On Optimal Instrumental Variables Generators, With an Application to Hedge Fund Returns (Report‪)‬

Abstract In this paper, we propose a new benchmarking procedure lying on cumulants for computing the factor loadings in financial models of returns. We apply this technique to the well-known augmented Fama and French (J Fin Econ 43 (2): 153-193, 1997) model and compare it with another technique of ours based on higher moments. Our new procedure confirms the fact that the alpha is supposed to decrease when we disaggregate HFR indices to the level of individual funds while correcting for specification errors. Our new technique is therefore useful for hedge funds selection or ranking based on the alpha of Jensen corrected for specification errors. This technique will also be useful for calibrating other financial models of returns like the simple market model or the conditional alpha and beta models. Keywords Hedge funds returns * Alpha of Jensen * Financial models * Cumulants * Higher moments * Specification errors * Aggregation bias