Are shocks to hedge fund returns permanent or temporary?

This paper examines whether shocks to hedge funds are permanent or temporary. The paper applies two recently developed unit root tests including the Narayan and Popp (NP) and the Liu and Narayan (LN) procedures. These procedures allow for two structural breaks in the data. The data on hedge funds consist of monthly observations retrieved from the TASS/Lipper database (http://www.lipperweb.com/products/LipperTASS.aspx). The data span the time period January 1996 through March 2004. For individual funds, the study uses all funds for which at least 60 observations are available. Individual funds are classified into eleven categories based on their reported investment strategies including: 1) convertible arbitrage; 2) fixed-income arbitrage; 3) event driven; 4) equity market neutral; 5) long-short equity; 6) global macro; 7) emerging markets; 8) dedicated short bias; 9) managed futures; 10) funds of funds and 11) other.

Based on the preliminary results from the NP test, the null hypothesis of a unit root is rejected at least at the 5 percent level of significance in all of the cases. Interestingly, the results from the LN procedure confirm those obtained from the NP technique. Taken together, the results suggest that shocks to the various hedge fund returns are stationary and therefore temporary. This finding implies that hedge funds can be used to buffer volatilities in other financial markets such as the stock and foreign exchange markets.