Evidence of Predictability in Hedge Fund Returns and Multi-Style Multi-Class Tactical Style Allocation Decisions

While there has been a significant amount of research on the predictability of traditional asset classes, very little is known about the predictability of returns emanating from alternative vehicles such as hedge funds. This is perhaps surprising, given that significant attempts at structuring the alternative investment markets have occurred over the last decade which now allow investors to implement dynamic trading strategies in hedge fund indexes. This paper attempts to fill this gap by documenting evidence of predictability in hedge fund index returns, focusing on their use for tactical style allocation decisions. Using data from nine CSFB-Tremont hedge fund indexes, we find that there is strong evidence of very significant predictability in hedge fund returns. We also find that the benefits in terms of tactical style allocation portfolios are potentially very large. Even more spectacular results are obtained both for an equity-oriented portfolio mixing traditional and alternative investment vehicles, and for a fixed-income oriented portfolio mixing traditional and alternative investment vehicles. These results do not seem to be significantly affected by the presence of reasonably high transaction costs.