The cash VIX can hedge the short volatility risks of the S&P 500 and selected hedge fund strategies. Short volatility behavior occurs when returns are not normally distributed, but demonstrate negative skewness and excess kurtosis. It is not appropriate to use Markowitz-style mean-variance optimization and Sharpe ratios with non-normal returns to justify hedge fund allocations in an efficient portfolio. A small investment in cash VIX offsets the short volatility exposure of hedge fund and equity investments, allowing these investments to be appropriately modeled as having normally distributed returns.;VIX futures exhibit significantly lower volatility than cash VIX, with deferred months having a lower volatility than the front contract month. VIX futures have a risk premium in excess of that found in the calculation of cash VIX relative to the realized volatility of the S&P 500. The size of this risk premium is large, with the front (second) month futures underperforming cash VIX by 4% (1%) per month. While VIX futures maintain the ability to hedge higher moments exposures of short volatility investments in equity and hedge funds, the cost of using VIX futures to hedge can be prohibitively expensive.;Over 70% of the returns to single manager hedge funds can be explained by capital markets factors. After the LTCM incident in 1998, neither funds of funds or single manager returns are market neutral. After accounting for the additional layer of fees, fund of funds investments underperform investments in a portfolio of single strategy hedge fund managers.;Returns based style analysis for hedge funds starts with traditional market beta exposures, which explain over 70% of the variance in hedge fund returns from 1990 through 2009. Adding exotic beta factors and using a variable to explain leverage improves the portion of variance explained to over 81%. The addition of Credit Default Swaps (CDS) and lagged variables to explain smoothed returns increases the r-squared of the regression to over 91%. Using simple traditional market betas to evaluate hedge fund managers overstates the alpha. A unique application of CDS prices adds significant explanatory power to understanding hedge funds since 2001.
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