We analyze hedge fund performance using the stochastic discount factor (SDF) approach and
imposing the arbitrage-free requirement to correctly value the derivatives and dynamic trading
strategies used by hedge funds. Using SDFs of many asset-pricing models, we evaluate hedge
fund portfolios based on style and characteristics. Without the arbitrage-free requirement, pricing
errors are relatively small and a few models can explain hedge fund returns. With this
requirement, pricing errors are much bigger, and all models fail to price style and volatility
portfolios. Fund manager characteristics like age, experience, and education explain some of the
mispricing of our best risk model.
