Predictability and Hedge Fund Investing

Hedge fund managers are largely free to pursue dynamic trading strategies and standard linear regression is no longer accurate for measuring hedge fund abnormal return (alpha) and risk exposure (beta). Accordingly, this paper presents a dynamic linear model to capture hedge fund dynamics. By allowing time-varying alpha and beta, this dynamic linear model facilitates improved prediction in alpha, beta, and future hedge fund return. By simulating hypothetical trading strategies, we demonstrate that the model-based predictability helps to implement a profitable fund selection process