Explain how factor models can shed light on the risk exposures of hedge funds

Factor models explain a hedge fund's returns through exposures to market factors, such as equity returns, credit spreads, currencies, interest rates, commodities and volatility, and treat what is left as alpha. The fit shows whether apparent skill is really hidden beta. Because many strategies behave differently in stressed markets, a conditional model estimates separate exposures for normal and crisis periods, often by adding a dummy variable for stress months, so that in each regime the expected return is R = alpha + sum of (beta × factor return), using that regime's betas. A strategy with modest equity beta in normal times may show much higher equity and credit beta in a crisis, just when diversification is needed. The trap is relying on full-period average exposures.