Hedge fund strategies typically generate option-like returns. Linear-factor models using benchmark asset indices have difficulty explaining them. Following the suggestions in Glosten and Jagannathan (1994), this article shows how to model hedge fund returns by focusing on the popular "trend-following" strategy. We use lookback straddles to model trend-following strategies, and show that they can explain trend-following funds' returns better than standard asset indices. Though standard straddles lead to similar empirical results, lookback straddles are theoretically closer to the concept of trend following. Our model should be useful in the design of performance benchmarks for trend-following funds.

This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, which when added to Sharpe's (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.

Hedge fund strategies typically generate option-like returns. Linear-factor models using benchmark asset indices have difficulty explaining them. Following the suggestions in Glosten and Jagannathan (1994), this article shows how to model hedge fund returns by focusing on the popular “trend-following” strategy. We use lookback straddles to model trend-following strategies, and show that they can explain trend-following funds’ returns better than standard asset indices. Though standard straddles lead to similar empirical results, lookback straddles are theoretically closer to the concept of trend following. Our model should be useful in the design of performance benchmarks for trend-following funds.

This article presents some new results on an unexplored dataset on hedge fund performance. The results indicate that hedge funds follow strategies that are dramatically different from mutual funds, and support the claim that these strategies are highly dynamic. The article finds five dominant investment styles in hedge funds, which when added to Sharpe’s (1992) asset class factor model can provide an integrated framework for style analysis of both buy-and-hold and dynamic trading strategies.