DYNAMIC HEDGE FUND STYLE ANALYSIS WITH ERRORS‐IN‐VARIABLES

We revisit the traditional return‐based style analysis in the presence of time‐varying exposures and errors‐in‐variables (EIV). We apply a benchmark selection algorithm using the Kalman filter and compute the estimated EIV of the selected benchmarks. We adjust them by subtracting their EIV from the initial return series to obtain an estimate of the true uncontaminated benchmarks. Finally, we run the Kalman filter on these adjusted regressors. Analyzing EDHEC alternative index styles, we show that this technique improves the factor loadings and allows more precise identification of the return sources of the considered hedge fund strategy.