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The authors construct a time-varying factor model of hedge fund returns that accounts for market risk, leverage, and illiquidity and tail events. Prior to analysis they investigate database biases arising from voluntary self-reporting and suggest how to minimize these biases. Using a constant beta model, they find that between 1994 and 2009 the average hedge fund manager realizes an excess return of 2.8 percent per annum and the average manager outperforms in eight of the hedge fund types that they examine. However, they find that almost all this added value comes from stock selection skills with only a small subsample of the universe displaying market timing skills. These conclusions are robust to the inclusion of time-varying beta, volatility clustering and leverage effects.
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