recursion en-
ables us to simulate from the marginal posterior distribution of the
positions of the breaks. The advantage of this approach over other
Bayesian approaches which are based on Markov chain Monte Car-
lo methods is that it produces exact inferences on the number and
the positions of the breaks.
We have applied our approach to hedge fund composite and
single strategy indices. We have also applied several previous
methods of testing for breaks to these series (fluctuation tests, F-
tests and least squares based tests) and compared the obtained re-
sults to ours. Our analysis revealed that structural breaks did occur
in hedge fund return series and that the break-dates were close to
important market events, such as the Long-Term Capital Manage-
ment crisis and the Technology and Internet bubble. Some of the
breaks are common among different series, which suggests that
there are certain events that affected several strategies, while in
general there are different factors that explain the different series.
Finally, we have conducted an out-of-sample exercise with the aim
to show potential benefits of our models and methods over ap-
proaches that ignore the presence of breaks in the series.
The contributions of our work are several. First, we employ an
exact and efficient Bayesian approach to inference with the aim
to detect structural breaks in hedge fund return series. Our Bayes-
ian approach detected structural breaks that could not be captured
using the classical methods. Second, we search for the relevant risk
factors which best describe the series of hedge funds returns, tak-
ing into account the possible presence of one or multiple structural
breaks in the series. Third, working in a Bayesian model compari-
son framework, we are able to compute posterior model probabil-
ities for a large number of competing models and to account for
model misspecification. Finally, the proposed Bayesian approach
enables us to obtain the posterior distributions of the model
parameters, i.e. the alphas, the betas and the variances in different
segments. Thus, we are able to compute reliable estimates for the
model parameters, and assess the parameter uncertainty.
The paper proceeds as follows. In Section 2 we briefly describe
some classical tests for structural breaks in linear regression. Then
we present our break-point models and describe the proposed
Bayesian approach to inference on the number and the positions
of the breaks. In Section 3 we report the results of our empirical
analysis and we conclude in Section 4.
2. Methods of testing for structural breaks
Here we briefly describe some classical techniques of testing for
structural breaks in linear regression and present the proposed
Bayesian method of detecting multiple breaks.
2.1. Classical tests for structural breaks in linear regression
There are three classes of classical tests for structural breaks in
the econometrics literature; the fluctuation tests, the F-tests and
tests based on least squares. The first attempt to testing for breaks
in linear regression using fluctuation processes was based on
cumulative sums (CUSUM) of recursive residuals (Brown et al.,
1975). Linear boundaries (Brown et al., 1975) and alternative
non-linear bounds (Zeileis, 2004), which are more sensitive to
early and late breaks, have been proposed for the recursive CUSUM
process. The process crossing the boundaries suggests deviation
from parameter constancy. A CUSUM test based on standard OLS
residuals was derived by Ploberger and Kramer (1992). Chu et al.
(1995) proposed tests for structural breaks based on moving sums
(MOSUM) of recursive and OLS residuals.
The F-tests are tests for the null hypothesis of parameter con-
stancy against the alternative of a single structural change. Chow
(1960) first suggested an F-test for the case that the break-date is
known. A straightforward generalization of the Chow test was to
calculate the F statistics for all possible break-dates and reject
the null hypothesis if any of those statistics were too large. An-
 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481
drews (1993); Andrews and Ploberger (1994) proposed F-tests
based on quantities obtained from the sequence of F statistics.
The time at which the F statistic becomes maximum provides an
estimate for the break-date. The F-tests enjoy optimality properties
in the case of a single break alternative (Andrews, 1993). On the
other hand, the MOSUM tests have greater power at detecting dou-
ble structural changes (Chu et al., 1995).
Recently, Bai and Perron (1998, 2003) considered theoretical
and computational issues regarding the estimation of and testing
for multiple structural breaks in linear regression models. Their
method (BP, hereafter) is a dynamic programming approach based
on the calculation of the sums of squared residuals in all possible
segments of the data, with the minimum size of each segment
being prespecified. Then a sequential procedure is used for the glo-
bal minimization of the overall sum of squared residuals. The
method produces a single optimal m-breaks partition for each gi-
ven value of m. The BP method selects the optimal number of
breaks given the estimated break-dates, by sequentially testing
the hypothesis of l breaks versus l + 1 breaks using significance
tests, or using information based criteria such as the AIC and the
BIC. In our applications we use the BIC to select the number of
breaks.
2.2. Bayesian inference for ABS factor models with multiple breaks
Suppose that we observe T consecutive realizations of hedge
0
fund returns r = (r1,. . .,rT) and that we use k risk factors fi = (fi1,. . .,
0
fiT) , i = 1,. . .,k, to explain this series of returns. We consider a linear
model subject to multiple structural breaks occurring at unknown
times. We assume that m breaks have occurred at times s 0 < s1 <
s2 <. . .< sm < sm+1, and we set s0 = 0 and sm+1 = T. These breaks de-
fine m + 1 disjoint segments. Note that for m = 0 the model reduces
to a standard linear regression. Let rt:s and fi,t:s, i = 1,. . .,k, denote
the hedge fund returns and the ith factor returns, respectively,
from time t to time s inclusive. Similarly, let Ft:s denote the design
matrix of the regression for observations from time t to time s,
whose first column is a vector of ones and the remaining columns
contain the returns of the k factors, fi,t:s, i = 1,. . .,k. The observations
in the jth segment are modeled as
X
k t  1. The calculation of the marginal likelihood of the model with
r t ¼ aj þ bji fit þ t ; t  Nð0; r2j Þ; for sj1 < t 6 sj ;
i¼1
where rt is the return of a hedge fund at time t, fit is the return of
factor i at time t, aj is the intercept, bji is the loading of risk factor
i associated with segment j, and the t are assumed to be indepen-
dent and normally distributed with zero mean and segment specific
variance r2j , j = 1,. . .,m + 1. That is the breaks reflect changes in all
the parameters.
Suppose that there are K available factors. An important prob-
lem is that of selecting the subset of most relevant factors to be in-
cluded in the model. This variable selection problem can be
considered as a special case of model selection, where each model
corresponds to a different subset of factors. It is convenient to indi-
cate each of these 2K possible choices of subsets by the vector c
0
= (c1,. . .,cK) , where ci = 1 if the ith factor is included and ci = 0 if
not. In our study we deal with model uncertainty associated with
both the number of structural breaks and the factors included in
the regression. Assuming that the factors included in all the seg-
ment-specific regressions are common, the number of models con-
sidered is (M + 1)2K, where M is a prespecified maximum number
of breaks allowed to occur.
First, consider factor models with k factors, allowing for m
structural breaks, m = 0,1, . . ., M. In order to perform Bayesian infer-
ence we need to specify prior distributions for the model parame-
ters. We assume independent conjugate priors for the regression
2473
parameters in different segments. This choice enables us to inte-
grate out all of the model parameters, and therefore the calculation
0
of the marginal likelihoods is exact. Let hj = (aj,bj1,. . .,bjk) , denote
the vector of regression coefficients in segment j. We assume a
multivariate normal N kþ1 ðl; cr2j VÞ prior for each hj, and an inverted
Gamma IG(d/2,m/2) prior for each r2j , j = 1,. . .,m + 1. In applications
in this paper we choose l = 0, which reflects prior ignorance about
the location of the means of the coefficients, and V ¼ ðF01:T F1:T Þ1 ,
which for the standard regression model (m = 0) replicates the
covariance structure of the data and yields the g-prior of Zellner
(1986). We take c = T, as in the g-prior, while the hyperparameters
d and m are chosen as follows. We prespecify the prior mean
Eðr2j Þ ¼ s2 and the prior variance Varðr2j Þ ¼ v of the r2j ’s and then
obtain the values of d and m by equating these values to the mean
and variance of the IG(d/2,m/2) distribution, respectively, i.e. by set-
m , d > 2, and v ¼ 2 ð m Þ2 . In this paper we took s2 equal
ting s2 ¼ d2 d4 d2
to the maximum likelihood estimate, r ^ 21 , of the variance of the
standard regression (m = 0) and set v ¼ 100r ^ 21 .
For the number of breaks we assume a Poisson Po(k) prior dis-
tribution, truncated over the range {0,1, . . ., M}. The prior for the
positions of the breaks is specified conditional on their number
as pm(s1,. . .,sm) = pm(sm)pm(sm1jsm). . .pm(s1js2), where pm(.) de-
notes conditioning on m breaks, pm(s m) is the prior on the position
of the last break and pm(sjjsj+1) is the prior on the position of the jth
break given the position of the (j + 1)th. In this paper we took k = 2,
and we adopted discrete uniform priors for the positions of the
breaks.
Following Fearnhead (2006), for all t 6 s we define P(c)(t,s) to be
the probability of the data rt:s under a linear model with k factors
and risk factor identifier c, given that times t and s are in the same
segment. Then,
Cðd =2Þmd=2 j V j1=2
PðcÞ ðt; sÞ ¼  ;
Cðd=2Þp ðstþ1Þ=2 ð  Þd =2
m cðkþ1Þ=2 j Vj1=2
where V ¼ ðc1 V1 þ F0t:s Ft:s Þ1 , m ¼ m þ r0t:s rt:s þ c1 l0 V1 l  ðl Þ0
ðV Þ1 l , d* = d + (st + 1), and l ¼ V ðc1 V1 l þ F0t:s rt:s Þ. For
ðm;cÞ
j = 1,. . .,m, and t = j + 1,. . .,Tm + j, we define Q j ðtÞ to be the prob-
ability of rt:T under a linear regression with factors specified by c,
conditional on m breaks and given that the jth break is at time
ð1Þ m breaks is based on the following recursion. For t = m + 1,. . .,T,
Q ðm;cÞ
m ðtÞ ¼ PðcÞ ðt; TÞpm ðsm ¼ t  1Þ:
For j = 1,. . .,m1, and t = j + 1,. . .,Tm + j,
X
Tmþj
ðm;cÞ ðm;cÞ
Qj ðtÞ ¼ PðcÞ ðt; sÞQ jþ1 ðs þ 1Þpm ðsj ¼ t  1jsjþ1 ¼ sÞ;
s¼t
(for the proof, see Fearnhead, 2006). The marginal likelihood of the
model with m breaks is
X
Tm
ðm;cÞ
Prðr1:T jm; cÞ ¼ PðcÞ ð1; sÞQ 1 ðs þ 1Þ:
s¼1
For any value of m, the marginal likelihood can be evaluated using
the recursions. Then, the posterior probabilities of the models with
m = 0,. . .,M breaks are given by
pðmÞPrðr1:T jm; cÞ
Prðmjr1:T ; cÞ ¼ PM ;
j¼0 pðjÞPrðr1:T jj; cÞ
where the calculation of the marginal likelihood of the simple
regression (m = 0) is given by P(c)(1,T). Conditional on m breaks,
samples from the joint posterior distribution of their positions can
ðm;cÞ
be also obtained given the values of Q j ðtÞ, j = 1,. . .,m,
t = j + 1,. . .,Tm + j, using a second recursion. Then, given a sample
from the posterior distribution of the break-dates, we can easily
2474 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481
simulate draws from the conditional posterior distributions of the
model parameters.2
In the full model comparison problem where the uncertainty
about which factors should be included in the model is taken into
account, c is treated as a further parameter and has to be assigned
a prior distribution. We assign equal prior probability, p (c) = 1/2K,
to each model specification, i.e we assume that the investor is neu-
tral about the factors that will enter the model. For each specific c
we can perform all the above calculations in order to obtain the
marginal likelihoods of the models with m structural breaks, for
m = 0,1,. . .,M. Then, it is straightforward to compute the posterior
probabilities of the models, as well as the marginal posterior prob-
abilities of the number of breaks and the risk factor identifier.
3. Data and empirical analysis
In this section we present empirical applications of the pro-
posed Bayesian method to hedge fund composite and single strat-
egy indices. In particular, we analyze the Hedge Fund Research
Composite Index (HFRCI hereafter) and the Credit Suisse/Tremont
Hedge Fund Composite Index (CSTHFCI hereafter), which are both
relevant to asset allocation investment decisions. These indices are
constructed using different subsets of the hedge fund indices uni-
verse, they are weighted differently and, hence, can be expected to
have different risk characteristics. We also analyze hedge fund in-
dex data from Hedge Fund Research (HFR), which are more rele-
vant to style allocation decisions. We consider six HFR single
strategy indices, using net-of-fee monthly excess returns (in excess
of the three month US Treasury Bill), from January 1994 to Novem-
ber 20053. This period includes a number of crises and market
events which affected hedge fund returns; the abrupt increase in
the US interest rates in early 1994, the Asian crisis in July 1997,
the Long-Term Capital Management (LTCM) crisis in late 1998, the
Technology and Internet bubble in March 2000, the Japanese crisis
in March 2001 and the events of September 2001.
We model the hedge fund returns using the seven ABS factors of
Fung and Hsieh, 2004. These factors include two equity factors,
namely the excess returns on the S&P 500 index (S&P) and the
spread between small-cap and large cap stock returns (SCMLC),
constructed as the difference of the Wilshire Small Cap 1750 index
returns and the Wilshire Large Cap 750 index returns. These are
the most important risk factors for a large number of hedge funds.
Two fixed income factors are also included; the change in the 10-
year treasury yields (10Y) and the difference between the change
in the Moody’s Baa bonds yields and the change in the 10-year
T-bonds yields (CredSpr). The latter factor can be regarded as the
excess log return of the Baa bond over the 10-year one, which is in-
cluded in factor models to capture an additional risk premia factor
to that associated with the 10-year government bond. Finally, we
use three primitive trend-following factors, i.e. three portfolios of
lookback straddles on bonds (PTFSBD), currencies (PTFSFX) and
commodities (PTFSCOM),4 which have the ability to explain the re-
turns of trend-following funds. The ABS factors have been shown to
be valuable explanatory variables for fund of funds and hedge fund
returns; see for example Fung and Hsieh (2001, 2002); Fung et al.
(forthcoming); Kosowski et al. (2007).
2
Details on the sampling scheme for the positions of the break-dates and the
model parameters are available from the authors upon request.
3
Details can be found in Hedge Fund Research, www.hedgefundresearch.com, and
in Credit Suisse Tremont Hedge Index, www.hedgeindex.com.
4
See Fung and Hsieh (2001) for a detailed description of the construction of the
three primitive trend-following (PTF) factors. The seven ABS factors have been
downloaded from David A. Hsieh’s Data Library on Hedge Fund Risk Factors at http://
faculty.fuqua.duke.edu/~dah7/HFRFData.htm.
3.1. Analysis of hedge funds composite indices
Here, we analyze monthly data on the HFRCI and the CSTHFCI
from January 1994 to November 2005 using ABS factor models.
We use the Bayesian approach described in Section 2.2 to compare
simultaneously various break-point models of different numbers of
breaks and subsets of factors. We consider all the possible subsets
in the set of the seven ABS factors (i.e. 27 = 128 model specifica-
tions) and 0–10 break-points. We also use several previous meth-
ods to test for structural breaks, namely the fluctuation tests, the F-
tests and the BP test described in Section 2.1. The tests are applied
to the most probable specification in each case, so that the results
to be comparable with those obtained under the Bayesian
approach.
3.1.1. HFRCI
For the HFRCI series, the most probable model, with posterior
probability of 0.49, is the single break model including the S&P,
SCMLC, 10Y and CredSpr factors. The marginal posterior probabil-
ity of a single break is high (equal to 0.76). In Fig. 1a is shown the
HFRCI return series together with a histogram of draws from the
posterior distribution of the break-date, obtained under the most
probable model. The posterior is highly concentrated with proba-
bility mass from the end of 2000 to the middle of 2001 and mode
at February 2001. The F-tests reject the null hypothesis of param-
eter constancy in favour of the single break alternative. The se-
quence of F statistics is shown in Fig. 1b with pick, i.e. estimate
of the break-date, at February 2001. The BP test also finds a single
break at February 2001, while none of the fluctuation tests (tech-
niques previously used in the hedge fund literature) identify any
break in the HFRCI series (see Fig. 1c–f).
Looking at Fig. 1a we observe that the variability of the returns
in the first segment (pre-break period; 1994–2001) is larger than
that in the second segment (post-break period; 2001–2005). Note
that the first period is characterized by high instability due to sev-
eral market events; the Asian crisis, the Long-Term Capital Man-
agement episode, the Technology and Internet boom. In
particular, the break in early 2001 can be associated with the latter
crisis after which the variability of the returns has reduced.
As expected, the variance in the pre-break period is substan-
tially larger than that of the post-break period (see Table 1). The
risk exposures to the equity ABS factors are quite high in both seg-
ments, but they clearly decrease in the second segment. The risk
exposure to the 10Y factor is significant5 only in the second subpe-
riod, with a negative value which indicates a larger exposure of the
HFRCI to bonds (according to the inverse price-to-yield relationship).
The differences in the exposures to the first three risk factors are sig-
nificant. The intercept is positive and significant in both segments,
however there is a decline in its value in the second subperiod.
Now, the most probable simple linear model includes only the two
equity factors, and the alpha (0.0035) and the risk exposures to
the S&P (0.3521) and the SCMLC (0.3137) are rough averages of
the respective break-point model parameters.
3.1.2. CSTHFCI
For this series, the most probable model (with posterior proba-
bility of 0.30) is that with two breaks including the S&P, SCMLC,
10Y, CredSpr and PTFSFX factors. The posterior distribution of the
break-dates, obtained under the most probable model, is shown
in Fig. 2a. The posterior of the first break puts probability mass
over the year 1994, with posterior mode at December 1994. The
uncertainty about the position of this break can be attributed to
5
Certainly, significance tests do not match with the Bayesian approach to
inference. We use the term ‘significant parameter’ to refer to a parameter whose
posterior distribution does not include zero in its highest posterior density region.
 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481 2475

100

50

0
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

4 2

2 1

0 0

-2 -1

-4 -2
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

2 2

1 1

0 0

-1 -1

-2 -2
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

Fig. 1. Tests for structural breaks in the hedge fund research composite index: (a) posterior distribution of the break-date, (b) F-test, (c) recursive CUSUM test, (d) OLS CUSUM
test, (e) recursive MOSUM test, (f) OLS MOSUM test.

the market instability which followed the Mexico crisis and the
abrupt rise of US interest rates in 1994. There is also some uncer-
tainty associated with the position of the second break. Its poster-
ior distribution is mostly concentrated over the period from March
2000 to February 2001, with posterior mode at November 2000.
This structural break can be associated with the Technology and
Internet bubble in March 2000.
For the CSTHFCI return series the F-tests favour the hypothesis
of a single break, with estimated break-date at April 2000. Many
values of the F statistics exceed the boundary over a period from
1998 to 2000 (see Fig. 2b), which indicates the presence of a break
within this period. The BP test favours the model with one struc-
tural break at April 2000. Again, none of the fluctuation tests iden-
tify any structural breaks in this series (see Fig. 2c–f). Fung and
Hsieh (2004) applied a modified CUSUM test to the CSTHFCI series
and concluded that there is no break in this series. However, our
approach does capture a break in 1994 and a second important
break in 2000 after which the variability of the series clearly re-

60

40

20

0
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

4 2

2 1

0 0

-2 -1

-4 -2
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

2 2

1 1

0 0

-1 -1

-2 -2
1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

Fig. 2. Tests for structural breaks in the Credit Suisse/Tremont hedge fund composite index: (a) posterior distribution of the break-dates, (b) F-test, (c) recursive CUSUM test,
(d) OLS CUSUM test, (e) recursive MOSUM test, (f) OLS MOSUM test.
2476 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481

duces. These findings will, therefore, change the conclusions of lated bets. This might be an explanation for a structural break
previous studies. being detected only in the CSTHFCI at the end of 1994, when an
The posterior means and standard deviations of the most prob- abrupt increase in the interest rates occurred.
able model’s parameters are given in Table 2. We report results for Second, there is a common break in the two series, which can be
the parameters in the last two segments because the first segment attributed to the Technology and Internet bubble. It is well-known
is too short for accurate inferences to be drawn based on monthly (see Brunnermeier and Nagel, 2004) that hedge funds overweight-
data. The variance in the second segment is substantially larger ed high technology stocks in their portfolios over the period from
than that in the third segment. Indeed, the large variability of 1998 to 2000. Hedge fund managers were able to take advantage
CSTHFCI returns from 1995 to 2000 is apparent in the plot of the of the price increase of individual technology stocks and success-
series (see Fig. 2a). With respect to the regression coefficients, fully reduced their weights before prices collapsed. This sophisti-
there are substantial differences in risk exposures between the sec- cated investing strategy is reflected in the performance of hedge
ond and third segment. There is a significant decrease in the values fund composite indices; the estimated alphas in the pre-break per-
of the two equity factors’ betas, and a significant increase in the iod are larger than those in the post-break period. Furthermore, the
negative value of the CreadSpr beta in the third subperiod. Finally, pre-break period is characterized by large variability in hedge
there is some decrease in the value of alpha and of the PTFSFX beta. funds returns due to several crises having occurred over this peri-
These results are consistent with the bull market period before the od. This is reflected on the estimated variances, which are substan-
Technology and Internet boom and the bear market conditions that tially larger in the first segment. A model that ignores the break
followed the crisis. If the structural break in 2000 is ignored the produces misleading inferences about hedge fund performance
analysis will be misleading as it will not reveal the differences in through time.
risk exposures under different market conditions. For example,
from fitting the most probable simple regression model to the en- 3.2. Analysis of single strategy hedge funds indices
tire sample, the estimated alpha is 0.0038 and the risk exposures to
the S&P, SCMLC, and CredSpr factors are 0.2427, 0.1653 and In this section we analyze six HFR single strategy indices over
5.7778, respectively. These values are rough averages of the the period from January 1994 to November 2005. Specifically, we
respective parameters in the two segments of the sample. There- analyze emerging markets (EM), equity hedge (EH), macro (M), dis-
fore, this model is clearly not able to capture important informa- tressed securities (DS), fixed income arbitrage (FIA) and merger
tion about the risk profile of the CSTHFCI. arbitrage (MA). In the following analysis we apply the proposed
Bayesian approach of Section 2.2, as well as the classical tech-
3.1.3. Comments on the results niques of Section 2.1 for comparison.
The results of this empirical application suggest that the break-
point risk factor models and the proposed Bayesian methodology 3.2.1. Emerging markets
can capture several interesting features of the two hedge fund The emerging markets strategy includes funds that focus on
composite indices. First, regarding the risk factors that affect the emerging and less mature markets. This strategy involves equity
two series, we have found that both indices have significant risk as well as fixed income investments around the world. In our anal-
exposures to the two equity ABS factors, which decrease after ysis of the EM strategy the most probable model, with posterior
2001, with the exposures of the HFRCI being higher. On the other probability of 0.34, is the single break-point model that includes
hand, the CSTHFCI has higher exposures to the fixed income ABS the S&P, the SCMLC and the CredSpr factors. The marginal posterior
factors and, moreover, it is affected by the trend-following factor probability of one structural break is large (0.74), indicating that
on currencies (PTFSFX). It seems that the HFRCI is characterized there is strong evidence for the presence of a single break.
mainly by hedge funds with equity related bets, while the CSTHFCI The posterior distribution of the break-date, obtained under the
is characterized by hedge funds with equity and interest rate re- most probable model, is concentrated over the period from the end
of 2000 to the middle of 2001, with mode at January 2001 (Fig. 3a).
The break can be associated with the end of the Technology and
Table 1 Internet bubble. Both the F-tests and the BP test identify one break
Hedge fund research composite index: posterior means and standard deviations (in in this series, and the estimated break-date coincides with ours.
parentheses) of the parameters of the most probable model The recursive CUSUM and MOSUM tests do not identify any break,
First segment Second segment while the OLS CUSUM test detects a break in 1999 and the OLS MO-
a 0.0038 (0.0010) 0.0026 (0.0008)
SUM test detects a break in 1997.6 Hence, for the EM series there is
bS&P 0.4483 (0.0239) 0.2358 (0.0200) stronger evidence for a break in early 2001, since there are three
bSCMLC 0.3672 (0.0275) 0.1984 (0.0296) estimates that coincide. After this break-date there is obviously a
b10Y 0.0082 (0.5625) 1.5011 (0.4024) substantial reduction in the variability of the series (Fig. 3a).
bCredSpr 3.5338 (1.1637) 2.4889 (0.7628)
Table 3 presents the estimates of the most probable model’s
r2 0.7992  104 (0.1222  104) 0.3038  104 (0.0577  104)
parameters. It can be seen that the risk exposures to the two equity
factors are positive, with large values in the first segment which re-
duce in the second. The positive exposure to the S&P factor is sen-
Table 2 sible since in many emerging markets short-selling is not
Tremont hedge fund composite index: posterior means and standard deviations (in permitted and futures and options are not available. The higher
parentheses) of the parameters of the most probable model risk exposure in the first subperiod can be attributed to the fact
Second segment Third segment that several crises have occurred over this period (1994–2000)
leading to market instability and inability to hedge this exposure.
a 0.0049 (0.0025) 0.0031 (0.0010)
bS&P 0.4174 (0.0655) 0.1294 (0.0276) The risk exposure to the CredSpr factor is negative and quite high
bSCMLC 0.2498 (0.0700) 0.0887 (0.0391) in the first segment, while it is still negative but not significant in
b10Y 1.8010 (1.5095) 1.8677 (0.5407)
bCredSpr 12.7295 (3.1258) 2.5720 (1.0366)
bPTFSFX 0.0249 (0.0138) 0.0156 (0.0057)
6
r2 0.3309  103 (0.1220  103) 0.0452  103 (0.0202  103) Figures are not shown for reasons of space and are available from authors upon
request.
 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481 2477

1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

1994 1996 1998 2000 2002 2004 1994 1996 1998 2000 2002 2004

Fig. 3. Posterior distribution of the break-date(s) for the HFR indices: (a) emerging markets, (b) equity hedge, (c) macro, (d) distressed securities, (e) fixed income arbitrage
and (f) merger arbitrage.

Table 3
Emerging markets index: posterior means and standard deviations (in parentheses) of
the parameters of the most probable model
First segment Second segment
a 0.0042 (0.0036) 0.0092
bS&P 0.8037 (0.0884) 0.3767
bSCMLC 0.4324 (0.0993) 0.3072
bCredSpr 13.4495 (3.0967) 2.4400
r2 0.0010 (0.1597  103) 0.0003
the second segment. The alpha is insignificant in the first segment,
while it is positive and significant in the second. Note that the esti-
mated alpha under the most probable simple linear regression is
insignificant. However, if the break is taken into account, in the
post-break period there is some added value from the average
EM fund manager beyond systematic bets.
3.2.2. Equity hedge
The HFR equity hedge strategy includes funds that take long and
short positions in equities, based on the A.W. Jones model. The
most probable model for this index, with posterior probability of
0.39, is the two break-points model including the two equity fac-
tors. The marginal posterior probability of this set of factors is
0.70. S&P and SCMLC are identified as important risk factors for
the EH also by Agarwal and Naik (2004).
The posterior distribution of the first break is bimodal (see
Fig. 3b) with a mode at November 1998 and a second smaller mode
at February 1995. The posterior of the second break is very concen-
trated with mode at November 2000. By visual inspection of the
plot of the series it can be said that the series suffers from large
variability from the end of 1998 to the end of 2000, i.e. between
the LTCM crisis and the end of the Technology and Internet bubble.
The BP test also favours the two-breaks model with estimated
break-dates at November 1998 and November 2000, identical to
ours. All the remaining tests identify one structural break in the
EH series; the F-test and the CUSUM tests detect the second break,
the former at November 2000 and the latter in early 2000, while
the MOSUM tests detect the first break around the second part of
1998. Hence, the fluctuation tests fail to detect both breaks and
seem to be complementary in this case.
(0.0024) In Table 4 are shown the estimates of the most probable mod-
(0.0608) el’s parameters. The risk exposures to both equity factors are posi-
(0.0918) tive, significant and vary over time; their values are low (in the first
(2.0115)
and third segments) to medium (in the second segment). The posi-
(0.0572  103)
tive exposure to the SCMLC factor suggests that the managers tend
to buy undervalued small stocks and go short on the large stocks to
eliminate the market risk. Alpha is positive in all periods, but it is
significant only in the second segment. The significant risk-ad-
justed performance in the second period (1998–2000) is statisti-
cally different from that in the last. The superior performance in
the second segment can be associated with the bull market period
from April 1998 to December 2000 during which the equity hedge
funds had strong positive exposures to high technology stocks (for
details, see Brunnermeier and Nagel, 2004).
Note that the estimate of alpha under the most probable simple
regression model is statistically significant (equal to 0.0052) indi-
cating superior performance of the average EH fund manager.
However, if the break is taken into account, the performance of
the funds is much better over the second segment while it is insig-
nificant in the other segments. Therefore, the simple regression
model may create a, so called, ‘alpha illusion’ in this case, produc-
ing misleading inferences about the EH managers’ performance.
3.2.3. Macro
The HFR Macro strategy funds make use of derivatives and
leverage and invest on price movements of stock markets, interest
rates, currencies and commodities. Not surprisingly, the most
probable model in our analysis, with posterior probability of
0.22, is the two break-points model including all the ABS factors
except for the PTFSBD, with the marginal posterior probability of
this subset of factors being 0.59.
In Fig. 3c is shown a histogram of draws from the posterior dis-
tribution of the break-dates obtained under the most probable
2478 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481

Table 4
Equity hedge index: posterior means and standard deviations (in parentheses) of the parameters of the most probable model

First segment Second segment Third segment

a 0.0042 (0.0042) 0.0098 (0.0034) 0.0015 (0.0011)
bS&P 0.3709 (0.0980) 0.6159 (0.1137) 0.3105 (0.0292)
bSCMLC 0.3608 (0.1734) 0.5388 (0.0782) 0.3008 (0.0413)
r2 0.1455  103 (0.0945  103) 0.2443  103 (0.1265  103) 0.0569  103 (0.0193  103)

model. The posterior of the first break puts mass over the year
1994, with mode at May 1994, while that of the second break puts
mass over the years 2000 and 2001, with mode at April 2000. The
presence of and the uncertainty about the position of the first
break can be attributed to the Mexico crisis and the abrupt rise
of US interest rates in 1994. The second break can be associated
with the Technology and Internet bubble in March 2000. The F-
tests identify a structural break at April 2000 but, surprisingly,
the BP test favours the simple model without breaks for the M ser-
ies. However, the optimal two-breaks partition according to the BP
method detects the first break at December 1994 and the second at
April 2000. Note that the BIC, used by the BP method for selecting
the optimal number of breaks, often underestimates it since it
penalizes large increases in the number of parameters (here a
break results in seven additional parameters, while, if only four
factors are used, there will be five additional parameters and the
BP test will advocate the two-breaks model). None of the fluctua-
tion tests identify any break.
In Table 5 are shown the estimates of the most probable mod-
el’s parameters (we report results for the second and third seg-
ments which are long enough). It can be seen that alpha is
always positive, but it is significant only in the third segment.
The variance is larger in the second segment and it reduces in
the third. The risk exposures to the equity factors are positive
and quite low in the second segment with a decline in their values
in the third. This result is consistent with the bull market condi-
tions over the period prior to April 2000 and the bear market effect
that followed the Internet and Technology boom. Also consistent
with the bearish conditions is the more negative beta in the 10Y
factor, which indicates an increase in the bond market, as well as
the reduction in the CredSpr risk exposure. These features are
not captured by the simple linear model. The estimated alpha of
the most probable simple regression is significant (equal to
0.0037), thus creating an ‘alpha illusion’.
3.2.4. Distressed securities
This strategy involves funds that invest in the securities of com-
panies in financial distress. These funds take positions in reorgani-
zations, bankruptcies and other corporate restructuring through
bank debt, common stock, trade claims and high yield corporate
bonds. For DS, the most probable model, with posterior probability
of 0.13, is the two break-points model including the S&P, SCMLC,
10Y, CredSpr and PTFSBD factors.
Table 5
Macro index: posterior means and standard deviations (in parentheses) of the
parameters of the most probable model
Second segment Third segment
a 0.0033 (0.0020) 0.0044
bS&P 0.3210 (0.0504) 0.1086
bSCMLC 0.1974 (0.0543) 0.1155
b10Y 2.3348 (1.2366) 3.0191
bCredSpr 9.6295 (2.2692) 2.6215
bPTFSFX 0.0177 (0.0109) 0.0295
bPTFSCOM 0.0168 (0.0153) 0.0390
r2 0.2457  103 (0.0555  103) 0.1161  103
The posterior distribution of the first break-date (Fig. 3d) puts
most probability mass over the year 1998, with mode at July
1998, while the posterior of the second break puts mass over the
years 2000 and 2001, with mode at December 2000. The first break
can be associated with the LTCM crisis, while the second break can
be associated with the Technology and Internet bubble. The F-tests
identify a structural break at January 2001, with the F statistics
exceeding the boundary in 1999, in early 2000 and finally during
2001. The BP test does not detect any break in this series (again
probably due to the large number of explanatory factors), however
the best two-breaks partition obtained by the BP method estimates
the first break-date at May 1998 and the second at December 2000,
almost identical to ours. Finally, the fluctuation tests do not detect
any break in this series.
In Table 6 are shown the estimates of the most probable mod-
el’s parameters. The alpha is positive in the first and third segment,
while it is negative but not significant in the second. The risk expo-
sure to the equity market factor is positive in all segments but it is
significant only in the first and last segment. The risk exposure to
the SCMLC factor is also low positive. This should be expected since
small firms are more likely to be in distress. The estimated alpha of
the most probable simple linear regression is significant and equal
to 0.0052, i.e. a rough average of the alphas in the three segments
of the sample.
3.2.5. Fixed income arbitrage
According to HFR, FIA is ‘‘a market neutral hedging strategy that
seeks to profit by exploiting pricing inefficiencies between related
fixed income securities while neutralising exposure to interest rate
risk”. Indeed, our analysis showed that there is no relationship be-
tween FIA and the equity factors. The most probable model (pos-
terior probability of 0.27) is the three breaks model including the
10Y and the CredSpr factors. Fung and Hsieh (2002) have also
pointed out that FIA funds are exposed to yield spreads.
From Fig. 3e it can be seen that the first two breaks are close to
each other, both with highly concentrated posterior distributions.
Their posterior modes are at July 1998 and November 1998,
respectively. These breaks, as well as the large decline in the values
of the returns over the period in between, can be associated with
the LTCM crisis. The distribution of the last break is less but quite
concentrated, with mode at September 2001, which coincides with
the time of the events in the US. The BP test captures two breaks in
this series, the first at July 1998 and the second at December 1998.
The method identifies the two breaks that are close to each other,
but fails to detect the third one in late 2001 after which the vari-
ability of the series clearly reduced. The F statistics exceed the
boundary over a long period from the end of 1998 to the beginning
of 2002. The estimate of the break-date is at October 1998. The
recursive CUSUM and MOSUM tests identify at least one break in
(0.0015) the FIA series, the former after 1998 and the latter in late 1997
(0.0353)
(0.0556)
and early 1998. In 1998 is also identified a single break by the
(0.7855) OLS MUSUM test, while the OLS COSUM test is not able to identify
(1.4582) any breaks. These results suggest that there is at least one break in
(0.0085) 1998, while the break in 2001 which is captured by our approach is
(0.0121)
possibly difficult to be identified by previous methods which do
(0.0250  103)
not account for breaks in the error variance.
 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481 2479

Table 6
Distressed sequrities index: posterior means and standard deviations (in parentheses) of the parameters of the most probable model

First segment Second segment Third segment

a 0.0055 (0.0014) 0.0016 (0.0066) 0.0070 (0.0014)
bS&P 0.1868 (0.0426) 0.2073 (0.1043) 0.0978 (0.0367)
bSCMLC 0.1459 (0.0534) 0.1624 (0.1574) 0.0864 (0.0471)
b10Y 0.1612 (0.8257) 0.6756 (3.3305) 2.2692 (0.7354)
bCredSpr 2.3533 (2.6650) 3.7845 (4.6675) 5.8283 (1.3794)
bPTFSBD 0.0126 (0.0081) 0.0524 (0.0286) 0.0196 (0.0082)
r2 0.0600  103 (0.0365  103) 0.2078  103 (0.2717  103) 0.0933  103 (0.0247  103)

In Table 7 are shown the estimates of the most probable mod-
el’s parameters (we report results for the first, third and fourth seg-
ments, which are long enough). The risk exposure to the 10Y factor
is significant only in the first and last subperiod, with a large posi-
tive value in the first segment, but a large negative value in the last.
The risk exposure to the CredSpr factor is significant in the last
subperiod with a large negative value. The value of alpha is positive
in all segments and it is highest in the last subperiod, in which the
variability of the fixed income ABS factors, especially of the Cred-
Spr, is low. On the other hand, in the third subperiod the variability
of the CredSpr is high, while the value of alpha is low. These find-
ings are in agreement with the observation that the FIA funds per-
form best in calm periods and worst in volatile periods.
3.2.6. Merger arbitrage
The merger arbitrage strategy includes funds that invest in the
securities of companies involved in a merger or aquisition by usu-
ally buying the stocks of the target (the company being acquired)
and going short on the stocks of the acquirer. Mitchell and Pulvino
(2001) found that MA returns are positively correlated with market
returns when the markets experience a large decline, but are
uncorrelated with market returns in flat and appreciating markets.
In our analysis, the most probable model (posterior probability of
0.39) is the three break-points model which includes the S&P
and the SCMLC factors.
Similarly to the results for the FIA strategy, the first two breaks
are close to each other, both with highly concentrated posterior
distributions with modes at April 1998 and December 1998,
respectively (Fig. 3f). These breaks, as well as the large decline in
the values of the returns over the period in between, can be asso-
ciated with the LTCM crisis. The posterior of the last break has
mode at January 2001, a few months after the end of the Technol-
ogy and Internet bubble and just before the Japanese crisis. The BP
test also identifies three breaks in the series with break-dates at
April 1998, December 1998 and November 2000. The F statistics
exceed the boundary over a period from late 1998 to late 2001
with estimated break-date at November 1999. From the fluctua-
tion tests only the OLS CUSUM and the recursive MOSUM tests
identify one break, the former at the end of 2000 and the latter
in early 2001. That is, the F-tests capture the first break(s), a bit la-
ter than we and the BP method do, while some of the fluctuation
tests capture the last break in the series.
In Table 8 are shown the estimates of the most probable mod-
el’s parameters (results for the first, third and fourth segments).
The risk exposure to the S&P is positive and significant in the first
and fourth segment. The SCMLC coefficient is positive in all seg-
ments and significant in the first and last. This is not surprising
since merger arbitrage traders usually take a long position in rela-
tively small targets and short in relatively large acquirers. Finally,
the alphas are positive in all segments but are significant only in
the first and third, while the estimate of alpha from the simple
regression model is significant (equal to 0.0036).
3.2.7. Comments on the results
Our results reveal vital information about the presence of struc-
tural breaks in the series of returns and how these breaks can be
interpreted in connection with well-known market episodes. In
most single strategy indices there is a break in 2000, which can
be associated with the Technology and Internet bubble; before this
event many individual hedge funds were heavily investing on high
technology stocks, while they successfully avoided much of the
downturn that followed the bubble. Another important break,
which is common among several styles (see DS, FIA and MA),
seems to have occurred in 1998, near to the Long-Term Capital
Management crisis. This crisis mostly affected funds which were
placing their bets on bonds and, in particular, on the yield spread
between high and low yield bonds (Edwards, 1999). Funds with
this profile are, for example, most fixed income arbitrage funds
which, like LTCM, experienced large losses in 1998.
Now, the comparison of our results with those obtained from
previous methods leads to the following conclusions. First, our
findings are in most cases similar, while being more informative,
to those of the F-type tests and the BP method. Our approach pro-
vides posterior distributions for the number and the positions of
the breaks, thus quantifying the uncertainty associated with them
and, unlike the other methods, it is able to capture all the breaks
that are present in the series. Second, for some classes of hedge
funds, the Bayesian methodology suggests structural breaks, where
no breaks were detected by using the fluctuation tests that have
been previously applied in the hedge fund literature. For example,
in the EH series our approach identifies two breaks but most of the
other methods can only capture either one or the other of them,
while in the M and DS series the fluctuation tests fail to identify
the breaks. Finally, our analysis reveals that in many cases there
are substantial differences in the alphas and/or the risk exposures
between different periods of the sample. We have shown that the
estimates from the simple regression models (which are rough
averages of the respective break-point models’ parameters) can
be misleading about the risk return characteristics of the series.
Therefore, our approach often changes the results that would have

Table 7
Fixed income arbitrage index: posterior means and standard deviations (in parentheses) of the parameters of the most probable model

First segment Third segment Fourth segment

a 0.0032 (0.0010) 0.0004 (0.0016) 0.0039 (0.0006)
b10Y 1.9544 (0.6774) 0.7845 (0.9232) 1.2040 (0.3211)
bCredSpr 2.2998 (2.3865) 0.4453 (1.4107) 1.4332 (0.6467)
r2 0.0557  103 (0.0109  103) 0.0841  103 (0.0242  103) 0.0184  103 (0.0041  103)
2480 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481

Table 8
Merger arbitrage index: posterior means and standard deviations (in parentheses) of the parameters of the most probable model

First segment Third segment Fourth segment

a 0.0064 (0.0009) 0.0073 (0.0014) 0.0002 (0.0008)
bS&P 0.0872 (0.0261) 0.0077 (0.0312) 0.1055 (0.0193)
bSCMLC 0.1079 (0.0349) 0.0405 (0.0244) 0.1487 (0.0299)
r2 0.3646  104 (0.0724  104) 0.3652  104 (0.1475  104) 0.3421  104 (0.0738  104)

Table 9
Two-sided t-tests and Wilcoxon signed-rank tests for the difference in the mean and median returns of hedge fund indices and respective portfolios for the break-point and the
simple linear regression model

Index Linear regression model Break-point model

t-test Signed-rank test t-test Signed-rank test
Dr p-value Dr p-value Dr p-value Dr p-value
HFRCI 0.0015 0.3032 0.0025 0.3758 0.0005 0.7100 0.0000 0.6272
CSTHFCI 0.0043 0.0044* 0.0046 0.0051* 0.0009 0.5310 0.0007 0.2414
EM 0.0060 0.1709 0.0038 0.1451 0.0006 0.8854 0.0005 0.6892
EH 0.0043 0.0072* 0.0033 0.0079* 0.0013 0.4495 0.0036 0.5111
M 0.0028 0.1746 0.0027 0.1096 0.0032 0.1681 0.0054 0.3313
DS 0.0012 0.4755 0.0030 0.3914 0.0023 0.2028 0.0051 0.1985
FIA 0.0007 0.3515 0.0003 0.4237 0.0017 0.0509 0.0018 0.0719
MA 0.0031 0.0078* 0.0020 0.0079* 0.0007 0.5440 0.0023 0.2192

Dr is the mean/median return of the index minus that of its replicating portfolio. * indicates that Dr is significantly different from zero at 5% level.

been drawn by using previous methods, especially if the latter
advocate ignoring the breaks.
3.3. Out-of-sample evaluation of the models
In this section we examine the usefulness of the most probable
break-point models by using them to construct replicating portfo-
lios of hedge funds based on the realized values of the factors in an
out-of-sample period. The results are compared with those ob-
tained by applying simple regression models to the series. The idea
is that a model that correctly identifies the relevant risk factors and
estimates the risk exposures will be good at replicating the out-of-
sample performance of hedge funds. Our evaluation of the models
is carried out by conducting standard t-tests and Wilcoxon signed-
rank tests to investigate if the mean and median returns of the rep-
licating portfolios are statistically different from the realized re-
turns (see Agarwal and Naik, 2004). In addition, we use the
logarithmic scoring rule which is based on the calculation of the
conditional predictive ordinates (see Vrontos et al., 2008).
In this evaluation exercise we use the data from January 1994 to
November 2003 for inference (estimation period) and we consider
the period from December 2003 to November 2005 as our two-
year out-of-sample period. The most probable model, obtained
using the estimation sample, is used for the construction of one
year of out-of-sample mimicking portfolios. Then, the estimation
period is redefined iteratively; it grows by one observation at each
step. Let T0 denote the initial estimation sample size. At the ith iter-
ation, the data r1:T 0 þi1 , F1:T 0 þi1 , i = 1,. . .,12, are used for inference,
conditional on the most probable model. The return in the next
period, rT 0 þi , can be estimated using the estimates of the parame-
ðsÞ 2ðsÞ
where hmþ1;T 0 þi1 , rmþ1;T 0 þi1 , s = 1,. . .,B, are draws from the posterior
of the parameters in the last segment. The above procedure is re-
peated once again, after a year, to obtain the most probable model
and then estimate the returns rT 0 þi and the conditional predictive
^ðr T 0 þi jr1:T 0 þi1 ; fT 0 þi ; m; cÞ, for i = 13,. . .,24. The same proce-
densities p
dure is also used to calculate the out-of-sample replicating portfo-
lios under the most probable specifications of the simple
regression models. The values ^r T 0 þ1 ; . . . ; ^r T 0 þ24 , can be used to per-
form t-tests and Wilcoxon signed-rank tests, while the respective
P
predictive log scores, 24 ^ 0
i¼1 log pðr T þi jr1:T þi1 ; fT þi ; m; cÞ, can be used
0 0
to measure the models’ predictive ability.
In Table 9 we present results on two-sided t-tests and Wilcoxon
signed-rank tests for the difference in the mean and median re-
turns of the two composite and the six single strategy indices. In
many cases (see HFRCI, EM, M, DS, FIA) the differences are insignif-
icant for both models’ predictions. These findings show that our
method is able to capture the dominant economic risk factors of
hedge funds and, therefore, the replicating portfolios based on
these factors are able to track hedge fund returns in the out-of-
sample period. However, for a number of indices, namely the
CSTHFCI, EH and MA, the differences are significant at 5% level
for the simple regression, while being insignificant for the break-
point model. That is the latter model does a better job at estimating
Table 10
Predictive log scores for the break-point and simple regression models for the eight
hedge fund indices
Index Regression Break-point Improvement in predictive
model model performance (%)

ters in the last segment and the realized values of the factors at HFRCI 82.94 84.43 6.4
time T0 + i, fT 0 þi . Furthermore, we can calculate the conditional pre- CSTHFCI 72.28 84.85 68.8
EM 55.70 60.18 20.5
dictive density at time T0 + i as
EH 77.17 81.76 21.1
M 71.31 74.43 13.9
^ðrT 0 þi jr1:T 0 þi1 ; fT 0 þi ; m; cÞ
p DS 80.23 78.03 9.8
FIA 85.36 96.16 56.8
1X B
ðsÞ 2ðsÞ MA 86.92 90.83 17.7
¼ pðr T 0 þi jr1:T 0 þi1 ; fT 0 þi ; m; c; hmþ1;T 0 þi1 ; rmþ1;T 0 þi1 Þ;
B s¼1
Also shown is the ‘per month’ improvement in the out-of-sample predictive per-
formance achieved by the break-point model over the linear regression model.
 L. Meligkotsidou, I.D. Vrontos / Journal of Banking & Finance 32 (2008) 2471–2481
the risk exposures and at mimicking the fund’s performance during
the out-of-sample period.
In Table 10 are shown the values of the predictive log score for
the eight indices, obtained under the most probable simple regres-
sion and break-point models. The predictive log score is a measure
of the predictive ability and consequently of the efficacy of a pric-
ing model. Models which assign large predictive probability to the
values that actually occur return a large log score. Between two
competing models, that with the highest score is preferred. In all
but one case the break-point models perform best in terms of their
predictive ability, and in some cases (see CSTHFCI, FIA, EH) the dif-
ferences are substantial. The difference between predictive log
c 2 , repre-
c 1 and pls
scores of two models, respectively denoted by pls
sents a ‘per month’ improvement in the predictive performance by
a factor of expfð pls c 2 Þ=24g. For example, for CSTHFCI the dif-
c 1  pls
ference in log score between the break-point model and the linear
model represents an improvement in the predictive performance
by a factor of exp{(84.85-72.28)/24}=1.6883 or by about 68.8%.
On average, the break-point models are about 24.2% more effective
than simple regression models.
4. Conclusions
In this paper we have introduced a break-point risk factor mod-
el which is appealing for modeling hedge fund returns, since it cap-
tures the nonlinearitites in the generating process of these series
and reflect changes in market conditions. We have proposed a
Bayesian model comparison approach to detecting structural
breaks and identifying relevant risk factors. The proposed nonlin-
ear risk factor models enable us to examine the changes in hedge
fund exposure among different subperiods in the sample. For com-
parison, we have applied several well known techniques for testing
for structural breaks to the analyzed series.
Several results arose from our empirical investigation. First,
there are some dates, close to well-known market events, when
structural breaks did occur in the hedge fund return series. In par-
ticular, in almost all of the analyzed series we found breaks in 2000
or early 2001, after the Technology and Internet boom, while in
quite a few series we found breaks in the second half of 1998, i.e.
during and after the Long-Term Capital Management Crisis. Sec-
ond, we found that different hedge fund indices are affected by dif-
ferent factors. This seems reasonable since the composite indices
are differently constructed and weighted, while fund managers fol-
low different investment strategies. Third, for some funds, the
Bayesian approach identifies breaks where no breaks were de-
tected by using the classical tests previously applied in the hedge
fund literature. Fourth, we found evidence for substantial differ-
ences in the risk adjusted performance and the risk exposures of
hedge funds among different segments of the sample. Ignoring
the breaks is likely to result in misleading conclusions about alpha
and the risk exposures. Finally, we found that break-point models
perform better at replicating hedge fund portfolios than standard
regression models. Therefore, we believe that the proposed models
could be proven useful in portfolio selection and rebalancing
problems.
2481
Acknowledgements
This paper was originally submitted to Professor Giorgio Szego
on 26 February 2007 and was revised once prior to submission
through EES. We would like to thank the editor, Ike Mathur, and
an anonymous referee for numerous constructive comments that
improved the quality of the paper. We also thank Elias Tzavalis
for many helpful discussions.
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