The risk in hedge fund strategies: theory and evidence from trend followers

Hedge fund strategies typically generate option-like returns.Linear-factor models using benchmark asset indices have difficultyexplaining them. Following the suggestions in Glosten and Jagannathan(1994), this article shows how to model hedge fund returns byfocusing on the popular 'trend-following' strategy. We use lookbackstraddles to model trend-following strategies, and show thatthey can explain trend-following funds' returns better thanstandard asset indices. Though standard straddles lead to similarempirical results, lookback straddles are theoretically closerto the concept of trend following. Our model should be usefulin the design of performance benchmarks for trend-followingfunds.