Fung-Hsieh 7 Factor Model

The Fung-Hsieh 7 factor model is a risk factor model commonly used to evaluate hedge funds’ performance. The seven factors are risk factors that explain a large proportion of the returns of hedge funds. The model was proposed door David Hsieh and William Fung in 2001 in a paper titled Hedge Fund Benchmarks: A Risk-Based Approach”. The aim of the factors is to capture the returns to a well-diversified portfolio of hedge funds.

On this page, we discuss the Fung-Hsieh 7 factor model definition. In particular, we discuss the risk factors that are included in the model. We also briefly introduce the Fung-Hsieh 8 factor model.

Fung-Hsieh 7 factor model definition

The 7 factor model for hedge funds is actually a simple linear factor model, similar to the Fama and French 3 factor model for individual stocks. In this case, however, the model is used to explain hedge fund returns.

The model uses the following 7 factors:

  • Bond Trend-Following Factor
  • Currency Trend-Following Factor
  • Commodity Trend-Following Factor
  • Equity Market Factor
  • The Equity Size Spread Factor
  • The Bond Market Factor
  • The Bond Size Spread Factor

The first three factors are trend-following factors proposed by Fung and Hsieh in a different paper called “The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers“. These factors are available here.

Next, the equity market factor is captured using the S&P 500, the size factor is the difference between the Russell 2000 index monthly total return – Standard & Poor’s 500 monthly total return. The bond market factor is proxied using the the monthly change in the 10-year treasury constant maturity yield Finally, the size spread factor is measured using the monthly change in the Moody’s Baa yield less 10-year treasury constant maturity yield (month end-to-month end).

Fung-Hsieh 7 factor model formula

Once we have the factors, the model looks as follows

    $$r_{t} = \alpha_0 + \beta_1 PTFS_{B_{t}} + \beta_2 PTFS_{{Cur}_{t}} + \beta_3 PTFS_{{Com}_{t}} + \beta_4 EQ_{t} + $$

    $$\beta_5 ES_{t} + \beta_6 BM + \beta_7 BS_{t} + \epsilon_t$$

where PTFS are the trend-following factors for Bonds, Currencies, and Commodities, EQ is the equity factor, ES is the Equity Size factor, BM is the bond market, and BS is the Bond Size factor.

Fung-Hsieh 8 factor model

A few years after the introduction of the 7 factor model, Fung and Hsieh added an eighth factor. This model is referred to as the Fung-Hsieh 8-factor model. The additional factor that is added to the model is the MSCI Emerging Market index.

Summary

We discussed the Fung-Hsieh 7 factor model. This is the workhorse model when researchers try to explain hedge funds’ return and analyze whether hedge funds generate alpha.