Dynamic Trading Strategies of Equity Hedge Funds: Empirical Evidence on How They Adapt to Market Conditions

Hedge funds shift investment strategies in response to changing market conditions. We adjust hedge fund returns for their risks in an estimation that accounts for regime-switching effects. Index factors are used to capture the returns from buy-and-hold strategies followed by hedge fund. Besides, in order to capture the nonlinear dependence of hedge fund returns on these market indexes, we construct investable higher-moment factors and option-like strategies. Because our trading factors are mostly based on the equity markets, we focus on the equity-oriented hedge funds from the Hedge Fund Research database. Especially, we test whether these factors can explain the time series behavior of returns of a market neutral, short selling and long/short equity hedge funds. Average exposure sensitivities for systematic skewness are statistically significant for all funds. Equity hedge funds are moreover shown to follow a conservative investment strategy as they reduce their (linear or nonlinear) exposures in down-market regime relative to tranquil- or up-market regimes.