Do hedge funds "hedge" and make absolute returns? I focus on factor models with the presence of regime switching to explain hedge fund returns. In the regime switching CAPM, market betas, alphas and volatilities are allowed to vary across states. I use Gibbs Sampling procedure to estimate the models using CSFB/Tremont Hedge Fund Indices. At the index level, hedge funds have higher market risk exposure and poorer risk-adjusted performance during distressed states. The regime switching model can explain more variation in hedge fund returns than the static CAPM. However, the regime switching CAPM is rejected, which suggests multifactor models should be explored.
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