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  • Slow Trading and Stock Return Predictability

    Market returns predict the future abnormal returns on small and illiquid stocks, implying attractive dynamic investment strategies for investors investing in the size premium or in small and illiquid stocks either directly or through exchange traded funds. We provide evidence that this return predictability is due to institutional investors’ trading patterns: When rebalancing their portfolios the institutional investors initially buy (sell) relatively more the large and liquid stocks. In the case of illiquid stocks they split their orders over several days to avoid excessive price impact, thus inducing predictability in stocks returns. We provide evidence that some hedge funds exploit this return predictability. Click here for full article
    Matthijs Lof, Aalto University School of Business
    Matti Suominen, Aalto University School of Business
  • Acquiring and Trading on Complex Information: How Hedge Funds Use the Freedom of Information Act

    Using the Freedom of Information Act, hedge funds receive records from the Food and Drug Administration about new product approvals, factory inspections, and complaints. We use the funds' receipt of this information to empirically test implications of theories about investors with bounded rationality acquiring complex information for trading purposes. Consistent with theory, we find evidence that the magnitude of hedge fund trades is positively related to the funds' prior knowledge about the target firm and the FOIA process, and to the short-term abnormal stock returns derived from trading. Click here for full article
    April Klein, Professor of Accounting, Stern School of Business - New York University
    Tao Li, University of Warwick - Warwick Business School
  • Corporate Governance and Hedge Fund Activism

    Over the past 25 years, hedge fund activism has emerged as new form of corporate governance mechanism that brings about operational, financial and governance reforms to a corporation. Many prominent business executives and legal scholars are convinced that the entire American economy will suffer unless hedge fund activism with its perceived short-termism agenda is significantly restricted. Shareholder activists and their proponents claim they function as a disciplinary mechanism to monitor management and are instrumental in mitigating the agency conflict between managers and shareholders. I find statistically meaningful empirical evidence to reject the anecdotal conventional wisdom that hedge fund activism is detrimental to the long term interests of companies and their long term shareholders. Moreover, my findings suggest that hedge funds generate substantial long term value for target firms and its long term shareholders when they function as a shareholder advocate to monitor management through active board engagement to reduce agency cost. Click here for full article
    Shane C. Goodwin, Adjunct Professor (Finance and Managerial Economics), University of Texas Dallas
  • Financial Intermediation in Private Equity: How Well Do Funds of Funds Perform?

    This paper focuses on funds of funds (FOFs) as a form of financial intermediation in private equity (both buyout and venture capital). Compared to investments in hedge funds or publicly traded stocks, private equity investments in direct funds are less liquid, less easily scaled and have higher search and monitoring costs. As a consequence, FOFs in private equity may provide valuable intermediation for investors who want exposure to the asset class. We benchmark FOF performance (net of their fees) against both public equity markets and strategies of direct investment into private equity funds. We also examine the types of portfolios private equity FOFs create when they pool investor capital. After accounting for fees, primary FOFs provide returns equal to or above public market indices for both buyout and venture capital. While FOFs focusing on buyouts outperform public markets, they underperform direct fund investment strategies in buyout. In contrast, the average performance of FOFs in venture capital is on a par with results from direct venture fund investing. This suggests that FOFs in venture capital (but not in buyouts) are able to identify and access superior performing funds. Click here for full article
    Robert S. Harris, University of Virginia Darden School of Business
    Tim Jenkinson, Said Business School, University of Oxford and CEPR
    Steven N. Kaplan, University of Chicago Booth School of Business and NBER
    Ruediger Stucke, Warburg Pincus
  • The Case For and Against Activist Hedge Funds

    A subset of so-called hedge funds, henceforth known as “activists”, has latched on the idea that many corporations are not managed or governed in a manner likely to maximize value for shareholders. With the capital they have obtained from pension funds and other institutional investors, they take a small position in the equity of publicly traded companies and push, with a varying degree of aggressiveness, for measures they deem likely to boost targeted companies’ stock price.

    This is a fast growing business. The number of activist “interventions”, some 27 in 2000, has reached 345 in 2014 according to the WSJ-FactSet Activism Scorecard. Activist hedge funds have now amassed an estimated $200 billion in managed assets. To achieve more leverage on companies, smaller hedge funds may band in what has been aptly called “wolf packs”.

    In a by-now familiar scenario, the activist hedge fund calls on the targeted company to name to its board some people of its choosing (threatening a proxy fight if the company is not forthcoming). That is merely a first step, sometimes entirely skipped.

    Unless the company swiftly gives in to its demands, the hedge fund will produce a paper, or a long letter, critical of the company’s management and board and outlining the remedial actions that, in its view, would benefit shareholders. That document will be broadcast widely so as to gather the support of the company’s institutional shareholders, even if a tacit one. In due course, if matters come to a proxy fight, the hedge fund will try to persuade the proxy advisors (ISS and Glass Lewis) to come out in favour of the hedge fund’s nominees for the board. Click here for full article
    Yvan Allaire, PhD (MIT), FRSC Executive Chair, IGOPP Emeritus Professor
  • Effect of Regulatory Constraints on Fund Performance: New Evidence from UCITS Hedge Funds

    We economically motivate and then test a range of hypotheses regarding performance and risk differences between UCITS-compliant and other hedge funds. The latter exhibit more suspicious return patterns than do absolute return UCITS (ARUs), but ARUs exhibit higher levels of operational risk. We find evidence of a strong liquidity premium: hedge funds offer investors less liquidity than do ARUs yet exhibit better risk-adjusted performance. Our findings are substantially unchanged under various robustness tests and adjustments for possible selection bias. The liquidity premium for ARUs and their lack of performance persistence have implications for both investors and policy makers. Click here for full article
    Juha Joenväärä, University of Oulu, Risk Management Lab, Imperial College Business School
    Robert Kosowski, Imperial College Business School, CEPR, Oxford-Man Institute of Quantitative Finance and EDHEC
  • The Economic Consequences of Investor Relations: A Global Perspective

    We offer new evidence on the economic value of investor relations (IR) activity using the results of a 2012 global survey of IR officers and their activities at over 800 firms from 59 countries. More active IR programs, as measured by a firm’s involvement in broker-sponsored conferences, in facilitating one-on-one meetings with institutional investors, through global outreach, and with formal disclosure, media and governance policies, are associated with a statistically significant and economically large 8-12% higher Tobin’s q valuation. The findings are resilient to concerns about potential reverse-causality as we instrument the level of IR activity with firm-level constraints, or of their peers, on IR personnel, salaries, and budget. The channels through which IR activity increases market value is through greater analyst following, improved analyst forecast accuracy, and a reduced cost of capital. More IR activity is also associated with higher institutional and hedge fund ownership, and more equity issuance. Click here for full article
    G. Andrew Karolyi, Professor of Finance and Economics and Alumni Professor in Asset Management at the Johnson Graduate School of Management, Cornell University
    Rose C. Liao, Assistant Professor, Rutgers Business School, Rutgers University
  • Asset Bubbles: Re-thinking Policy for the Age of Asset Management

    In distilling a vast literature spanning the rational— irrational divide, this paper offers reflections on why asset bubbles continue to threaten economic stability despite financial markets becoming more informationally-efficient, more complete, and more heavily influenced by sophisticated (i.e. presumably rational) institutional investors. Candidate explanations for bubble persistence—such as limits to learning, frictional limits to arbitrage, and behavioral errors—seem unsatisfactory as they are inconsistent with the aforementioned trends impacting global capital markets. In lieu of the short-term nature of the asset owner—manager relationship, and the momentum bias inherent in financial benchmarks, I argue that the business risk of asset managers acts as strong motivation for institutional herding and ‘rational bubble-riding.’ Two key policy implications follow. First, procyclicality could intensify as institutional assets under management continue to grow. Second, remedial policies should extend beyond the standard suite of macroprudential and monetary measures to include time-invariant policies targeted at the cause (not just symptom) of the problem. Prominent among these should be reforms addressing principal-agent contract design and the implementation of financial benchmarks. Click here for full article
    Brad Jones, International Monetary Fund
  • Hedge Fund Flows and Performance Streaks: How Investors Weigh Information

    We examine the relative weights hedge fund investors attach to past information in the fund selection process. The weighting scheme appears inconsistent with econometric forecasting models that predict fund returns, alphas or Sharpe ratios. In particular, investor flows are highly sensitive to performance streaks despite their limited predictive power regarding fund performance. Further, allocations based on forecast models’ out-of-sample predictions beat investor allocations by a significant margin, which suggests that the latter are suboptimal and reflect overreaction to certain types of information. Our findings do not support the notion that sophisticated investors have superior information or superior information processing abilities. Click here for full article
    Guillermo Baquero, European School of Management and Technology
    Marno Verbeek, Rotterdam School of Management, Erasmus University
  • Duration of Poor Performance, Fund Flows and Risk-Shifting by Hedge Fund Managers

    A typical hedge fund manager receives greater compensation when the fund has a strong absolute or relative performance. Asymmetric performance fees and fund flow-performance relationship may create incentives for risk-shifting, estimated in our study by the change in fund return volatility in the middle of the year. However, hedge funds that cannot attract new funds or have had poor performance for a long period may face different incentives. The combination of these two observations confronts hedge fund managers with a complex strategic decision regarding the optimal level of their funds’ return volatility. While an increase in return volatility generally increases the expected payoff of the compensation contract, excessive volatility is not sustainable. This paper empirically examines the factors that affect hedge fund managers’ decisions to risk-shifting. We show that (1) if the fund has had prior poor performance, the magnitude of risk-shifting is larger; (2) as the duration of poor performance increases, risk-shifting is reduced; (3) if the fund is experiencing capital outflows, the magnitude of risk-shifting is smaller and (4) funds that have outflows and also use leverage or have short redemption notice periods display a smaller degree of risk-shifting. Click here for full article
    Ying Li, Asst. Professor of Business, Univ. of Washington Bothell
    A. Steven Holland, Professor of Business, Univ. of Washington Bothell
    Hossein B. Kazemi, Professor of Finance, Univ. of Massachusetts Amherst
  • Best Ideas of Hedge Funds

    We provide new compelling evidence that hedge funds possess investment skill. Using the longest-in-literature unbiased sample of hedge funds, we show that large holdings of past winners earn 7% annual benchmark-adjusted return. This remarkable performance is consistent with the notion that large holdings represent managers' best ideas. Our sample goes back to 1980 and does not miss non-surviving hedge funds, or those that do not voluntarily report to commercial databases. It consists of all investment managers that must report to the SEC, except those that we identify as managers other than hedge funds. While publicly available data is not sufficient to identify hedge funds directly, our \reverse identification" method achieves both high sensitivity and specificity. We also find weaker yet significant evidence of investment skill in standard indicators such as average fund performance and performance persistence. Click here for full article
    Sergey Maslennikovy, Ph.D. student and Parker Hund, undergraduate student
    both at Department of Finance, McCombs School of Business, University of Texas at Austin
  • Chasing Winners: The Appeal and the Risk

    For the large majority of hedge fund investors, frequent and repeated manager turnover is neither a practical nor desirable approach to managing a hedge fund portfolio. However, experiments simulating such an approach can be useful in that they can illustrate potential long-term consequences of different selection strategies. In this paper, we present results of one such experiment that offer a strong caution against the practice of chasing winners, or hiring managers that have had the highest returns. The experiment results also suggest that alpha – in this case, return not accounted for by beta to the broad equity market, including from manager skill – consistently outperforms absolute return as a selection criterion.

    Amid a prolonged bull market, there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the market’s upside; however, since such equity upside capture is statistically a relative rarity among hedge fund strategies, such a selection criterion may lead to adverse selection. Click here for full article
    Kristofer Kwait, Managing Director, Head of Hedge Fund Research and John Delano, Director
    Commonfund Hedge Fund Strategies Group
  • Do Incentive Fees Signal Skill? Evidence from the Hedge Fund Industry

    We examine whether fee structure acts as a reliable signal of hedge fund performance. Recent theoretical work suggests that, given the unique information asymmetries faced by hedge fund investors, managers will use performance-based incentive fees to signal skill. We test this hypothesis empirically and find little support for the notion that high incentive fee funds generate superior risk-adjusted returns during normal market conditions; rather, increases in incentive fee level are accompanied by an increased proclivity to take on risk and increased leverage. Consequently, higher incentive fee funds suffer higher rates of attrition. Higher incentive fee funds do demonstrate lower market correlations and thus provide enhanced diversification benefits. As a result, high fee funds exhibited remarkable outperformance during the recent global financial crisis. Click here for full article
    Paul Lajbcygier, Department of Banking & Finance, Monash University
    Joe Rich, Department of Accounting and Finance, Monash University
  • Why Complementarity Matters for Stability — Hong Kong SAR and Singapore as Asian Financial Centers

    There is much speculation regarding a “race for dominance” among financial centers in Asia, arising from the anticipated financial opening up of China. This frame of reference is, to an extent, a predilection that results from a traditional understanding of financial centers as possessing historical, geographic, and scale economy advantages. This paper, however, suggests that there is an alternative prism through which the evolution of financial centers in Asia needs to be viewed. It underscores the importance of “complementarity” rather than “dominance” to better serve regional and global financial stability. We posit that such complementarity is vital, through network analysis of the roles of Hong Kong SAR and Singapore as the current leading financial centers in the region. This analysis suggests that a competition for dominance can result in de-stabilizing levels of interconnectivity that render the global “network” as a whole more susceptible to rapid propagation of shocks. We then examine the regulatory and policy challenges that may be encountered in furthering such complementary coexistence. Click here for full article
    Minsuk Kim, Vanessa Le Leslé, Franziska Ohnsorge, and Srikant Seshadri
    International Monetary Fund (IMF)
  • Do Alternative UCITS Deliver What They Promise? A comparison of alternative UCITS and hedge funds

    We study the performance of alternative UCITS funds and account for potential survivorship biases in our sample in the best possible manner. Alternative UCITS funds offer similar raw returns but a lower volatility compared to offshore hedge funds. Single-index models show that alternative UCITS funds provide only marginal exposure to variations in hedge fund returns. Multifactor models indicate that the most important risk factors for both alternative UCITS funds and their matched hedge funds strategies are related to stock market risks, but alternative UCITS funds exhibit a lower exposure to these factors than hedge funds. Moreover, we find factor loadings on different risk factors, suggesting that alternative UCITS and hedge funds pursue different strategies. Finally, we assess the degree of the value added for an investor in terms of enhanced diversification benefits by implementing a spanning test and find that both groups are different asset classes with time-varying diversification properties. Click here for full article
    Michael Busack, Absolut Research GmbH
    Wolfgang Drobetz, School of Business, University of Hamburg
    Jan Tille, Absolut Research GmbH
  • Evaluating and Predicting the Failure Probabilities of Hedge Funds

    Hedge funds have the most sophisticated risk management practices; however, hedge funds also appear to have a short lifetime relative to other managed funds. In this study, we investigate the failure probabilities of hedge funds—particularly the failures due to financial distress. We forecast the failure probabilities of hedge funds using both a proportional hazard model and a logistic model. By utilizing a signal detection model and a relative operating characteristic curve as the prediction accuracy metrics, we found that both of the models have predictive power in the out-of-sample test. The proportional hazard model, in particular, has stronger predictive power, on average. Click here for full article
    Hee Soo Lee, School of Business, Yonsei University
    Juan Yao, The University of Sydney Business School, The University of Sydney
  • Sentiment and the Effectiveness of Technical Analysis: Evidence from the Hedge Fund Industry

    This paper presents a unique test of the effectiveness of technical analysis in different sentiment environments by focusing on its usage by the most sophisticated and astute investors, hedge fund managers. We document that during high-sentiment periods, hedge funds using technical analysis exhibit higher returns, lower risk, and superior market-timing ability than those non-users. The advantages for hedge funds of using technical analysis disappear in low-sentiment periods. These findings are consistent with the view that technical analysis performs relatively better in high-sentiment periods with larger mispricing, which cannot be fully exploited by arbitrage activities due to short-sale impediments. Click here for full article
    David M. Smith, State University of New York at Albany
    Na Wang, Hofstra University
    Ying Wang, State University of New York at Albany
    Edward J. Zychowicz, Hofstra University
  • Hedge Fund Holdings and Stock Market Efficiency

    We examine the relation between changes in hedge fund stock holdings and measures of informational efficiency of equity prices derived from transactions data, and find that, on average, increased hedge fund ownership leads to significant improvements in the informational efficiency of equity prices. The contribution of hedge funds to price efficiency is greater than the contributions of other types of institutional investors, such as mutual funds or banks. However, stocks held by hedge funds experienced extreme declines in price efficiency during liquidity crises, most notably in the last quarter of 2008, and the declines were most severe in stocks held by hedge funds connected to Lehman Brothers and hedge funds using leverage. Click here for full article
    Charles Cao, Smeal College of Business, Penn State University
    Bing Liang, Isenberg School of Management, University of Massachusetts
    Andrew W. Lo, MIT Sloan School of Management
    Lubomir Petrasek, Board of Governors of the Federal Reserve System
  • CTAs – Which trend is your friend?

    The occurrence of trends within financial markets is inconsistent with the assumptions of classical financial theory. Nevertheless, it can be empirically validated that market prices can be subject to trends. But - which trends should you measure? Which trend is your friend? Click here for full article
    Fabian Dori, Manuel Krieger, and Urs Schubiger
    1741 Asset Management Ltd.
  • In Search of Missing Risk Factors: Hedge Fund Return Replication with ETFs

    Properly considering all potential risk factors through tradable liquid portfolios in the context of a risk based factor model is paramount to quantifying the benefits of investing in hedge funds. We attempt to span the space of potential risk factors with exchange traded funds (ETFs). We develop a methodology of hedge fund return replication with ETFs based on cluster analysis and LASSO factor selection that overcomes multicollinearity among ETFs and the data mining bias. We find that the overall out-of-sample accuracy of hedge fund replication with ETFs increases with the number of ETFs available. This is consistent with our interpretation of ETF returns as proxies to a multitude of alternative risk factors that could be driving hedge fund returns.

    We further consider portfolios of “cloneable” and “non-cloneable” hedge funds, defined as top and bottom in-sample R2 matches. We find superior risk-adjusted performance for “non-cloneable” funds, while “cloneable” funds fail to deliver significantly positive risk-adjusted performance. We conclude that our methodology provides value in both identifying skilled managers of “non-cloneable” hedge funds, and also successfully replicating out-of-sample returns that are due to alternative risk exposures of “cloneable” hedge funds, thus providing a transparent and liquid alternative to investors who may find these return patterns attractive. Click here for full article
    Jun Duanmu, Yongjia Li, and Alexey Malakhov
    Sam M. Walton College of Business, University of Arkansas
  • The Effect of Investment Constraints on Hedge Fund Investor Returns

    The aim of this paper is to examine the effect of frictions and real-world investment constraints on the returns that investors can earn from investing in hedge funds. We contribute to the existing literature by accounting for share restrictions, minimum diversification requirements and fund size restrictions that are commonly used by institutional investors. We show that the size-performance relationship is positive (negative) when past (future) performance is used. Evidence of performance persistence is reduced significantly when fund size and share restrictions such as notice, redemption and lockup period are incorporated into rebalancing rules. We test several hypotheses regarding the economic mechanism that underlies the size-performance relationship. We find empirical support for theoretical models based on decreasing returns to scale as well as managers responding optimally to fee incentives. The findings have significant implications for hedge fund investors since they caution against chasing performance in hedge funds and within the billion dollar club of hedge funds, in particular. Click here for full article
    Juha Joenväärä, University of Oulu and Imperial College Business School
    Robert Kosowski, Imperial College Business School and Oxford-Man Institute of Quantitative Finance
    Pekka Tolonen, University of Oulu
  • Equity Hedge Fund Performance, Cross–Sectional Return Dispersion, and Active Share

    This study examines several aspects of active portfolio management by equity hedge funds between 1996-2013. Consistent with the idea that cross-sectional return dispersion is a proxy for the market’s available alpha, our results show that equity hedge funds achieve their strongest performance during periods of elevated dispersion. The performance advantage is robust to numerous risk adjustments. Portfolio managers may use the current month’s dispersion to plan the extent to which the following month’s investment approach will be active or passive. We also estimate the active share for equity hedge funds and find an average of 53%. We further document the average annual expense ratio for managing hedge funds’ active share to be about 7%. This figure is remarkably close to active expense ratios reported previously for equity mutual funds, which may be interpreted as evidence of uniform pricing for active portfolio management services. Click here for full article
    David M. Smith, Department of Finance and Center for Institutional Investment Management, University at Albany
  • Crystallization – the Hidden Dimension of Hedge Funds’ Fee Structure

    We investigate the implications of variations in the frequency with which hedge funds update their high-water mark on fees paid by hedge fund investors. Using data on Commodity Trading Advisors (CTAs), we perform simulations to analyse the effect. We find a statistically and economically significant effect of the crystallization frequency on total fee load. Funds’ total fee load increases significantly as the crystallization frequency increases. As such, our findings indicate that the total fee load depends not only on the management fee and incentive fee, but also on the crystallization frequency set by the manager. Click here for full article
    Gert Elaut, Ghent University, Belgium
    Michael Frömmel, Ghent University, Belgium
    John Sjödin, Ghent University, Belgium, and RPM Risk & Portfolio Management AB, Sweden
  • Governance Under the Gun: Spillover Effects of Hedge Fund Activism

    This paper empirically studies the spillover effects of hedge fund activism. Activism threat, defined as a heightened rate of recent activism in an industry, predicts a higher probability that a firm in that industry will be targeted. Using institutional trading in stocks outside of the industry as an instrument, we identify the effects of activism threat from those of product market competition and time-varying industry structure. The threat of being targeted has a disciplining effect on peer firms, which respond by reducing agency costs and improving performance along the same dimensions as actual targets. These changes lead to substantial positive abnormal returns and lower the ex-post probability of becoming a target, suggesting the presence of a partial feedback effect. Overall, our results provide new evidence that shareholder activism, as a monitoring mechanism, reaches beyond the firms being targeted. Click here for full article
    Nickolay Gantchev, Finance Area, Univ. of North Carolina at Chapel Hill
    Oleg Gredil, Kenan-Flagler Business School, Univ. of North Carolina at Chapel Hill
    Chotibhak Jotikasthira, Kenan-Flagler Business School, Univ. of North Carolina at Chapel Hill
  • Evaluating Absolute Return Managers

    One traditional measure of investment performance, the Information Ratio (IR), is defined as the active return (alpha) divided by the tracking error (the standard deviation of the active return). Calculating an IR is straightforward when the benchmark for performance is a buy-and-hold standard like the S&P 500. For absolute return managers, however, the typical benchmark we observe is zero meaning that any excess return is classified as alpha and deemed to represent the return from active management or skill. In this paper, we argue that this standard approach confuses beta returns and alpha returns. The former can be earned by following generic strategies that can be easily implemented and are often replicated by ETFs while the later are associated with more original or complex strategies that more genuinely reflect unique skills or expertise. We propose a new performance metric that strips out beta returns associated with investment style factors. This approach leads to a new statistic, the alpha ratio, which can dramatically impact the relative performance rankings of managers and provide a clearer signal of manager skill. Click here for full article
    Momtchil Pojarliev, Hathersage Capital Management LLC
    Richard M. Levich, New York University Stern School of Business, Finance Department
  • CTAs: Shedding light on the black box

    In their paper they explore a number of the features they consider important when assessing Commodity Trading Advisors (CTAs), from the perspective of an investor in the asset class as well as issues of a more technical nature which will inform further those considering making an allocation to the sector. Throughout the paper they have tried to visit topics which are pertinent to this quest, and in so doing, limit re-visiting themes which are already much discussed; instead illustrating our assertions (where possible and appropriate) with technical data and examples of the techniques we have developed for finding, managing and monitoring managers in the space. We have covered a lot of ground: indeed this was the aim of their first paper on the sector and there exist many areas which may be the subject of dedicated papers in the future. Finally, they examine some traditionally held assertions with regards to CTAs and in turn assert that some hold true under analysis while others are likely not fully informed. Click here for full article
    Tommaso Sanzin, Partner, Risk Manager, Head of Quantitative Research – Hermes BPK Partners
    Larry Kissko, Head of CTA, Macro & RV Strategies – Hermes BPK Partners
  • How Do Hedge Fund ‘Stars’ Create Value? Evidence from Their Daily Trades

    I use transaction-level data to investigate the magnitude and source of hedge funds' equity trading profits. Bootstrap simulations indicate that the trading profits of the top 10% of hedge funds cannot be explained by luck. Similarly, superior performance persists. Outperforming hedge funds tend to be short-term contrarians with small price impacts, and their profits are concentrated over short holding periods and in their more contrarian trades. Further, I find that performance persistence is significantly stronger for contrarian funds with small price impacts. My findings suggest that liquidity provision is an important channel through which outperforming hedge funds persistently create value. Click here for full article
    Russell Jame, Gatton College of Business and Economics, University of Kentucky
  • Did Long-Short Investors Destabilize Commodity Markets?

    This paper contributes to the debate on the effects of the financialization of commodity futures markets by studying the conditional volatility of long-short commodity portfolios and their conditional correlation with traditional assets (stocks and bonds). Using several groups of trading strategies that hedge fund managers are known to implement, we show that long-short speculators do not cause changes in the volatilities of the portfolios they hold or changes in the conditional correlations between these portfolios and traditional assets. Thus calls for increased regulation of commodity money managers might at this stage be premature. Click here for full article
    Joëlle Miffre, PhD, Professor of Finance, EDHEC Business School
    Chris Brooks, Professor of Finance and Director of Research, ICMA Centre, Reading
  • Quantitative Trend Following Strategies and Equity Risk: From Diversifier to Hedge

    The goal of this paper is to analyze the equity risk hedging capabilities of CTA Trend Following (TF) strategies and to evaluate enhancements that would stabilize their hedging characteristics to equities. With real yields on US treasuries below zero, institutions are pushing the envelope to find new sources of return, Alpha and risk. More complex, but less liquid and less transparent, new investment conduits such as hedge funds have hidden the usually apparent equity market risk, as measured by volatility, by converting it in the form of tail risk and negative skew.

    Fixed Income has been extremely stable in the past 30 years and not many worry or care to hedge exposure to it yet. Equities, on the other side, have had some large cycles and drawdowns, which include some over 50%. Although it is now in the form of tail risk, rather than “old fashioned” volatility, most investors would still like to hedge the residual equity risk that is now the core risk in almost every portfolio including hedge funds and fund of hedge funds. The DJCS HFI Dedicated Short Bias (Short Biased Index) has been extremely costly with a negative true Alpha of around -5.5% a year to the SP500. Timing the overall equity market on a discretionary or fundamental basis has not worked for most. Put option buying is extremely costly despite the low implied volatility of the equity markets and it only rewards sporadically due to the negative skew of equities. A profitable or at least cheaper hedge would be most welcome and there still seems to be some hope that TF can effectively hold this responsibility. We will offer some enhancements that will make the correlation of TF to equities significantly negative in order to stabilize this relationship.

    Despite strong performance during equity drawdowns, TF has been used (and sized) only as a diversifier in portfolios, not as a hedge. This could be due to:

    1) A lack of model transparency and understanding, 2) High volatility that sometimes correlates to equities, and 3) Neutral rather than negative long term correlation to equities.

    In this paper, we will: 1) Analyze the ability of TF to improve a hedge fund portfolio’s risk adjusted returns and drawdowns, 2) Explore the increase in correlation of TF managers to equities and the reduction in their equity hedging characteristics over time, 3) Specifically analyze the impact of Fixed Income in TF portfolios and its role in TF hedging of equities, 4) Estimate the ability of TF ex-Fixed Income to hedge equity drawdowns across trading time frames and trading styles, 5) Explore the use of TF as a timing filter for equity indices, and 6) Enhance a diversified TF portfolio with covariance filtering to stabilize its ability to hedge equity risk. Click here for full article
    Nigol Koulajian, Quest Partners LLC
    Paul Czkwianianc, Quest Partners LLC
  • Do Hedge Funds Provide Liquidity? Evidence from Their Trades

    The paper provides significant evidence of limits of arbitrage in the hedge fund sector. Using unique data on institutional transactions, we show that the price impact of hedge fund trades increases when aggregate conditions deteriorate. The peak in trading impatience is reached during the financial crisis. The finding is consistent with arbitrageurs’ withdrawal from liquidity provision following a tightening in funding liquidity. Compared to other institutions in our data, hedge funds display the largest sensitivity of trading costs to aggregate conditions. We pin down this effect to a subset of hedge funds whose leverage, lack of share restrictions, asset illiquidity, and low reputational capital make them particularly exposed to funding constraints. These characteristics appear to negatively impact hedge funds’ trading performance when times get worse. Click here for full article
    Francesco Franzoni, Professor of Finance, University of Lugano – Institute of Finance
    Alberto Plazzi, Assistant Professor, University of Lugano - Institute of Finance
  • The Returns to Carry and Momentum Strategies

    We find that global time series carry strategies (across bonds, commodities, currencies, equities and metals) can be explained by a set of lagged macroeconomic variables. The payoffs to carry strategies disappear once futures returns are adjusted for their predictability based on these macroeconomic variables. On the other hand, momentum strategies are only weakly affected by lagged macroeconomic variables but are significantly related to measures of hedge fund capital flow. When studying these two findings together and over time we find that while momentum strategies were highly co-moving with carry strategies and therefore business cycle predictors between 1994 and 2002, when Hedge Fund AUM was low, correlation has since decreased. The decrease in correlation has coincided with significant increases in hedge fund AUM, and limits to arbitrage have become more relevant in explaining momentum returns. We embed these findings within a broad empirical investigation of time series carry and momentum strategies across 55 futures contracts spanning the asset classes bonds, currencies, commodities, equities and metals. Our results provide a possible avenue for identification strategies to disentangle the role of limited arbitrage effects on futures returns and systematic risks that are associated with time-varying expected returns in explaining momentum returns. Click here for full article
    Jan Danilo Ahmerkamp, Imperial College Business School
    James Grant, Imperial College Business School
  • Crises, Liquidity Shocks, and Fire Sales at Hedge Funds

    We investigate hedge fund stock trading from 1998-2010 to test for fire sales. While funds with high capital outflows sell large amounts of stock during crises, these funds also buy stock, rather than using all the proceeds to fulfill redemptions. Further, funds with large outflows rarely sell the same stocks at the same time. For the relatively few stocks that are sold en masse, there is no evidence of price pressure, largely because hedge funds overwhelmingly choose to sell their most liquid, largest, and best-performing stocks. We provide new and compelling evidence that hedge funds neither engage in nor induce fire sales, since their well-diversified portfolios allow them to cherry-pick the most appropriate stocks to sell during crises. Click here for full article
    Nicole Boyson, Northeastern University
    Jean Helwege, University of South Carolina
    Jan Jindra, Ohio State University
  • Drawdown-Based Stop-Outs and the “Triple Penance” Rule

    We develop a framework for informing the decision of stopping a portfolio manager or investment strategy once it has reached the drawdown or time under water limit associated with a certain confidence level. Under standard portfolio theory assumptions, we show that it takes three times longer to recover from the maximum drawdown than the time it took to produce it, with the same confidence level (“triple penance rule”).

    We provide a theoretical justification to why hedge funds typically set less strict stop-out rules to portfolio managers with higher Sharpe ratios, despite the fact that they should be expected to deliver superior performance. We generalize this framework to the case of first-order serially-correlated investment outcomes, and conclude that ignoring the effect of serial correlation leads to a gross underestimation of the downside potential of hedge fund strategies, by as much as 70%. We also estimate that some hedge funds may be firing more than three times the number of skillful portfolio managers, compared to the number that they were willing to accept, as a result of evaluating their performance through traditional metrics, such as the Sharpe ratio.

    We believe that our closed-formula compact expression for the estimation of drawdown potential, without having to assume IID cashflows, will open new practical applications in risk management, portfolio optimization and capital allocation. The Python code included confirms the accuracy of our solution. Click here for full article
    David H. Bailey, Complex Systems Group Leader, Lawrence Berkeley National Laboratory
    Marcos López de Prado, Head of Global Quantitative Research, Tudor Investment Corporation and Research Affiliate, Lawrence Berkeley National Laboratory
  • The Value of Funds of Hedge Funds: Evidence from their Holdings

    We examine the value of Funds-of-Hedge-Funds (FoFs) using a hand-collected database of the funds' hedge fund holdings. This holdings level data allows us to examine the determinants of hedge fund selection by FoFs, as well the ability to gauge the FoFs' skill at hiring and firing managers. We find that FoFs hire hedge funds that are more difficult for individual investors to access, all else equal. FoFs hire larger, younger hedge funds with more restrictive share liquidity and higher minimum investments. Contrary to the previous literature, we do not find that FoFs perform worse than their single manager peers. Rather, we find evidence that a primary source of FoF value comes via skillful monitoring of their underlying hedge fund investments after the hire date. Specifically, we find that hedge funds that are held by FoFs are less likely to fail. The hazard rate for hedge funds held by FoFs is 57% lower than comparable hedge funds. Further, funds fired by FoFs are more likely to underperform and subsequently fail more often; indicating FoFs have skill in their firing decisions. Click here for full article
    Adam L. Aiken, Quinnipiac University
    Christopher P. Clifford, University of Kentucky
    Jesse Ellis, University of Alabama
  • Trading Losses: A Little Perspective on a Large Problem

    Big losses by traders are back in the news. In September the trial of former Union Bank of Switzerland (UBS) derivatives trader Kweku Adoboli opened in London with jury selection. Adoboli stands accused of four counts of fraud and false accounting in connection with losses of $2.3 billion on apparently unauthorized equity derivatives trades in 2011. The trial comes not long after JPMorgan Chase's credit derivatives traders—including Bruno Iksil, known as the "London Whale" due to the size of his positions lost an estimated $7.5 billion ($5.8 billion in realized losses in addition to $1.7 billion yet to come) on apparently authorized credit default swap trades.
    Since 1990, there have been 15 instances when traders lost at least $1 billion (in 2011 dollars). Trading losses of this size are uncommon but matter when they occur. Shareholders suffer losses, counterparties are exposed to potential settlement failure in over-the-counter markets, bank regulators face the prospect of individual bank insolvencies or even systemic problems in the financial markets, and the public is always on the hook when a bailout is deemed necessary. Click here for full article
    James R. Barth, Senior Finance Fellow, Milken Institute
    Donald McCarthy, Consultant, Econ One Research
  • Exploring Uncharted Territories of the Hedge Fund Industry: Empirical Characteristics of Mega Hedge Fund Firms

    This paper investigates mega hedge fund management companies that manage over 50% of the industry’s assets, incorporating previously unavailable data from those that do not report to commercial databases. We document similarities among mega firms that report performance to commercial databases compared to those that do not. We show that the largest divergences between the performance reporting and non-reporting can be traced to differential exposure to credit markets. Thus the performance of hard-to-observe mega firms can be inferred from observable data. This conclusion is robust to delisting bias and the presence of serially correlated returns. Click here for full article
    Daniel Edelman, Head of Quantitative R&D, Alternative Investment Solutions
    William Fung, Visiting Research Professor, London Business School
    David A. Hsieh, Professor, Fuqua School of Business, Duke University
  • Revisiting Kat's Managed Futures and Hedge Funds: A Match Made in Heaven

    In November 2002, Cass Business School Professor Harry M. Kat, Ph.D. began to circulate a Working Paper entitled Managed Futures and Hedge Funds: A Match Made In Heaven. The Journal of Investment Management subsequently published the paper in the First Quarter of 2004. In the paper, Kat noted that while adding hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility, it also produced an undesired side effect - increased tail risk (lower skew and higher kurtosis). He went on to analyze the effects of adding managed futures to the traditional portfolios, and then of combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios. He found that managed futures were better diversifiers than hedge funds; that they reduced the portfolio's volatility to a greater degree and more quickly than did hedge funds, and without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with the traditional portfolios. Kat's original period of study was June 1994-May 2001. In this paper, we revisit and update Kat's original work. Using similar data for the period June 2001-December 2011, we find that his observations continue to hold true more than 10 years later. During the subsequent 10.5 years, a highly volatile period that included separate stock market drawdowns of 36% and 56%, managed futures have continued to provide more effective and more valuable diversification for portfolios of stocks and bonds than have hedge funds. Click here for full article
    Thomas N. Rollinger, Director of New Strategies Development, Sunrise Capital Partners
  • Segmenting Supply Chain Risk Using E/CTRM Systems: Unifying Theory of Commodity Hedging and Arbitrage

    The complexity of managing physical and financial risk throughout the commodity production, processing and merchandising chain presents numerous challenges. To solve this problem commercials are increasingly turning to Energy and Commodity Transaction Risk Management (E/CTRM) systems. Still, risk management functionality within these systems is reported as falling short of requirements. Our discussion, in response, provides an economic framework for developing commodity risk policy and evaluation tools. In doing so, we unify the theory of normal backwardation with theory of storage, macroeconomic general equilibrium with multiple equilibria and microeconomic agents, basis trading with arbitrage strategies, and the hedging response function with elastic/inelastic supply-demand economics. After establishing axioms and rules of inference, we investigate the agribusiness supply chain to help illustrate application. Click here for full article
    Michael Frankfurter, Partner, IQ3 Solutions Group
  • Send in the Clones? Hedge Fund Replication Using Futures Contracts

    Replication products strive to offer investors some of the benefits of hedge funds while avoiding their high fees, illiquidity, and opacity. We test whether a replication algorithm can deliver the diversification and high Sharpe ratio that investors seek. Our procedure constructs monthly clone returns out-of-sample using fully collateralized futures positions held for one-month, with position sizes determined using rolling window regressions. Clone returns have high correlation with their hedge fund targets, indicating replication is possible. Clones also have high correlation with a buy-and-hold investment in stocks, however, and neither the targets nor their clones demonstrate successful time variation in factor loadings. Click here for full article
    Nicolas P.B. Bollen, Owen Graduate School of Management - Vanderbilt University
    Gregg S. Fisher, President and Chief Investment Officer, Gerstein Fisher
  • The Life Cycle of Hedge Funds: Fund Flows, Size, Competition, and Performance

    This paper analyzes the life cycles of hedge funds. Using the Lipper TASS database it provides category and fund specific factors that affect the survival probability of hedge funds. The findings show that in general, investors chasing individual fund performance, thus increasing fund flows, decrease probabilities of hedge funds liquidating. However, if investors chase a category of hedge funds that has performed well (favorably positioned), then the probability of hedge funds liquidating in this category increases. We interpret this finding as a result of competition among hedge funds in a category. As competition increases, marginal funds are more likely to be liquidated than funds that deliver superior risk-adjusted returns. We also find that there is a concave relationship between performance and lagged assets under management. The implication of this study is that an optimal asset size can be obtained by balancing out the effects of past returns, fund flows, competition, market impact, and favorable category positioning that are modeled in the paper. Hedge funds in capacity constrained and illiquid categories are subject to high market impact, have limited investment opportunities, and are likely to exhibit an optimal size behavior. Click here for full article
    Mila Getmansky, Ph.D., Assistant Professor, Isenberg School of Management, University of Massachusetts
  • Managed Futures and Volatility: Decoupling a "Convex" Relationship with Volatility Cycles

    2011 was a period fraught with turbulence in financial markets. Managed Futures strategies, despite their common association with long volatility, did not fare as well as some might have expected amidst this turbulence. A closer look at volatility, what it means to be long or short volatility, and Managed Futures performance across different regimes in volatility can provide insights into the strategy’s complex or “convex” relationship with volatility. A closer look at the cycles of volatility demonstrates that Managed Futures is able to capture “crisis alpha” for investors over negative volatility cycles, while in certain turbulent periods they also face some of the same “short volatility” risks that plague many hedge fund strategies. Click here for full article
    Kathryn M. Kaminski, PhD., CIO and Founder, Alpha K Capital LLC
  • Lessons from the MF Global Collapse

    In her paper, Ms. Till presents an organized series of events leading up to the downfall of MF Global and subsequently the eighth largest filing of bankruptcy in U.S. history. Click here for full article
    Hilary Till, Principal, Premia Risk Consultancy
  • Contrarian Hedge Funds and Momentum Mutual Funds

    We study how hedge fund performance is related to the presence of mutual funds operating in the same asset class. We argue that hedge funds are able to exploit the constraints of the mutual funds related to both the high correlation between flows and value of investment and their tendency to cater to investors by invest in stocks that are "hot". Hedge funds exploit these features of the mutual funds, especially the domestic ones. We show that the performance of the hedge funds is significantly higher when mutual fund market coverage is higher. This effect is mostly concentrated among domestic mutual funds and is stronger the higher investment horizon of the hedge funds. A high presence of the mutual fund industry helps to explain 28% of the yearly hedge fund performance. Hedge funds are more likely to be "alpha" in the presence of a high degree of mutual fund market coverage and their probability of survival is higher. Hedge funds employ contrarian strategies at the very moment in which mutual funds ride market expectations. The degree by which hedge funds react to changes in public information is directly related to the degree of mutual fund market coverage. Click here for full article
    Massimo Massa, Rothschild Chaired Professor of Banking, Professor of Finance at INSEAD
    Andrei Simonov, Associate Professor Finance, Eli Broad Graduate School of Mgmt., MSU and CEPR; and
    Shan Yan, Eli Broad Graduate School of Mgmt., MSU
  • Revisiting 'Stylized Facts' About Hedge Funds - Insights from a Novel Aggregation of the Main Hedge Fund Databases

    This paper presents new stylized facts about hedge fund performance and data biases based on a novel database aggregation. Our aim is to improve the ability of researchers in this literature to compare results across different studies by highlighting differences between databases and their effect on previously documented results. Using a comprehensive hedge fund database, we document economically important positive risk-adjusted performance of the average fund while differences in magnitude are due to differences in fund size and data biases, but not differences in fund risk exposures. However, this performance does not persist in any of databases when using value-weighted returns; a finding which we show to be linked to fund size and more pronounced biases in certain databases. Hedge funds with greater managerial incentives, smaller funds and younger funds outperform while hedge funds with strict share restrictions are not associated with higher risk-adjusted returns. Overall we find that several stylized facts are sensitive to the choice of the database. To avoid biases, it is therefore important to use a high quality consolidated database such as the one used in this paper. Click here for full article
    Juha Joenväärä, University of Oulu,
    Robert Kosowski, Imperial College Business School, Imperial College, and
    Pekka Tolonen, University of Oulu and GSF
  • Regulated Alternative Funds: The New Conventional

    In what is beginning to seem like the distant past, a clear line had once separated traditional and alternative investment products. But as investors faced multiple market crises and rising volatility, fund managers responded with a range of innovative products designed to better manage volatility and offer alternatives to long-only investing in traditional markets.

    As investor segments and products converge, alternative strategies are increasingly being packaged within registered fund structures originally designed for retail buyers, but also used by institutions and other fund selectors. A growing number of alternative funds are being launched as UCITS (Undertaking for Collective Investment in Transferable Securities), a fund vehicle accepted for sale in countries throughout the European Union and many other nations. Alternatives also are becoming more prominent within U.S. mutual funds (registered under the Investment Company Act of 1940 or, in some cases, under the Securities Act of 1933). The growing popularity of these funds is clearly evident in strong asset flows, product proliferation, and a growing presence in Asian markets.

    One factor driving the popularity of alternative UCITS and mutual funds is the detailed requirements around risk measurement and management, liquidity, counterparty diversification, and limits on leverage. However, the increased use of derivatives and their associated counterparty and operational risks continue to concern investors and regulators alike. The regulatory environment remains in flux as new rules on hedge funds take shape in Europe, and as the framework around UCITS gets reviewed amidst the expansion of more complex products. Yet this too is encouraging further innovation.

    Meanwhile, new frontiers are emerging. Europe and the U.S. have led the way in the adoption of alternative strategies, but other markets are developing a taste for non-correlated funds. One of the biggest retail fund launches in Japan this year was an alternative managed futures strategy. Demand for alternatives is growing among sovereign wealth funds and national pension funds in Asia, Latin America and the Middle East. Wealthy individual investors around the world are also expected to consider alternatives more seriously after their recent experiences with traditional asset classes. Although U.S. institutions and high net worth individuals (HNWIs) can access hedge funds and alternatives directly, they may see the benefits of sourcing such strategies through regulated structures, just as their European counterparts have done. Click here for full article
    contributed by SEI Global Services, Inc. - Investment Manager Services
  • Investor Behavior, Hedge Fund Returns and Strategies

    We quantify risks associated with investor behavior using several asset pricing models and hedge fund data. After finding that irrational sentiments play a role in hedge fund returns, our multi-beta CAPM estimations reveal that beta belonging to irrational component varies around .037 for risky hedge funds and .018 for relatively less risky ones. Investors can use this irrational beta to gauge the extent of irrational sentiments prevailing in markets and compare the values in turbulent periods with more tranquil periods to re-adjust their portfolios and use these betas as an early warning sign. It can also guide investors in avoiding those funds that display greater irrational behavior. Our approach offers investors a solid quantitative rather than subjective approach in assessing the oncoming of a financial downturn and in doing so better protect against unpredicted losses that may result from irrational trading. Click here for full article
    Andres Bello, University of Texas-Pan American,
    Gökçe Soydemir, California State University Stanislaus, and
    Jan Smolarski, University of Texas-Pan American
  • A Review of the G20 Meeting on Agriculture: Addressing Price Volatility in the Food Markets

    Food price volatility has spiked to levels last seen in the 1970s. For low-income countries, food price hikes, such as have occurred recently, tend to significantly increase the incidence of intra-state conflicts, according to IMF research. Therefore, it was fitting and proper that the G20 meeting of agricultural ministers, which was hosted by France at the end of June, put food insecurity squarely at the top of the 2011 G20 agenda.

    The June G20 agricultural meeting resulted in an action plan that will be carried forward at the Cannes Summit of G20 leaders in November.

    The 2007-2008 food crisis, and the resumption of more recent food price spikes, clearly have a number of causes, which will require a great deal of political courage to address and ameliorate. That said, in reviewing over a century of commodity price volatility, there are episodes of low volatility and high volatility, which would indicate that this may be a pattern of recurrent phenomena. As a result, it may be wise to focus on how to manage price volatility rather than believe that this phenomenon can be eradicated, as noted by Dr. Pierre Jacquet of the Agence Française de Développement.

    The World Bank, for example, has launched a program that will assist and encourage companies in developing countries to buy insurance in the derivative markets against sudden changes in food prices, according to the Financial Times. Notably, the action plan, agreed to by the G20 agricultural ministers in June, largely embraces marketbased solutions to the problems of food insecurity and food volatility, amongst its many action items.

    In contrast to the benign view of commodity derivatives trading, French president Nicolas Sarkozy stated at the opening of the June G20 agricultural meeting that "the financialization of agriculture markets . is a contributory factor in price volatility" and that this was a priority issue for regulators to address.

    Ultimately, whether commodity derivatives trading (and speculation) increases price volatility is an empirical question. Assuming that one has access to transparent marketparticipant, position, and price data, one can carry out empirical studies to confirm or challenge this assumption.

    In reviewing the evidence so far regarding the impact of commodity trading, speculation, and index investment on price volatility, this report finds that the evidence for the prosecution does not seem sufficiently compelling at this point. That said, given the disastrous performance of financial institutions in 2007 and especially, in 2008, it is fully appropriate to revisit one's assumptions regarding the economic usefulness of all manner of financial instruments, including commodity derivatives contracts.

    This paper's conclusion is to agree with the World Bank president who has said, "the answer to food price volatility is not to prosecute or block markets, but to use them better." And one sensible use of financial engineering is for hedging volatile food price risk with appropriate commodity derivatives contracts. Click here for full article
    Hilary Till, Research Associate, EDHEC-Risk Institute,
    Principal, Premia Capital Management, LLC
  • Beware of Stranger Originated Life Insurance

    This issue summarizes two recent Delaware court decisions determining the validity of life insurance policies under a stranger originated life insurance program. These decisions are relevant to hedge funds and other investors that purchase life insurance policies for investment purposes. Click here for full article
    Christopher Machera, Hedge Funds Returns
  • Hedge Fund Performance and Liquidity Risk

    This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important predictor of hedge fund performance. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6.5% annually, on average, over the period 1994-2009, while negative performance is observed during liquidity crises. The returns are independent of share restriction, pointing to a possible imbalance between the liquidity a fund offers its investors and the liquidity of its underlying positions. Liquidity risk seems to account for a substantial part of hedge fund performance. The results suggest several practical implications for risk management and manager selection. Click here for full article
    Ronnie Sadka, Boston College, Carroll School of Management
  • The Importance of Business Process Maturity and Automation in Running a Hedge Fund: Know Your Score and Get to the “Sweet Spot”

    Over the past two years, Merlin has published several white pa¬pers that are designed to highlight and help managers imple¬ment industry best practices - from shoring up their business model to identifying their target investors based on the devel¬opment stage of their fund.

    In continuing with this theme, our latest white paper discusses the impor¬tance of business process automation within an asset management firm at all stages of development and how these organizations can measure their current processes versus investor expectations.

    It is critical that business process maturity and automation evolve over the life of a fund in a disciplined and forward-looking manner as they are key components to maintaining a scalable business. As a firm grows, processes that are maintained manually or with home-grown spread¬sheets will stress and may break, adding business risk and overhead to a firm's operations. This concept is especially important for fund manag¬ers because they cannot afford distractions and errors caused by broken or manual processes that affect the viability of the fund. Click here for full article
    by Merlin Securities
  • Hedge Funds: The Good, the (Not-so) Bad, and the Ugly

    This paper proposes a new methodology to evaluate the prevalence of skilled fund managers. We as-sume that each fund's alpha is drawn from one of several distributions based on its skill level (e.g., good, neutral, or bad). For a sample of funds, the composite distribution of alpha is thus a mixture of the underlying distributions. We use the Expectation-Maximization algorithm to infer the proportion of funds of different skill levels and estimate the conditional probability each fund is of a skill type given estimated alpha. Applying our approach to hedge funds over 1994-2009, we find that about 50% of funds have positive skill. Funds identified by our approach as superior persistently deliver high out-of-sample alpha over the next three years. While investors chase past performance, inflows do not reduce fund performance in the near future. Click here for full article
    Yong Chen, Assistant Professor of Finance, Virginia Tech
    Michael Cliff, Vice President, Analysis Group
    Haibei Zhao, PhD student, Georgia State University
  • Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify?

    Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds. Click here for full article
    Stephen J. Brown, New York University Stern School of Business
    Greg N. Gregoriou, State University of New York (Plattsburgh)
    Razvan Pascalau, State University of New York (Plattsburgh)
  • The Market Timing Skills of Hedge Funds During the Financial Crisis

    The performance of a market timer can be measured through the Treynor and Mazuy (1966) model, provided the regression alpha is properly adjusted by using the cost of an option-based replicating portfolio, as shown by Hubner (2010). We adapt this approach to the case of multi-factor models with positive, negative or neutral betas.

    This new approach is applied on a sample of hedge funds whose managers are likely to exhibit market timing skills. We stick to funds that post weekly returns, and analyze three hedge fund strategies in particular: long-short equity, managed futures, and funds of hedge funds. We analyse a particular period during which the managers of these funds are likely to magnify their presumed skills, namely around the financial and banking crisis of 2008.

    Some funds adopt a positive convexity as a response to the US market index, while others have a concave sensitivity to the returns of an emerging market index. Thus, we identify "positive", "mixed" and "negative" market timers. A number of signs indicate that only positive market timers manage to acquire options below their cost, and deliver economic significant performance, even in the midst of the financial crisis. Negative market timers, by contrast, behave as if they were forced to sell options without getting the associated premium. We interpret this behavior as a possible result of fire sales, leading them to liquidate positions under the pressure of repemption orders, and inducing negative performance adjusted for marketing timing. Click here for full article
    Arnaud Cavé, Georges Hubner, and Danielle Sougné
    HEC Management School - University of Liège, Belgium
  • Programmed Obsolescence: The Generic Paradigm in Quantitative Equity Investing and Why It's in Trouble

    Over the past forty years or so, actively managed quantitative equity strategies have become a growing presence within the asset management industry, with numerous competing firms offering a relatively standardized set of products. The vast majority of managers in the benchmark-relative quantitative equity space, which has the largest pool of quant equity assets, relies on what this paper terms the "generic paradigm": valuation and momentum alpha forecasts, highly standardized and often commercially available risk models, and mean-variance portfolio optimization tools. This paper argues that each element in this generic approach to quantitative equity management has become vulnerable to competitive pressure and changes in the nature of global equity trading. As a result, the performance of quant equity strategies in the benchmark-relative space has suffered over the past three years, and generic quant managers are likely to face considerable challenges in attracting additional assets going forward. Managers that eschew the generic approach by deploying more diversified sources of alpha, proprietary risk tools, and innovative approaches to dynamic portfolio optimization are likely to fare better, but to the extent they do, it will likely be on a far smaller scale in terms of aggregate assets under management. Click here for full article
    Tony Foley, Chief Investment Officer, D.E. Shaw Investment Management
  • Crisis Alpha and Risk in Alternative Investment Strategies

    The investment community has heard and is following the siren call of Alternative Investments. Their seductive return properties and the mystique surrounding how they make money has tantalized investors resulting in exponential growth of assets under management. The key issue remains that dynamic strategies in Alternative Investments perform differently and are exposed to a different set of underlying risks than traditional investment vehicles. By taking a closer look into times when markets are stressed or in crisis (often called "tail risk" events), this investment primer will explain how some Alternative Investment strategies provide crisis alpha opportunities while others suffer substantial losses during times of market stress. Crisis alpha opportunities are profits which are gained by exploiting the persistent trends that occur across markets during crisis. By gaining a better understanding of what happens during crisis, the underlying risks in Alternative Investment strategies can be divided into three key groups: price risk, credit risk, and liquidity risk. By understanding and classifying Alternative Investments according to their underlying risks, performance metrics commonly used in this industry can be explained in simpler terms helping investors to use them more effectively as part of a larger investment portfolio strategy or philosophy. Click here for full article
    Kathryn M. Kaminski, Sr. Investment Analyst, RPM Risk & Portfolio Mgmt
    Alexander Mende, Sr. Investment Analyst, RPM Risk & Portfolio Mgmt AB
  • Were Bank Bailouts Effective During the 2007-2009 Financial Crisis? Evidence from Contagion Risk in the Global Hedge Fund Industry

    Using the hedge fund industry as our laboratory, we examine whether bank bailout programs initiated in seven countries during the 2007-2009 global financial crisis reduced contagion risk in the financial system. We test for the likely channel of achieving any such benefits. Reduced fund liquidation probabilities followed bailouts of financial firms offering prime brokerage, custodial and investment advisory services to hedge funds in the short term. However, bailouts did not lead to increased capital levels in bank-related hedge funds. Collectively, our evidence suggests that bailouts helped stem the propagation of contagion through information channels rather than directly through counterparty funding. Click here for full article
    Robert W. Faff, University of Queensland
    Jerry T. Parwada and Kian M. Tan, University of New South Wales
  • The Business of Running a Hedge Fund - Best Practices for Getting to the ‘Green Zone’

    2010 was a transformative year for the hedge fund industry and served as a strong reminder that managing money is not the same as running a business. The significant number of small, mid-size and large fund closures already in 2011 provides continuing evidence of the material, multifaceted challenges facing operators of hedge fund businesses. Managers who understand the distinction between managing money and running a business and who execute both effectively are best positioned to maintain a sustainable and prosperous business - to achieve not only investment alpha, but also enterprise alpha.

    This paper examines the hedge fund business model and is based on our observations and numerous conversations with hedge fund managers, investors and industry experts. Our goal is to share the best practices we have witnessed among "green zone" hedge funds that are well positioned for sustainability across a variety of economic and market conditions. Click here for full article
    Aaron Vermut, Ron Suber, and Patrick McCurdy of Merlin Securities
  • Portfolio Construction Technique: Overlay/Underlay Alternatives Blend

    This paper introduces the portfolio construction technique of Overlay/Underlay Alternatives Blend of CTAs (overlay) and Hedge Funds (underlay). The well-established result, in both industry literature and practice, that adding alternatives to a traditional-only portfolio leads to superior risk-adjusted returns is re-established in this paper. Additionally, it is demonstrated that invoking an overlay/underlay of with CTAs and hedge funds-attainable due to the cash efficiency of futures-is better than investing in either hedge funds or CTAs alone. This finding helps to establish that a "hedge funds versus CTAs" attitude should be replaced by "hedge funds and CTAs." Different nuances of how to blend hedge funds with CTAs are explored. Click here for full article
    Ranjan Bhaduri, PhD, Chief Research Officer, AlphaMetrix Alternative Investment Advisors
  • Can Factor Timing Explain Hedge Fund Alpha?

    Hedge funds are in a better position than mutual funds in timing systematic risk factors because they are less regulated and thus have more freedom to use leverage and short sales. To examine whether factor timing is a source of hedge fund alpha, this paper decomposes excess return generated by hedge funds during 1994 - 2008 into security selection, factor timing, and risk premium using the new measure of performance developed by Lo (2008). I find that security selection on average explains most of the excess return generated by hedge funds, and the contributions of factor timing and risk premium are trivial. In the U.S. equity market, hedge funds on average show negative timing ability especially in recent years that include the financial crisis period of 2007-08. Click here for full article
    Hyuna Park, Assistant Professor of Finance at the College of Business, Minnesota State University
  • On the Economics of Hedge Fund Drawdown Status: Performance, Insurance Selling and Darwinian Selection

    In this paper we study the drawdown status of hedge funds as a hedge fund characteristic related to performance. A hedge fund's drawdown status is the decile to which the fund belongs in the industry's drawdown distribution (at a given point in time). Economic reasoning suggests that both the current level and the past evolution of a fund's drawdown status are informative of key fund aspects, including the manager's talent, as well as fund investors' assessment of the fund, and, hence, are predictive of future performance. The analysis delivers four completely new insights on hedge funds. First, the presence of insurance selling (shorting deep out-of-the-money puts) in the industry is large enough to make portfolios of low drawdown funds weak performers, in general, and bad performers in times of turmoil.

    Second, the market operates a Darwinian selection process according to which funds running large drawdowns for a prolonged period of time (survivers) are managed by truly talented traders who deliver outstanding future performance. Third, a completely new dimension of risk arises as a distinctive feature of hedge funds: risk conditional on survival is tantamount to outstanding performance. Fourth, drawdown status analysis raises serious concerns about the role played by other hedge fund characteristics {such as total delta{ on fund performance and casts doubts on the validity of some performance evaluation measures (such as the Calmar and Sterling ratios) that are widely used in practice. Click here for full article
    Sevinc Cukurova, Universidad Carlos III de Madrid
    Jose M. Marin, IMDEA Social Sciences Institute
  • Capitalizing on Capitol Hill: Informed Trading by Hedge Fund Managers

    In this paper, we examine the hypothesis that hedge fund managers obtain an informational advantage in securities trading through their connections with lobbyists. Using datasets on hedge fund long-equity holdings and lobbying expenses from 1999 to 2008, we show that hedge funds that are connected to lobbyists tend to trade more heavily in politically sensitive stocks than those that do not. We further show that connected hedge funds perform significantly better on their holdings of politically sensitive stocks. Using a difference-in-differences approach, we ?find that connected hedge funds, relative to non-connected ones, outperform by 1.6 to 2.5 percent per month in politically sensitive stocks, relative to non-political stocks. These results suggest that hedge fund managers exploit private information, which can be an important source of their superior performance. Our study provides evidence for the ongoing debate about regulatory reform governing informed trading based on private political information. Click here for full article
    Meng Gao, Risk Management Institute, National University of Singapore
    Jiekun Huang, Department of Finance, NUS Business School
  • Are All Currency Managers Equal?

    We present a post-sample study of currency fund managers showing that alpha hunters and especially alpha generators are more effective in providing diversification benefits for a global equity portfolio than currency managers who earn beta returns from popular style strategies or managers with high total returns regardless of their source. Our study is unusual in that we measure the alpha from currency investing using a simple factor model rather than based on total excess returns, that we use rankings of currency managers from an earlier published study and examine their performance truly out-of-sample, and finally that our data reflect actual trades and returns earned by these managers, so the data are not contaminated by the usual biases in hedge fund databases. Our results suggest that a factor model approach to analyzing currency fund returns, coupled with the revealed degree of alpha and beta persistence in our data, offer institutional investors with large equity exposure a useful tool for improving their performance. Click here for full article
    Momtchil Pojarliev, Hathersage Capital Management
    Richard M. Levich, New York University Stern School of Business
  • Do Funds of Hedge Funds Really Add Value? A 'Post' Crisis Analysis

    In spite of a somewhat disappointing performance throughout the crisis, and a series of high profile scandals, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing out-flows. Can this phenomenon be explained by the failure of funds of hedge funds' managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry? Little attention has been paid so far to the added-value, and the sources of the added-value, of funds of hedge funds. The lack of transparency that is characteristic of the hedge funds arena and makes the performance attribution exercise particularly challenging is probably an explanation. The objective of this article is to fill in the gap. We introduce to this end a return-based attribution model allowing for a full decomposition of funds of hedge funds' performance. The results of our empirical study suggest that funds of hedge funds are funds of funds like others. Strategic Allocation turns out to be a crucial step in the investment process, in that it not only adds value over the long-term, but most importantly, it brings resilience precisely when investors need it the most. Fund Picking, on the other hand, turns out to be a double-edged sword. Overall, funds of hedge funds appear to succeed in overcoming their double fee structure, and add value across market regimes, although to varying degrees and in different forms. Click here for full article
    Serge Darolles, Ph.D., Research Fellow, CREST and Deputy Head R&D, Lyxor Asset Management
    Mathieu Vaissié, Ph.D., Research Associate, EDHEC-Risk Institute and Senior Portfolio Manager, Lyxor Asset Management
  • Hedge Fund Leverage

    We investigate the leverage of hedge funds using both time-series and cross-sectional analysis. Hedge fund leverage is counter-cyclical to the leverage of listed financial intermediaries and decreases prior to the start of the financial crisis in mid-2007. Hedge fund leverage is lowest in early 2009 when the market leverage of investment banks is highest. Changes in hedge fund leverage tend to be more predictable by economy-wide factors than by fund-specific characteristics. In particular, decreases in funding costs and increases in market values both forecast increases in hedge fund leverage. Decreases in fund return volatilities also increase leverage. Click here for full article
    Andrew Angy, Columbia University and NBER
    Sergiy Gorovyyz, Columbia University
    Gregory B. van Inwegenx, Citi Private Bank
  • Regular(ized) Hedge Fund Clones

    This article addresses the problem of portfolio construction in the context of efficient hedge fund investments replication. We propose a modification to the standard à la Sharpe 'style analysis' where we augment the objective function with a penalty proportional to the sum of the absolute values of the replicating asset weights, i.e. the norm of the asset weights vector. This penalty regularizes the optimization problem, with significant impacts on the stability of the resulting asset mix and the risk and return characteristics of the replicating portfolio. Our results suggest that the norm-constrained replicating portfolios exhibit significant correlations with their benchmarks, often higher than 0.9, have a fraction, i.e. about 1/2 to 2/3, of active positions relative to those determined through the standard method, and are obtained with turnover which is in some instances about 1/4 of that for the standard method. Moreover, the extreme risk of the replicating portfolios obtained through the regularization method is always lower than that exhibited by currently available commercial hedge fund investment replication products. Click here for full article
    Daniel Giamouridis, Dept. of Accounting & Finance, Athens University of Economics and Business
    Sandra Paterlini, Center for Quantitative Risk Analysis, Dept. of Statistics, LMU, Munich, Germany
  • Dedicated Short Bias Hedge Funds - Just a one trick pony?

    During the recent period of significant market unrest in 2007 and 2008 dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This study, prompted by this recent episode, investigates the DSB hedge funds performance over an extended sample period, from January 1994 to December 2008. Performance evaluation is carried out both initially at the individual fund level and then on an equally weighted dedicated short bias hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. We conclude that DSB hedge funds are indeed more than a one trick pony. They are a significant source of diversification for investors and produce statistically significant levels of alpha. Our findings are robust to the specification of traditional and alternative risk factors, nonlinearity and the omission of the flattering credit crisis period. Click here for full article
    Ciara Connolly, Dept. of Accounting, Finance & Information Systems
    Mark C. Hutchinson, Dept. of Accounting, Finance & Information Systems and Centre for Investment Research
    University College Cork
  • Replicating Hedge Fund Indices with Optimization Heuristics

    Hedge funds offer desirable risk-return profiles; but we also find high management fees, lack of transparency and worse, very limited liquidity (they are often closed to new investors and disinvestment fees can be prohibitive). This creates an incentive to replicate the attractive features of hedge funds using liquid assets. We investigate this replication problem using monthly data of CS Tremont for the period of 1999 to 2009. Our model uses historical observations and combines tracking accuracy, excess return, and portfolio correlation with the index and the market. Performance is evaluated considering empirical distributions of excess return, final wealth and correlations of the portfolio with the index and the market. The distributions are compiled from a set of portfolio trajectories computed by a resampling procedure. The nonconvex optimization problem arising from our model specification is solved with a heuristic optimization technique. Our preliminary results are encouraging as we can track the indices accurately and enhance performance (e.g. have lower correlation with equity markets). Click here for full article
    Manfred Gilli, University of Geneva and The Swiss Finance Institute
    Enrico Schumann, Gerda Cabej and Jonela Lula
    University of Geneva
  • Absolute Returns Revisited

    The term "absolute returns" has been battered as well as misused by business and politics alike. We aim to clarify. The term stands for an investment philosophy that stands in stark contrast to financial orthodoxy. And that's a good thing. Market heterogeneity with moderately leveraged financial institutions reduces systemic risk. Market homogeneity with excessively leveraged institutions doesn't. After challenging some "axioms" of financial orthodoxy, we introduce PPMPT (Post-post-modern portfolio theory) as an alternative to mean-variance optimization. Click here for full article
    Alexander Ineichen, founder of IR&M and Senior Advisor to Prime Capital
  • The Survival of Exchange-Listed Hedge Funds

    This paper attempts to determine whether exchange-listed hedge funds experience longer lifetimes than non-listed funds, even after factors known to affect survival, such as size and performance, are considered.

    The Kaplan-Meier estimator is used to compare survival times of listed and non-listed funds. The Cox proportional hazards model is used to make the same comparison, but by controlling for additional factors. The accelerated failure time (AFT) regression model is used to estimate the median survival time of hedge funds, based on values of explanatory variables.

    Listed hedge funds tend to be larger and adopt more conservative investment strategies than non-listed funds. Listed funds tend to survive roughly two years longer on average than non-listed funds, and this difference in longevity is persistent even after controlling for factors known to affect survival. Finally, we find that the failure rate of listed funds is substantially lower than that of non-listed funds, but only during the first five years of life. Click here for full article
    Greg N. Gregoriou, SUNY College at Plattsburgh - School of Business and Economics
    François-Serge Lhabitant, Kedge Capital Fund Management & EDHEC Business School
    Fabrice Douglas Rouah, McGill University - Faculty of Management
  • Merlin's Necessary Nine: How to Raise and Retain Institutional Capital

    This article is based on a presentation by Ron Suber at the Feb. 18th event Hedge Funds: Getting to the Next Level By Ron Suber -- Not long ago, pre-2008, hedge fund managers held relative power over investors. Because demand for their products was so high across a range of strategies, they controlled the terms, often with little transparency and very favorable gating provisions. Recent market events and a general scarcity of investors has shifted the power to the investor. While raising and retaining institutional capital has always been challenging, in today's environment hedge fund managers must be more diligent than ever in clearly defining and explaining their process, controls and their differentiation. Worries about performance are now often eclipsed by other concerns such as volatility, liquidity, attribution, transparency and, of course, fraud. The following checklist - we call it the Merlin Necessary Nine - is designed to help hedge fund managers understand and articulate their edge to institutional investors. Click here for full article
    Ron Suber, Sr. Partner and Head of Global Sales & Marketing
    Merlin Securities
  • A Comparison of Quantitative and Qualitative Hedge Funds

    In the last 20 years, the amount of assets managed by quantitative and qualitative hedge funds have grown dramatically. We examine the difference between quantitative and qualitative hedge funds in a variety of ways, including management differences and performance differences. We find that both quantitative and qualitative hedge funds have positive risk-adjusted returns. We also find that overall, quantitative hedge funds as a group have higher s than qualitative hedge funds. The outperformance might be as high as 72 bps per year when considering all risk factors. We also suggest that this additional performance may be due to better timing ability. Click here for full article
    Ludwig Chincarini, CFA, Ph.D., Assistant Professor
    Department of Economics, Pomona College
  • Lies of Capital Lines

    In this paper we examine in detail the qualitative effects caused by the investors sensitivity to mark-to-market and price of liquidity. This distorts CAPM-like portfolio construction causing the Capital Line to become curved and eventually inverted. We show that in the world of strongly concave and non-monotonous Capital Lines, pushing up return targets results in increasing risk but not in increasing return. This is due to the decreasing and eventually negative marginal returns per unit of risk. By chasing returns and prompting investment managers to deliver unsustainable performance, the investment community damages its own chances through a greedy search for yield. Besides negatively skewing the risk-return characteristics, this also amplifies destabilizing pro-cyclical dynamics and increases the component of volatility, which is not accompanied by corresponding return. The latter has profound consequences for investment management and economic policy making. We examine the influence of non-linearity of the Capital Line on the cyclical volatility of capital market and short optionality "negative gamma") profile, implicitly embedded in classical investment approach. We show how to mitigate this negative effect by including long volatility funds in the investment portfolio. We also discuss adverse selection bias among investment managers, created by the investors demand for high unsustainable returns. Since one can only hope that the behaviour of either capital allocators or investment managers will change, we argue that it is left up to regulators to take measures to limit the use of credit and leverage, and to control the self-enforcing mechanism of market destabilization. Click here for full article
    Kirill Ilinski, Fusion Asset Management
    Alexis Pokrovski, Laboratory of Quantum Networks, Institute for Physics, St-Petersburg State University
  • Detecting Crowded Trades in Currency Funds

    The financial crises in 2008 highlights the importance of detecting crowded trades due to the risks they pose to the stability of the financial system and to the global economy. However, there is a perception that crowded trades are difficult to identify. To date, no single measure to capture the crowdedness of a trade or a trading style has developed. We propose a methodology to measure crowded trades and apply it to professional currency managers. Our results suggest that carry became a crowded trading strategy towards the end of Q1 2008, shortly before a massive liquidation of carry trades. The timing suggests a possible adverse relationship between our measure of style crowdedness and the future performance of the trading style. Crowdedness in the trend following and value strategies confirm this hypothesis. We apply our approach to currencies but the methodology is general and could be used to measure the popularity or crowdedness of any trade with an identifiable time series return. Our methodology may offer useful insights regarding the popularity of certain trades - in currencies, gold, or other assets - among hedge funds. Further research in this area might be very relevant for investors, managers and regulators. Click here for full article
    Momtchil Pojarliev, Hathersage Capital Management LLC
    Richard M. Levich, New York University's Leonard N. Stern School of Business
  • Has There Been Excessive Speculation in the US Oil Futures Markets?

    Because many facets of the global oil markets have not been sufficiently transparent, it is unclear how much of the oil-price rally that peaked in July 2008 can be put down to speculation. This uncertainty has led to concerns that there was actually excessive speculation in the oil derivatives markets. In an effort to make the oil markets more transparent, the U.S. Commodity Futures Trading Commission has recently launched the "Disaggregated Commitments of Traders" report. This report includes three years of enhanced market-participant data for twenty-two commodity futures contracts. This report makes it possible to examine whether, over the last three years, speculative position-taking in the exchange-traded oil derivatives markets has been excessive relative to commercial hedging needs. We use a traditional metric for evaluating speculative position-taking and find that this position-taking does not appear to be excessive over the past three years when compared to the scale of commercial hedging at the time. Click here for full article
    Hilary Till, Research Associate, EDHEC-Risk Institute and
    Principal, Premia Capital Management, LLC
  • A New Look at Building Teamwork Portfolios

    The original Superstars versus teamwork (Nov. 8, 2007) was the first in a sequence of research pieces that have persuaded us that the best way to build portfolios of CTAs is to look for low correlation and place your bets there. Correlations appeared to be predictable, especially for portfolios, while Sharpe ratios did not. We found that choosing managers to maximize the portfolio's Sharpe ratio yielded better results than did choosing managers based on their individual Sharpe ratios, and the difference was statistically significant. The teamwork portfolios in that research were constructed, however, using conventional mean/ variance analysis that was based on estimated means, volatilities and correlations. And, when we applied it to the construction of a teamwork index, we found out, quite by accident, that it was unusually sensitive to minor changes in the eligible set. Too sensitive, for that matter, which led us back to the question of just how one should approach the selection of managers for a teamwork portfolio. The flaw, we found, was not in giving past correlations a role in shaping our teamwork portfolios, but in allowing past returns to have any effect at all. As you will see on page 3 (Exhibit 3), past correlations for large enough portfolios of CTAs can be highly predictable while past returns and, by extension, past Sharpe ratios are not. In this new look at that research, we changed two things. First, we formed teamwork portfolios using three different rules. Second, we allowed ourselves to construct new portfolios each year without regard to the costs of dropping and adding managers. The three teamwork rules were these. One used the conventional mean/variance approach to maximize the Sharpe ratio of the portfolio. The other two used only correlations and gave no weight at all to past returns. The first of these, which is illustrated in Exhibit 1, simply calculated the probability that a CTA would have been in a low-average correlation portfolio and chose those with the highest probabilities of inclusion. The second ranked CTAs using each CTA's average return correlation with all others CTAs in the eligible set and chose those with the lowest average correlations. The superstar portfolios were formed by identifying those CTAs who had, over the previous three years, produced the highest individual Sharpe ratios. In a nutshell, what we found is this. First, the teamwork portfolios gave us an edge over the superstar portfolios. While the superstar portfolios delivered the highest Sharpe ratio in two of the eight years, they came in dead last the other six years. In contrast, the correlation-only teamwork portfolios came in first or second in five of the eight years, and came in last only once. Second, the correlation-only approaches gave us two benefits over the conventional mean/variance approach. For one thing, they are more robust. The removal of one or more managers from the eligible set does not materially affect the probability that the remaining low correlation CTAs will end up in the low correlation portfolio. For another, they are more economical and use the eligible CTA set far more sparingly. While the mean/variance portfolios performed almost as well as the correlation-only portfolios, they used 21 of the 42 CTAs over the eight years, while the correlation-only portfolios used only 14. Thus, the mean/variance approach would have dropped and added 11 CTAs, the correlation-only rules would have dropped and added only four. Given the high costs of dropping and adding CTAs, this kind of stability in one's choice of CTAs can be worth a great deal. In the remainder of this note, we review this reworking of our research and conclude with a discussion of how we have applied what we've learned to the construction and management of the AlternativeEdge Teamwork Index. In particular, we take a more complete look at which return statistics are persistent or predictable (volatilities and correlations) and which are not (means and Sharpe ratios); explore two empirical approaches to constructing low correlation portfolios; explain why we volatility weight the CTAs in the AlternativeEdge indices. Click here for full article
    Galen Burghardt and Lianyan Liu
    NewEdge Group
  • The End of Emerging Markets?

    We believe the distinction between emerging markets and developed markets is no longer useful. The differences that justified the segregation of emerging and developed markets have disappeared or are in the process of disappearing. Emerging markets, because of their characteristics, should matter a great deal to investors today. Investors handicap themselves by limiting how much they invest in emerging markets. The term "emerging markets" is obsolete. The end of emerging markets has arrived, as the distinction between emerging markets and developed markets has run the course of its usefulness to investors. Distinctions are disappearing between emerging and developed markets. Emerging markets represent half of the world's economy; they are large and liquid with volatility similar to that of developed markets; and their corporate governance and government policies are no worse than, and in some cases superior to, those of developed markets. There is one measure by which there is still a distinction between emerging markets and developed markets: Growth. We believe that, for the foreseeable future, this differentiation in growth will remain, leading to more attractive investment opportunities in emerging markets than in developed markets. For this reason, investors should focus more on emerging markets than developed markets. Click here for full article
    Everest Capital
  • Do Hedge Fund Managers have Stock-Picking Skills?

    I study novel data from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. These value investors are not easily defined: they exploit traditional tangible asset valuation discrepancies such as buying high book-to-market stocks, but spend more time analyzing intrinsic value, growth measures, and special situation investments. Evidence suggests that the managers' long recommendations earn economic and statistically significant long-term abnormal returns. Oddly enough, these managers share their profitable ideas with other skilled investors. This evidence is puzzling in a world where there is an efficient market for fund managers and asset prices. Click here for full article
    Wesley R. Gray, University of Chicago, Booth School of Business
  • On the Consistency of Hedge Fund Indexes Across Providers

    Based on the style analysis pioneered in [Sharpe, W.F. (1992). Asset Allocation: Management Style and Performance Measurement, Journal of Portfolio Management, 7-19.] I define a procedure to examine the consistency of hedge fund indexes across providers. The results of my investigation suggest that the competing indexes of the different providers are homogeneous. However, I also find two cases for which one provider differently allocates the funds between styles compared to its peers. Click here for full article
    Oliver Dietiker, University of Basel
  • Applying a Global Optimization Algorithm to Fund of Hedge Funds Portfolio Optimization

    Portfolio optimisation for a Fund of Hedge Funds ("FoHF") has to address the asymmetric, non-Gaussian nature of the underlying returns distributions. Furthermore, the objective functions and constraints are not necessarily convex or even smooth. Therefore traditional portfolio optimisation methods such as mean-variance optimisation are not appropriate for such problems and global search optimisation algorithms could serve better to address such problems. Also, in implementing such an approach the goal is to incorporate information as to the future expected outcomes to determine the optimised portfolio rather than optimise a portfolio on historic performance. In this paper, we consider the suitability of global search optimisation algorithms applied to FoHF portfolios, and using one of these algorithms to construct an optimal portfolio of investable hedge fund indices given forecast views of the future and our confidence in such views. Click here for full article
    B. Minsky, International Asset Management Ltd.
    M. Obradovic, School of Mathematical & Physical Sciences, Sussex Univ.
    Q. Tang, School of Mathematical & Physical Sciences, Sussex Univ.
    R. Thapar, International Asset Management Ltd.
  • What is the Optimal Number of Managers in a Fund of Hedge Funds?

    This paper investigates the level and the determinants of the optimal number of hedge fund managers in a Fund of Hedge Funds (FOFs). The paper also analyzes the impact that this level has on the performance and the volatility of returns of the typical FOF. Several important findings emerge. First, we find that the number of underlying hedge funds (HFs) included into a FOF has a negative and significant impact on the volatility of returns but less of an impact on the actual returns. However, if we properly classify the FOFs into several larger categories of interest, we find evidence that the FOFs having between 6 and 10 hedge fund managers perform the best. On average this group of FOFs has assets under management of around $200 million. Second, further evidence shows that there is a positive relationship between the size of the FOF portfolio and the lifetime of the fund. Third, several factors that influence the number of HF managers into a FOF include, but are not limited to the amount of leverage, the redemption frequency, the size of the fund, the total number of assets managed by the FOF manager, whether the fund issues a K-1 schedule for tax purposes, the currency in which the fund trades, the geographical focus, and the strategy pursued. Click here for full article
    Greg N. Gregoriou, Professor of Finance, State University of New York
    Razvan Pascalau, Assistant Professor of Economics, State University of New York
  • Investor Irrationality and Closed-End Hedge Funds

    This study questions the rationality of people investing in HFs. I use a sample of London listed closed-end hedge funds to evaluate two criteria that imply irrational behavior. I nd that the rationality of investors can not be rejected for the majority of time. However, the results also imply that investors react irrationally when facing the worsening economic conditions in the second half of 2008. Click here for full article
    Oliver Dietiker, University of Basel
  • Skill, Luck and the Multi-Product Firm:
    Evidence from Hedge Funds

    We propose that higher skilled firms diversify in equilibrium even though managers exploit idiosyncratic performance shocks to time diversification moves. We formalize this intuition in a mistakefree equilibrium and test our predictions using a large panel dataset on the hedge fund industry 1977- 2006. The results show that returns fall following new fund launches, but are 13 basis points per month higher in diversified firms compared to a matched control sample of focused firms. Consistent with the theory, the evidence suggests that both idiosyncratic performance shocks and systematic differences in skill influence diversification decisions. Click here for full article
    Rui J.P. de Figueiredo, Jr., University of California, Berkeley
    Evan Rawley, University of Pennsylvania
  • Crowded Chickens Farm Fewer Eggs -
    Capacity Constraints in the Hedge Fund Industry Revisited

    We revisit the question of capacity constraints in the hedge fund industry by looking at over 2,000 individual funds operating within ten different strategy segments over the years 1994 to 2006. By first looking at fund specific determinants of alpha returns, we demonstrate that the negative effect of inflows on performance is dominated by a concave size effect and thus nonlinear. Secondly, we investigate how competitive dynamics within a strategy segment influence alpha returns. The finding of a concave relationship between the total size of a segment and individual fund performance supports the notion of limiting capacity constraints on strategy level. While fund specific determinants only apply to funds that generated alpha in the past, strategy segment effects apply to all funds. Click here for full article
    Oliver Weidenmüller and Marno Verbeek
    Rotterdam School of Management, Erasmus University
  • The Good, the Bad or the Expensive? Which Mutual Fund Managers
    Join Hedge Funds?

    Does the mutual fund industry lose its best managers to hedge funds? We find that a mutual fund manager with superior past performance is more likely to start managing an in-house hedge fund while continuing to manage mutual funds. However, a mutual fund manager with poor past performance is more likely to leave the mutual fund industry to manage a hedge fund. Thus, mutual funds appear to use in-house hedge funds to retain the best-performing managers in the face of competition from hedge funds. In addition, the managers of mutual funds with greater expenses are more likely to enter the hedge fund industry. The magnitude of such expenses is negatively related to subsequent performance in the hedge fund industry. Hence, hedge funds do not acquire superior performance for their investors by hiring these expensive managers. Click here for full article
    Prachi Deuskar, University of Illinois at Urbana
    Joshua M. Pollet, Goizueta Business School, Emory University
    Z. Jay Wang, University of Illinois at Urbana
    Lu Zheng, Paul Merage School of Business, University of California Irvine
  • Performance Bias from Strategic Asset Allocation:
    The Case of Funds of Hedge Funds

    Evaluating the performance of portfolio managers has received wide attention in the finance literature. The common practice is to divide performance, which is attributable to active management, into two main components, security selection and market timing. However, the Brinson et al. studies and the controversial debate on the relative importance of asset allocation and security selection reveal that the strategic asset allocation has a significant impact on the performance of an actively managed portfolio. Nevertheless, up to now neither an empirical study has taken that portfolio decisions into account in the performance evaluation nor has anyone previously discussed a possible performance bias which could arise from the strategic asset allocation decisions. Beside its direct influence on the performance of funds of hedge funds, the strategic asset allocation induces a performance bias similar to the timing bias, which results from actively changing the beta of the portfolio of hedge funds by the portfolio manager. Unfortunately, normally the historical portfolio holdings of funds of hedge funds are not available due to their low transparency. In order to estimate the strategic asset allocation of each fund of hedge funds we use Sharpe's [1988, 1992] returns-based style analysis (RBSA), which requires only the monthly performance. By comparing the selectivity and timing performance of 2638 funds of hedge funds, 2095 live funds and 543 dead funds, estimated with Jensen's [1968] model and the timing model of Treynor and Mazuy [1966] using fund specific benchmark portfolios - which reflect the funds' strategic asset allocations - against the selectivity and timing performance estimates generated with traditional hedge fund and fund of hedge funds indices, we document a performance bias which is clearly induced by the strategic asset allocation decision. This bias causes an overestimation of the true selectivity and timing performance of funds of hedge funds. In order to avoid these biases, both academics and practitioners should evaluate the performance of funds of hedge funds against benchmark portfolios which reflect the fund specific strategic asset allocation. Over the period from 1994 - 2006, we find that funds of hedge funds exhibit a negative monthly selectivity performance of -0.1648 and a monthly timing performance of -0.0263. Click here for full article
    Dr. Oliver A. Schwindler, Department of Finance, Bamberg University
  • Lintner Revisited:
    The Benefits of Managed Futures 25 Years Later

    In this paper we attempt to update Professor Lintner's work by demonstrating that the beneficial correlative properties of managed futures presented in his research persist today. Click here for full article
    Ryan Abrams, AlphaMetrix Alternative Investment Advisors, LLC
    Ranjan Bhaduri, AlphaMetrix Alternative Investment Advisors, LLC
    Elizabeth Flores, CME Group
  • Selectivity and Timing Performance of Funds of Hedge Funds:
    A Time-Varying Approach

    This paper empirically examines the time variation of the selectivity and timing performance of funds of hedge funds by employing rolling versions of the performance regression models of Jensen (1968) and Treynor and Mazuy (1966). The analysis is based on a sample of 1,207 funds of hedge funds during January 1994 until December 2006. We propose for the first time a cross-sectional regression method similar to those used by Fama and McBeth (1973) for the analysis of the determinants of the performance of funds of hedge funds. Moreover, we use fund specific style benchmarks, which reflect the performance of the individual strategic asset allocation decision of each fund. Our results show that positive selectivity performance has faded away over the sample period and has become negative in recent years while the timing performance erratically fluctuates around zero. The cross-sectional regression reveals that the importance of the selectivity and timing seems to rotate over time, as both variables show considerable variation over time and different magnitudes in the cross-section. Summing up, we present profound and robust evidence that selectivity performance can be regarded as a good discriminating factor for superior funds of hedge funds. Click here for full article
    Dr. Marco Rummer, Saïd Business School, Oxford University
    Dr. Oliver A. Schwindler, Department of Finance, Bamberg University
  • Recovering Delisting Returns of Hedge Funds

    Numerous hedge funds stop reporting to commercial databases each year. An issue for hedgefund performance estimation is: what delisting return to attribute to such funds? This would be particularly problematic if delisting returns are typically very different from continuing funds' returns. In this paper, we use estimated portfolio holdings for funds-of-funds with reported returns to back out maximum likelihood estimates for hedge-fund delisting returns. The estimated mean delisting return for all exiting funds is small, although statistically significantly different from the average observed returns for all reporting hedge funds. These findings are robust to relaxing several underlying assumptions. Click here for full article
    James E. Hodder, Professor - Finance, University of Wisconsin-Madison
    Dr. Jens Jackwerth, Head Dept of Economics, University of Konstanz
    Olga Kolokolova, Research Asst., University of Konstanz
  • The Impact of Hedge Fund Family Membership on Performance and Market Share

    We study the impact that hedge fund family membership has on performance and market share. Hedge funds from small fund families outperform those from large families by a statistically significant 4.4% per year on a risk-adjusted basis. We investigate the possible causes for this outperformance, and find that regardless of family size, fund families that focus on their core competencies have "core competency" funds with superior performance, while the family's non-core competency funds underperform. We next examine the determinants of hedge fund family market share. A family's market share is positively related to the number and diversity of funds offered, and is also positively related to past fund performance. Finally, we examine the determinants of fund family market share at the fund style/strategy level. Families that focus on their core competencies attract positive and significant market share to these core-competency funds. Hence, by starting new funds only in their family's core competencies, fund managers can enjoy increased market share while their investors enjoy good performance. Click here for full article
    Nicole M. Boyson, Asst. Professor of Finance, Northeastern University
  • How Successful is the G7 in Managing Exchange Rates?

    The paper assesses the extent to which the Group of Seven (G7) has been successful in its management of major currencies since the 1970s. Using an event-study approach, the paper finds evidence that the G7 has been overall effective in moving the US dollar, yen and euro in the intended direction at horizons of up to three months after G7 meetings, but not at longer horizons. While the success of the G7 is partly dependent on the market environment, it is also to a significant degree endogenous to the policy process itself. The findings indicate that the reputation and credibility of the G7, as well as its ability to form and communicate a consensus among individual G7 members, are important determinants for the G7's ability to manage major currencies. The paper concludes by analyzing the factors that help the G7 build reputation and consensus, and by discussing the implications for global economic governance. Click here for full article
    Marcel Fratzscher, Senior Adviser, European Central Bank-Frankfurt
  • The Performance of Funds of Hedge Funds: Do Experience and Size Matter?

    This paper is the first to use quantile regression to analyze the impact of experience and size of funds of hedge funds (FHFs) on performance. In comparison to OLS regression, quantile regression provides a more detailed picture of the influence of size and experience on FHF return behaviour. Hence, it allows us to study the relevance of these factors for various return and risk levels instead of average return and risk, as is the case with OLS regression. Because FHF size and age (as a proxy for experience) are available in a panel setting, we can perform estimations in an unbalanced stacked panel framework. This study analyzes time series and descriptive variables of 649 FHFs drawn from the Lipper TASS Hedge Fund database for the time period January 1996 to August 2007. Our empirical results suggest that experience and size have a negative effect on performance, with a positive curvature at the higher quantiles. At the lower quantiles, however, size has a positive effect with a negative curvature. Both factors show no significant effect at the median. Click here for full article
    Roland Füss, International University Schloss Reichartshausen
    Dieter G. Kaiser, Feri Institutional Advisors GmbH
    Anthony Strittmatter, University of Freiburg
  • Trades of the Living Dead: Style Differences, Style Persistence and Performance of Currency Fund Managers

    We make use of a new database on daily currency fund manager returns over a threeyear period, 2005-08. This higher frequency data allows us to estimate both alpha measures of performance and beta style factors on a yearly basis, which in turn allows us to test for persistence. We find no evidence to support alpha persistence; a manager's alpha in one year is not significantly related to his alpha in the prior year. On the other hand, there is substantial evidence for style persistence; funds that rely on carry, trend or value trading or with a long/short bias toward currency volatility are likely to maintain that style in the following year. In addition, we are able to examine the performance of managers that survive through the entire sample period, versus those that drop out. We find significant differences in both the investment styles of living versus deceased funds, as well as their realized alpha performance measures. We conjecture that both style differences and ineffective market timing, rather than market conditions, have impacted performance outcomes and induced some managers to close their funds. Click here for full article
    Momtchil Pojarliev, Hermes Investment Management Limited
    Richard M. Levich, New York University's Leonard N. Stern School of Business
  • The Rising Costs of Low U.S. Interest Rates

    The Federal Open Market Committee's (FOMC) decision to drastically reduce interest rates over the past year may be viewed positively in hindsight because it prevented a collapse of the U.S. credit markets. But it is more likely that this decision will be remembered for the toll it exacted on the U.S. economy and global markets. After tightening monetary policy for two years, from June 2004 to June 2006, the decision by the FOMC in the autumn of last year to reverse course seems to have provided some short-term relief to U.S. financial institutions and credit markets. But it also has significantly raised the long-term costs and challenges of restoring price stability in the consumer goods and financial markets. Click here for full article
    Ryan Faulkner, President, Faulkner Capital Inc.
  • Credit Risk Transfer, Hedge Funds, and the Supply of Liquidity

    This paper provides a discussion about some recent issues related to the transfer of credit risk (CRT) from the perspective of global liquidity. The CRT market is enormously growing and exhibits major structural shifts in terms of buyers and sellers of protection. I try to address these issues from an options perspective by suggesting that liquidity providing can be understood, in economic terms, as selling put options. The overall conclusion of the paper is that it is not the extent of CRT per se, as often claimed, which causes liquidity related systemic risk, but rather the potential coordination failures of the behavior market participants in adverse market environments. In this context, I critically address the role of investments banks in providing liquidity to hedge funds, and finally, the (limited) access of global banks to central bank liquidity through cross-border collateral trading. Since coordination failures, seen as the major issue of a potential liquidity crisis, is to a large extent a matter of market structure, regulatory actions to improve liquidity should focus on the architecture of the financial system in the first place, not so much on the behavior of individual agents. Market stabilization should therefore be understood as a process of establishing informative markets and adequate infrastructure. Click here for full article
    Heinz Zimmermann, University of Basel, Switzerland
  • Crisis and Hedge Fund Risk

    We study the effect of financial crises on hedge fund risk. Using a regime-switching beta model, we separate systematic and idiosyncratic components of hedge fund exposure. The systematic exposure to various risk factors is conditional on market volatility conditions. We find that in the high-volatility regime (when the market is rolling-down and is likely to be in a crisis state) most strategies are negatively and significantly exposed to the Large-Small and Credit Spread risk factors. This suggests that liquidity risk and credit risk are potentially common factors for different hedge fund strategies in the down-state of the market, when volatility is high and returns are very low. We further explore the possibility that all hedge fund strategies exhibit a high volatility regime of the idiosyncratic risk, which could be attributed to contagion among hedge fund strategies. In our sample this event happened only during the Long-Term Capital Management (LTCM) crisis of 1998. Other crises including the recent subprime mortgage crisis affected hedge funds only through systematic risk factors, and did not cause contagion among hedge funds. Click here for full article
    Monica Billio, University of Venice - Department of Economics
    Mila Getmansky, University of Massachusetts at Amherst
    Loriana Pelizzon, University of Venice - Department of Economics
  • A Portrait of Hedge Fund Investors: Flows, Performance and Smart Money

    We explore the flow-performance interrelation of hedge funds by separating the investment and divestment decisions of investors. We report three main results. First, we find a weak inflow-performance relation at quarterly horizons together with a very steep outflow-performance relation. At annual horizons, these patterns revert. We attribute this differential response time of inflows and outflows to the combined effect of liquidity restrictions, high searching costs and active investors' monitoring. Second, consistent with the theory that performance persistence is more pronounced where money flows are the least responsive, we find remarkable differences in persistence levels across horizons for the subsets of funds experiencing inflows and outflows. Third, we show that investors' limited response capacity precludes them from investing into the subsequent good performers. Conversely, investors appear to be fast and successful in de-allocating from the subsequent poor performers. Click here for full article
    G. Baquer, ESMT European School of Management and Technology
    Marno Verbeek, Rotterdam School of Management, Erasmus University
  • Time Frames, Research Quality and Strategy: The Differentiating Factors for CTAs?

    Studies dealing with the classification of CTAs have not effectively examined the distinction between the time frame these managers trade and the strategies they employ. Nor have such studies examined the information that rigorous due diligence adds to the process of classifying CTA s. This paper utilizes a set of CTA managers screened from the Barclay CTA (Managed Futures) Data Feeder database. Returns of these managers are analyzed using variables in this database as well as information collected in an extensive due diligence review. The results suggest that time frame and strategy are distinct factors in the classification of CTA managers. Furthermore, with ratings derived from the due diligence review, research quality is identified as a separate factor affecting CTA returns. Click here for full article
    Elliot Noma, Amal Alibair, and William T. Long
    Asset Alliance Corporation
  • Do Professional Currency Managers Beat the Benchmark?

    We investigate an index of returns on professionally managed currency funds and a subset of returns from 34 individual currency fund managers. Over the period 1990-2006, excess returns earned by currency fund managers have averaged 25 basis points per month. We examine the relationship of these returns to four factors representing returns based on carry trading, trend-following, value trading and currency volatility. These four factors explain a substantial portion of the variability in index returns in the entire period and in sub-periods. We perform similar regressions for the 34 individual funds, and find many funds where returns are significantly related to these four factors. Our approach impacts the definition of alpha returns from currency speculation, modifying it from the excess return earned by the fund, to only that portion of the excess returns not explained by the four factors. While the impact on measured alpha is substantial, we find that some currency fund managers continued to generate alpha returns in the most recent sample period. Click here for full article
    Momtchil Pojarliev, Hermes Investment Management Limited
    Richard M. Levich, New York University Stern School of Business
  • Is Managed Futures an Asset Class? The Search for the Beta of Commodity Futures

    This paper investigates potential sources of return to speculators in the commodity futures market. Initially, we focus on the classic arbitrage model based on the theories of Keynes (1930), Kaldor (1939), Hicks (1939, 1946), Working (1948) and Brennan (1958). Next our study examines the simplified arbitrage model which references the term structure of the futures price curve and provides rationale for a structural risk premium known as the roll return. We then introduce our theory of roll yield permutations which is derived from integrating the futures price curve with the expected future spot price variable. Last, we investigate Spurgin's (2000) hedging response model from which asymmetric hedging response functions transfer risk premia to speculators.
    Our research indicates that these models have inherent shortcomings in being able to pinpoint a definitive source of structural risk premium within the complexity of the commodity futures markets. We hypothesize that the classic arbitrage pricing theory contains circular logic, and as a consequence, its natural state is disequilibrium, not equilibrium. We extend this hypothesis to suggest that the term structure of the futures price curve, while indicative of a potential roll return benefit, in fact implies a complex series of roll yield permutations. Similarly, the hedging response function elicits a behavioral risk management mechanisms, and therefore, corroborates social reflexivity. Such models are inter-related and each reflects certain qualities and dynamics within the overall futures market paradigm.
    With respect to managed futures, it is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models - the CAPM, arbitrage pricing theory or otherwise - to single-handedly isolate a persistent source of return without that source eventually slipping away. Click here for full article
    Davide Accomazzo, Adjunct Professor of Finance, Pepperdine University
    Michael Frankfurter, Managed Account Research, Inc.
    Principals, Cervino Capital Management, LLC
  • What Happened to the Quants In August 2007?

    During the week of August 6, 2007, a number of quantitative long/short equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwind of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses by triggering stop/loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the long/short equity sector in a completely unrelated set of markets and instruments suggesting that systemic risk in the hedge-fund industry may have increased in recent years. Click here for full article
    Andrew W. Lo, Harris & Harris Group
    Amir E. Khandani, MIT Laboratory for Financial Engineering
  • Conducting Investment Due Diligence on Active Natural-Resource Managers

    Natural-resource managers make or lose their bread-and-butter by structuring active bets in the commodity markets in a variety of ways. Active managers may try to call the market direction correctly; make relative-value bets in the derivatives markets; take on basis risk; invest in natural-resources equities, particularly in emerging markets; or they may trade physical commodities. Active natural-resource managers need to be clearly differentiated from Commodity Trading Advisors (CTA's) and index funds. CTA's (or systematic trend followers) exploit trends in the financial and commodity markets. Indexed commodity funds, in turn, offer the investor pure commodity exposure. The case for institutional investors to include both passive commodities portfolio exposure as well as active commodities management has been made by a variety of industry observers. Until now, however, the subset of active natural-resource managers has not seen the growth in assets that the commodity index funds have seen. Clearly, active natural-resource investing is not nearly as well understood by institutional investors. As such, an institutional investor considering an investment with a naturalresources manager needs to understand the trading strategies, risks, and potential returns in this investment category. This article will focus on the due-diligence process as it applies to investment strategies commonly used by active natural-resource managers. Click here for full article
    John E. Dunn, III, Oak Point Investments
  • FUNDCREATOR - Reply to the Critics

    Since the publication of our first paper on hedge fund replication in 2005, our FundCreator methodology has met with many positive reactions. There have also been some negative responses though. Until now we have not responded to the criticism launched against FundCreator, other than the occasional remark when asked for comments. However, with a number of high profile conferences on the subject coming up this year and early next year and investors clearly becoming confused as a result of the amount of disinformation that is being circulated, in this short paper we will address the 10 most common points of criticism. We will argue that most of these are largely unjustified and fairly trivial at best and no reason whatsoever to doubt the capability of FundCreator to deliver exactly what it promises: returns with predefined statistical properties. Here we go. Click here for full article
    Harry M. Kat and Helder P. Palaro
    Cass Business School
  • Is There Hedge Fund Contagion?

    We examine whether hedge funds are more likely to experience extremely poor returns when equity, fixed income, and currency markets or other hedge funds have extremely poor performance than would be predicted by correlations of hedge fund returns with returns on these markets or with returns of other hedge funds (contagion). First, we consider whether extreme movements in these markets are contagious to Arbitrage, Directional, and Event Driven hedge fund indices. Second, we investigate whether extreme adverse returns in one hedge fund index are contagious to other hedge fund indices. To conduct these examinations, we estimate Poisson regressions using both monthly and daily returns on hedge fund style indices. We find no systematic evidence of contagion from equity, fixed income, and currency markets to hedge fund indices, although the Arbitrage index exhibits evidence of contagion from the equity and currency markets for monthly data. In contrast, we find systematic evidence of contagion across hedge fund styles for both monthly and daily data. Our results provide a new perspective on the systemic risks of hedge funds and suggest that diversification across hedge funds may not help as much as correlations would imply in reducing the probability of very poor returns. Click here for full article
    Nicole M Boyson, Northeastern University
    Christof W. Stahel, George Mason University
    René M. Stulz, Ohio State University
  • A Subprimer on Risk

    Early in 2007, there were concerns about two issues that could wind up causing significant havoc. One was the potential unwind of the yen carry trade, which we covered in our last issue. The other was the weakness in subprime mortgages in the US. At the risk of further cursing the market, it is fair to say that the yen carry trade scenario has not come about as yet. But clearly, the subprime issue has come to a head, and by now has impacted markets directly linked to subprime, such as securitized products and the equity of mortgage lenders, and others where the link is at best indirect, such as corporate credit, leveraged buyouts, and global equities. A postmortem analysis of these market events is premature, since the situation is still quite fluid. A comprehensive analysis of subprime mortgages, the catalyst of our current excitement, is beyond the scope of our efforts here. Still, it is not a market we can ignore, and so we offer some thoughts here on what is particular about subprime, and what we might be able to learn after this storm has blown over. Click here for full article
    Christopher C. Finger, RiskMetrics Group
  • Trading Strategies in the Current Commodity Market Environment

    When I recently co-edited the book, "Intelligent Commodity Investing" (Risk Books, 2007), a risk-management professional asked me if the title of the book is an oxymoron. This question was posed soon after the Amaranth debacle so perhaps the question is an appropriate one. This article will argue that one can indeed intelligently invest in the commodity markets and will briefly touch on three approaches, which in turn are drawn from the "Intelligent Commodity Investing" book. The first two sections of this article will discuss two historically profitable approaches that take into consideration the largely mean-reverting properties of commodity prices. The final section of the article will argue that we are in the midst of a rare trend shift in prices for some commodity markets and will provide some ideas on how to benefit from this shift. Click here for full article
    Hillary Till, Principal, Premia Capital Management, LLC
  • "Carried Away?"

    Dubbed the "Trade of the Decade" by at least one website, it is difficult to imagine a single trading strategy getting more popular attention than the carry trade has over the last eighteen months. Headlines in early 2006 included "Japan's Boom May Explode Yen-Carry Trade" and "Yen Carry Trade to Unwind-Market Crash Alert". Fears rose again in early 2007: in "What keeps bankers awake at night?" the Economist made the carry trade first on its list. But the fears seem to have subsided, with the Economist acknowledging more recently that the carry trade may have gone "Out With a Whimper." Click here for full article
    Christopher C. Finger, RiskMetrics Group
  • Survey of Recent Hedge Fund Articles

    In this article, we provide the busy reader with a survey of articles that were written over the past four years on hedge funds. Specifically, we review the economic basis for hedge fund returns and then discuss some of the logical consequences of these observations. Next, we summarize the general statistical properties of hedge fund strategies. We then examine what the appropriate performance measurement and risk management techniques are for these investments. And lastly, we briefly cover ways that investors can consider incorporating hedge funds within their overall portfolios. Click here for full article
    Hilary Till, Premia Risk Consultancy, LLC
  • Hedge Funds: Myths & Facts

    Never has an industry so extensively studied by "experts" produced such a surplus of myths, misunderstandings, and half-truths. Many of these myths could easily be clarified with a call or two to knowledgeable industry professionals. Too often, a seemingly logical statement that sounds-good-when-you-say-it-fast becomes accepted conventional wisdom despite the reams of evidence weighted against it. Although many of these experts are well-intentioned, they may not be sufficiently well-informed. The solution lies in enhanced collaboration between academia, industry, and the press. Click here for full article
    Ed Easterling, Crestmont Research
  • Performance in the Currency Industry - Is the End Nigh?

    The interest in commodity trading advisers (CTAs) and hedge funds trading purely currency has increased significantly in recent times; this has both been with respect to the number of participants involved and the money-under-management allocated to the sector, Middleton (2006). Performance has suffered over the past couple of years and this has led many to question how sustainable this popularity in currency will be.
    The purpose of this paper is to investigate the downturn in performance experienced by currency programmes over the past couple of years. Active currency indices are used, together with transparent proxies for style, to highlight the importance of assessing performance over as long a period as possible prior to making investment decisions. The paper puts forward some possible explanations for the recent difficulties; investigates whether the investor's appetite for currency as an asset class still remains; and concludes with thoughts on the ways in which participants may have to change in order to adapt to the new environment. Click here for full article
    Amy Middleton, Bank of America
  • Replication - Based Evaluation of Hedge Fund Performance

    In this paper we use the hedge fund return replication technique recently introduced in Kat and Palaro (2005) to evaluate the net-of-fee performance of 875 funds of hedge funds and 2073 individual hedge funds, up to an including November 2006. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 18.6% of the funds of funds and 22.5% of the individual hedge funds in our sample convincingly beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading a diversified basket of liquid futures contracts. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time. This supports the hypothesis that increased assets under management tend to endanger future performance. Click here for full article
    Harry M. Kat, Cass Business School
  • Exploring Value in Hedge Fund Lock Ups: A Sector View

    One of the more notable trends in the hedge fund industry over the past few years is the migration toward more stringent liquidity terms. That is, managers are requiring lock ups of one year or longer and are also lengthening notice periods for redemptions. Numerous reasons exist for this shift including potential SEC registration that may be skirted by employing a lock up of two years or more, a trend toward lesser-liquid underlying investments in an attempt to generate favorable returns and, for lack of a better term, manager greed. The SEC regulation rationale appears moot for the time being given that the mandatory registration requirement has been indefinitely tabled (see Goldstein, et al v. SEC, 2006). The most legitimate argument appears to be the utilization of more strict liquidity terms in order to better match fund assets and liabilities as managers migrate toward lesser-liquid underlying investments. Manager greed on the other hand continues to exemplify a straight forward supply and demand issue: the highest quality managers with the best performance are likely to be more in demand and will best be in a position to dictate lock up requirements.
    Notwithstanding the aforementioned arguments, the question remains as to what longterm value is being added by managers employing more inflexible liquidity terms. In this study we revisit, albeit with a different set of data, the observations of Liang (1999) pertaining to fund lock ups and performance. We then delve further into the data on a sub-strategy basis to determine the extent of value added and to discuss the necessity of lock ups given the nature of the underlying securities employed within each sub-strategy. Click here for full article
    Jeffrey F. Kuchta, CFA
  • Superstars Versus Teamwork

    One of the most powerful tensions in the world of money management is in the pull between assets that perform well on their own and portfolios that perform well. Even the most casual students of finance know about the importance of diversification. But as soon as any one asset turns in a bad performance, the temptation to dump that asset and replace it with something that performed better is nearly irresistible. What we found in this research is that team players outperformed superstars. We found that the difference was statistically significant. We found that in most cases replacing "underperforming" managers with someone who would have been better did little or nothing to improve overall portfolio performance. We did find, though, that firing team players for poor individual performance and replacing them with managers with higher Sharpe ratios seriously degraded the performance of the portfolio. Click here for full article
    Galen Burghardt, Ryan Duncan, Lianyan Liu
    Calyon Financial
  • EDHEC Comments on the Amaranth Case: Early Lessons from the Debacle

    We examine how Amaranth, a respected, diversified multi-strategy hedge fund, could have lost 65% of its $9.2 billion assets in a little over a week. To do so, we take the publicly reported information on the fund's Natural Gas positions as well as its recent gains and losses to infer the sizing of the fund's energy strategies. We find that as of the end of August, the fund's likely daily volatility due to energy trading was about 2%. The fund's losses on 9/15/06 were likely a 9-standard-devation event. We discuss how the fund's strategies were economically defensible in providing liquidity to physical Natural Gas producers and merchants, but find that like Long Term Capital Management, the magnitude of Amaranth's energy position-taking was inappropriate relative to its capital base. Click here for full article
    Hilary Till, EDHEC Risk and Asset Management Research Centre
    and Principal, Premia Capital Management, LLC
  • Is The Case For Investing In Commodities Really That Obvious?

    Although commodity markets have been around for centuries, investors? interest in them has always been quite limited. Over the last few years, however, this has changed completely. Commodities have very quickly become very popular and investment in commodities is growing at an unprecedented rate. It is estimated that over the past few years (institutional) investors have poured $75 billion into commodities and according to a recent institutional investor survey by Barclays Capital, many institutions expect to significantly increase their commodity exposure further over the next three years1. After initially taking a somewhat reserved view on the commodity investment boom, the supply side is rolling out a whole range of commodity-linked products; funds, ETFs, trackers, and all kinds of structured products. Given investors? appetite for and the very healthy profit margins earned on these products, the end of the boom may not be in sight yet. Click here for full article
    Harry M. Kat, Cass Business School
  • Early Reporting Effects on Hedge Fund and CTA Returns

    New research by CISDM and the Barclay Group examines the early reporting habits of hedge funds and CTAs. In the article, "Early Reporting Effects on Hedge Fund and CTA Returns," published in the Journal of Alternative Investments, Fall 2006 issue, it is shown that hedge funds and to a lesser extent CTAs who delay reporting returns often report lower performance than those who report early. Hedge fund and CTA indices published by the Barclay Group are used to demonstrate the differences between early estimates and final numbers. Each month, Barclay's provides an early estimate (usually within the first week of the month) of the previous month's returns by strategy based on reporting managers. Typically within weeks following the early estimate, Barclay's provides a final estimate for the previous month's hedge fund and/or CTA index returns.
    Note that hedge fund and CTA fund/manager returns are reported in the month following the actual month of performance. This provides enough time for firms to properly calculate returns using various administrative reporting services and report them (if desired) to several of the existing hedge fund databases. The Barclay group is one of several firms or organizations currently reporting hedge fund and CTA returns on the industry. Other major hedge fund and CTA index reporting organizations include CISDM and HFR. While some overlap exists among databases managed by various firms and organizations, past research (Jones, 2005) has shown that each database differs as to reporting managers (approximately 50%). Click here for full article
    Thomas Schneeweis, Richard Spurgin, and Sol Waksman
  • What Every Investor Should Know About Commodities. Part II: Multivariate Return Analysis

    In this paper we study the multivariate return properties of a large variety of commodity futures. We find that between commodity groupings (such as metals, energy, etc.) correlations are very low and mostly insignificant whereas within groups they tend to be much stronger. In addition, commodity futures are roughly uncorrelated with stocks and bonds. Still, correlations may vary somewhat over the different phases of the business cycle, suggesting that not all commodities make equally good diversifiers at all times. Copula-based tests do not indicate any deviant behaviour in the tails of the joint return distribution of commodity futures and stocks or bonds. Contrary to equities and bonds, we show that commodity futures returns are positively correlated with unexpected inflation (i.e. 25% on average with CPI inflation as opposed to 30% for equities and 50% for bonds). There are significant differences between the various commodities, however, with energy, metals, cattle, and sugar offering the best hedging potential. Altogether, assuming that the observed regularities will persist, our results confirm that a well-balanced commodity futures portfolio could offer a worthwhile diversification service to the typical traditional investment portfolio. Click here for full article
    Harry M. Kat, Cass Business School
    Roel Oomen, Warwick Business School
  • Absolute Returns in Commodity (Natural Resources) Futures Investments.

    In this chapter, we introduce readers to commodity (natural resource) futures programs. We begin the chapter by describing the present investment landscape as one where return compression in a number of popular hedge fund strategies has led absolute-return investors to investigate other promising return sources. This includes the highly volatile natural-resource markets, which Lammey (2004) describes as a "paradise for speculators."
    The second section of the chapter discusses how (real) spot commodity prices have been in a long-term secular decline, which has meant that in the past, most arguments for investing in commodities have had to rely on one of the two following rationales. An investment in a commodity futures program has had to (1) capture cyclical opportunities, or (2) provide an inherent risk premium that has only been available in certain futures markets. This latter concept is admittedly esoteric and will be explained later in this chapter.
    In the chapter's third section we will argue that current commodity investment programs, which are designed to either capture cyclical opportunities or monetize risk premia, are still valid in the current environment. But we will further note that one can also make a plausible case for investing in commodities based on increases in spot commodity prices. The 1990's were marked by "a series of unusually favorable supply shocks," which may not be the case going forward, as O'Neill of Goldman Sachs et al. (2004) have warned. In the concluding section of the article, we will outline the risk management requirements for a commodity investment program, given that absolute-return investors require that hedge funds control downside risk rather than just "capture the premium of the asset class," as Ineichen of UBS (2003) has explained. Click here for full article
    Hilary Till, Premia Capital Management
    Jodie Gunzberg,Ibbotson Associates
  • Does Optimizing Fund Growth Require Managerial Skill?

    Optimizing fund growth maximizes fund value. We argue that growth in fund size results from managerial skill. To test this argument, we estimate a model that links fund growth to performance characteristics. We use the model to isolate significant performance characteristics, and then confirm that the model has predictive power out-of-sample. This predictive ability suggests that a manger can employ strategies to optimize his fund's size and hence maximize overall fund value, thus demonstrating skill.
    Click here for full article Paul Lajbcygier
    Clayton School of IT, Monash University, Australia
  • Future Risk

    In November, we discussed risk modeling of credit spreads. We raised two broad questions. First, we asked which market should we look to for information. And when credit is traded in more than one market, should we choose the one with the greatest liquidity, or the one that most closely matches our position? Second, we asked what made a time series useful as a risk factor, and whether we could choose among a variety of definitions of spread to obtain the best properties for forecasting purposes. A third question we could have asked, but did not, was how we should model the volatility once we had obtained a useful time series. We picked up that question in our December note.
    In this note, we ask the first two questions again, but for futures contracts rather than credit spreads. As we will discuss, there are modeling choices we have applied for a long time which, while serving us well broadly, are in fact questionable in specific cases. Moreover, it is never a bad thing to return to models that have been around a while, and revisit the thinking that led us to those choices in the past.
    Click here for full article Christopher Finger and Luis O'Shea
  • Separating the Wheat from the Chaff: Backwardation as the Long-Term Driver of Commodity Futures Performance.

    We examine the role of backwardation in the performance of passive long positions in soybeans, corn and wheat futures over the period, 1950 to 2004. We find that over this period, backwardation has been highly predictive of the return of a passive long futures position when measured over long investment horizons. The share of return variance explained by backwardation rises from 24% at a one-year horizon to 64% using five-year time periods. A historical examination of soybean production and trading suggests that the profitability of a passive long soybean position during the early part of our sample may have resulted from inadequate inventories and storage facilities at the time. These conditions created the conditions for demand-driven price spikes. Further, the thin margins of soybean processors likely increased hedging demand. The implications for commodity investing are considered. Click here for full article
    Barry Feldman, Russell Investment Group and Prism Analytics
    Hilary Till, Premia Capital
  • What Every Investor Should Know About Commodities. Part I: Univariate Return Analysis.

    In this paper we study the univariate return properties of a large variety of commodity futures. Our analysis shows that the volatility of commodity futures is comparable to that of US large cap stocks. Yet, with the exception of energy, a consistently positive risk premium is lacking in commodity futures. We also find that for many commodities, futures returns and volatility can vary considerably over different phases of the business cycle, under different monetary conditions as well as with the shape of the futures curve. Skewness in commodity futures returns is largely insignificant, whereas kurtosis is significantly positive and comparable to that of US large cap stocks. In almost all commodities we find significant degrees of autocorrelation, which affects the properties of longer horizon returns. Click here for full article
    Harry M. Kat, Cass Business School
    Roel C.A. Oomen, Warwick Business School
  • Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds

    In this paper we use the hedge fund return replication technique recently introduced by Kat and Palaro (2005) to evaluate the net-of-fee performance of 1917 individual hedge funds. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 17.7% of the hedge funds in our sample beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading S&P 500, T-bond and Eurodollar futures. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time. This supports the hypothesis that increased assets under management endanger future performance. Click here for full article
    Harry M. Kat and Helder P. Palaro
    Cass Business School
  • Hedge Fund Transparency Increasing, 2005 Hedge Fund Database Study
    Strategic Financial Solutions

    January 5, 2006 - NEW YORK - Strategic Financial Solutions, LLC, (SFS) creator of the world's leading asset allocation and investment analysis software, the PerTrac Desktop Analytical Platform, is pleased to present the aggregate results of the 2005 SFS Hedge Fund Database Study, an annual report that aims to shed additional light on the hedge fund industry. Click here for full article
  • Does a Change in Risk Regime Spell Trouble for Hedge Funds?
    Conquest Capital Group LLC

    The risk-adjusted returns since inception of most hedge fund indices have been enhanced by a favorable environment and could be susceptible to a decrease in market risk appetite. However, this vulnerability is not uniform; managed futures strategies have proven more robust than other hedge fund strategies, yielding positive returns under both risk-seeking and risk-averse conditions.
    Risk-averse periods tend to cluster and therefore the current state of market risk appetite provides information about the future state of market risk appetite. These effects in combination mean that it is possible to enhance portfolio performance by combining a measure of risk aversion with allocations to the managed futures space. Click here for full article
  • Volatility, Leverage and Returns

    In this paper, we attempt to fill this gap by developing a fundamental framework to project future market volatility. We then apply it to current conditions, expecting in 2006 a rebound in market volatility from depressed levels, but with high volatility delayed to 2007-08. We draw implication for asset returns, active returns, and for what policy markets should be looking out for. We come up with some expected results, but also with quite a few surprises (at least to us). Among these are that leverage by investors tends to lag, rather than lead market volatility; that corporate leverage and macroeconomic volatility are more causally related to market volatility; that hedge funds seem very reluctant to raise leverage, in contrast to banks; and that active investors tend to do poorly when volatility rises unexpectedly. Click here for full article
    Jan Loeys and Nikolaos Panigirtzoglou
    J.P. Morgan
  • A Critique of the Sharpe Ratio

    The Sharpe ratio is a statistic which aims to sum up the desirability of a risky investment strategy or instrument by dividing the average period return in excess of the risk-free rate by the standard deviation of the return generating process. Devised in 1966 as a measure of performance for mutual funds, it undoubtedly has some value as a measure of strategy "quality", but it also has several crucial limitations (see Sharpe 1994 for a recent restatement and review of its principles). Furthermore, its widespread and often indiscriminate adoption as a quality measure is leading to distortion of proper investment priorities, as investment firms manipulate strategies and data to maximise it. Click here for full article
    David Harding, Winton Capital Management
  • 2005 Alternative Investor Survey

    Over 1,000 representatives from 650 firms completed the 2005 Deutsche Bank Alternative Investment Survey. These 650 investors represent $645 billion dollars in direct hedge fund assets, which we estimate is nearly two-thirds of all assets in the hedge fund industry. We asked each respondent to categorize themselves as a fund of funds, bank, corporation, consultant, insurance company, pension, endowment, foundation, family office or high net worth individual. We received responses from all these investor types, with a particularly strong showing from pensions, endowments and foundations, comprising 18% of respondents. Family offices and high net worth individuals are also well represented, at 15%. Funds of funds represent the largest group, with 43% of all responses. We polled investors from all over the world, with roughly half from the United States and more than a third from Europe. Click here for full article
    Deutsche Bank's Hedge Fund Capital Group
  • The Right Place for Alternative Betas in Hedge Fund Performance: An Answer to the Capacity Effect Fantasy

    Two studies, by Watson Wyatt and UBS (both from March 2005), give a pessimistic view of the hedge fund industry's capacity to generate long-term returns, due to its increasing size. Unfortunately, these studies focus almost exclusively on alpha. In the present paper, we show the importance of considering not only the exposure to the market (the traditional beta), but also the other exposures (the alternative betas) to cover all the sources of hedge fund returns. To do so, we examine the real extent to which the variability and level of hedge fund returns are affected by (static) betas, dynamic betas (i.e. factor timing), and pure alpha (i.e. security selection). Click here for full article
    Walter Gehin and Mathieu Vaissie
    Edhec Risk and Asset Management Research Centre
  • Hedge Fund Returns: You Can Make Them Yourself!

    Over the last 10 years hedge funds have become very popular with high net worth investors and are currently well on their way to acquire a significant allocation from many institutional investors as well. The growing popularity of hedge funds and the availability of various hedge fund databases have spawned several hundreds of academic research papers on various aspects of the hedge fund industry and especially the risk-return performance of hedge funds and fund of funds. Many of these papers apply methods, like standard mean-variance and Sharpe ratio analysis for example, which are ill-suited for the analysis of hedge funds returns and have, as a result, produced incorrect conclusions. Fortunately, some studies have taken a more sophisticated approach and have made it clear that hedge fund returns are not really superior to the returns on traditional asset classes, but primarily just different. With hedge fund performance getting worse every year, the hedge fund industry has come to more or less the same conclusion. Unlike in the early days, hedge funds are no longer sold on the promise of superior performance, but more and more on the back of a diversification argument: due to their low correlation with stocks and bonds, hedge funds can significantly reduce the risk (as measured by the standard deviation) of a traditional investment portfolio without giving up expected return. Once we accept that hedge fund returns are not superior, but just different, the obvious next question is: is it possible to generate hedge fund-like returns ourselves by mechanically trading stocks and bonds (either in the cash or futures markets)? Although hedge fund managers typically put a lot of effort into generating their returns, maybe it is possible to generate very similar returns in a much more mechanical way and with a lot less effort. If it is, we may be able to do without expensive hedge fund managers and all the hassle, including the due diligence, the lack of liquidity, the lack of transparency, the lack of capacity, and the fear for style drift, which comes with investing in hedge funds. There might well be more than one road leading to Rome. Based on earlier work into hedge fund return replication by Amin and Kat (2003), we have done a lot of research in this area, which has lead to the development of a 3 general procedure that allows us to design simple trading strategies in stock index, bond, currency and interest rate futures that generate returns with statistical properties that are very similar to those of hedge funds, or any other type of managed fund for that matter. In what follows, we briefly describe this procedure as well as provide some examples of the procedure?s amazing results. Click here for full article
    Harry Kat, Helder P. Palaro
  • Falling Knives Around the World

    U.S. stock market from 1986 through 2002. While the falling knives we identified did post a relatively high bankruptcy rate over the three-year period following their initial drop, they also outperformed the S&P 500 by wide margins. We followed up our study of U.S.-based falling knives by extending our falling knife analysis to markets outside the United States - and we concluded that non-U.S. knives also tended to outdistance their benchmarks. What's new in this paper? First, we study both U.S. and non-U.S. falling knives over a synchronized time period: 1980 through the end of 2003. As a result, our analysis now includes many falling knives that were generated in 2000, when the generally high valuation levels of the late 1990s began to wind down amid the collapse of the technology stock bubble. We also take an in-depth look at falling knives over time, by sector, and - for non-U.S. knives - on a country-by-country basis. In addition, we test market capitalization and enterprise-value-to-sales ratios as possible predictors of falling knife performance. Click here for full article
    The Brandes University
  • The Big One... The Asian Dollar

    Demographics, climate change, debt problems, deficit worries: the list of potential life changing events goes on. Yet there is one other decision that could overwhelm all these. If Asia - from Japan to China - formally begins to use the US dollar as their standard of value it will change the outlook for asset prices for decades to come. The idea is not fantasy. China's latest infusion of cash into State banks suggests that floating the RMB may not be as high on the political agenda as some hope. Moreover, the long-term Yen outlook looks far from assured. A simple pan-Asian dollar fix would drive Asian asset prices sky-high. And it's happened before: Japan fixed to the US dollar in 1949 at Y360 and Hong Kong fixed in 1983 at HK$7.80. Both markets subsequently enjoyed sharp increases in asset prices. Click here for full article
    CrossBorder Capital
  • Is Indexing Suitable for Hedge Fund Investing?

    Hedge funds have become increasingly popular among institutional investors due to their potential for generating positive returns in any market environment. The recent growth in the number, style, and complexity of these investments has increased the importance of the fund-offunds service provider. More recently, investable hedge fund indices have emerged to represent a quasi-passive low-cost beta approach to hedge fund investing. On the other hand, fund-of-funds are being relied upon to provide manager selection, due diligence, asset allocation, and riskmonitoring advice to institutional investors who are resource-constrained; they are viewed as an active alpha-producing investment when compared with rules-based hedge fund indices. In this paper, we outline the theoretical and practical challenges of applying an investable index-based approach to an actively managed hedge fund industry, and seek to identify the potential value that fund-of-funds may provide. Click here for full article
    Jim Tomeo, Rob Covino, and Brian Chung
    SSaris Advisors, LLC
  • The Continuing Case for Emerging Markets, Revisited

    In February 2004, Everest Capital authored a White Paper titled "The Continuing Case for Emerging Markets" highlighting our positive outlook for emerging markets equities. We revisit our thesis below, and reiterate our favorable view for the performance of the asset class. Click here for full article
    Everest Capital
  • Hedge Funds Have Alpha is a Hypothesis Worth Testing

    In this article, we describe the reasons traditional performance evaluation approaches do not work-for traditional investments as well as hedge funds. However, unlike previous articles that have simply documented the problems, we offer a solution: Namely, performance evaluation in general, and hedge fund performance evaluation in particular, should be viewed as a hypothesis test where we assess the validity of the hypothesis "Performance is good." To accept or reject this hypothesis, the textbooks say you should construct all of the possible outcomes and see where the actual performance result falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not. In other words, the hypothesis test gives us a chance to determine if a manager truly has the skill to outperform a group of monkeys randomly playing the same game. Click here for full article
    Ron Surz, PPCA
  • The Scrap Steel Standard

    The two most remarkable features in financial markets in recent years have been the plunge in stock market volatility and the bull market in credits. Together they have helped to sustain high valuation levels across world equity markets. Yet the two features are closely linked: their common factor being monetary policy, or more accurately monetary stability. In short, low currency market volatility has led to low stock market volatility, which, in turn, has fuelled the appetite for credit. We argue in this report that the world economy is operating two monetary standards. One looks rock steady; the other appears close to change. The bottom line is that financial markets may be nearer to the fault line than most investors believe. Volatility could jump and credits blow out. Click here for full article
    CrossBorder Capital
  • On the Role of Hedge Funds in Institutional Portfolios

    Hedge funds do not easily fit into the current way institutions go about investing. Based on a survey of recent academic and practitioner research, this article reviews six competing frameworks for how to incorporate hedge funds in institutional portfolios. Each framework has very different implications for institutional asset allocation, manager selection, and benchmarking. Click here for full article
    Hilary Till, Premia Risk Consultancy, Inc.
  • Investable Hedge Fund Indices

    Investable Hedge Fund Indices (IHFI's) have grown in numbers since the first meaningful introduction of these during 2003. While making their presence wide spread through a number of main providers, investors have been left with the task of considering whether or not IHFI's achieve in practice a better if not outright alternative to established Hedge Funds of Funds (HFOF's ). What the assessments provided by this report show is that IHFI's are not very different to HFOF's and in many ways HFOF's remain a more viable alternative. Large dispersions are shown to exist for the same types of Hedge Fund Strategies amongst the different IHFI providers. The subscription and redemption costs, notice periods and annual fees make the actual performance which investors can expect to realise from Buy and Hold investing, substantially less than that reported for the underlying indices on which the IHFI's are based. In summary, many practical challenges remain open with investing in IHFI's and will require considerable time and resources to shift the vote towards IHFI's away from HFOF's if at all. Click here for full article
    Jacobson Fund Managers Ltd
  • The Role of Long/Short Equity Hedge Funds in Investment Portfolios

    Long/short equity hedge funds have historically outperformed traditional long equity exposure with lower risk. This is a result of a demonstrated capability by long/short managers to generate alpha via stock selection, rotation in and out of cash and timely shifts in market exposures (e.g. large vs. small capitalization, sector, geography, etc). As a consequence, long/short managers have tended to generate a highly favorable characteristic: a higher correlation to equity markets in rising markets and lower correlation in falling markets (sometimes referred to as an "asymmetrical" risk/return profile). Over the past decade, assets under management by long/short equity hedge funds have grown more than 20% annually. This expansion was the most rapid of any hedge fund strategy and long/short managers have displaced global macro funds to claim the largest share of industry assets. Although a portion of this growth in long/short assets was attributable to market appreciation, the demonstrated ability of the managers themselves was also a key factor stimulating inflows. In my view, the optimum portfolio allocation should include adequate doses of "unconstrained" long/short managers in lieu of passive or active long equity exposure. Indeed, if one relies solely on the historical performance record, long/short managers would entirely displace traditional long-only managers. This view holds up even when long/short manager returns are liberally adjusted downward to reflect possible survivor bias. And while there is no guarantee that long/short manager performance will hold up in the future, it would take a severe deterioration in manager capabilities to justify no allocation, in my opinion. There is no one preeminent asset allocation scheme for delineating the role of long/short hedge funds in portfolios-it depends on an investor's current positions and portfolio management structure. Approaches include allocating to an aggregate long/short category and populating the space with generalist managers that invest broadly. Alternatively, one can distinguish between geographic markets (developed, emerging, etc) or invest in styles (value/growth) as part of the overall equity allocation. In this article, I make the case for incorporating the alpha-generating capabilities and the implicit beta exposure of long/short managers explicitly in the asset allocation process. The first section reviews the evolution of long/short hedge funds. The performance characteristics of the long/short managers are then reviewed in the second section. The third section describes the basic determinants of long/short manager returns. This is followed by an analysis of what allocations to long/short managers might make sense. The final section discusses the attributes of various long/short managers who specialize in sectors. The key conclusion is that long/short managers have a demonstrated ability to outperform on a risk-adjusted basis compared to most long-only vehicles. I believe substantial allocations to these managers are appropriate regardless of whether one views them as a substitute for active equity managers or as a stand-alone hedge fund strategy. Click here for full article
    R. McFall Lamm, Jr., DB Absolute Return Strategies
  • The Capacity Implications of the Search for Alpha

    Anjilvel et al [2001] emphasize the "alpha advantage" of hedge fund managers. They write, "Our research has shown that a significant proportion of the total return to hedge funds in the past has been alpha, in contrast with a small negative total alpha for mutual funds ." They hypothesize, "One possible explanation for an 'alpha advantage' . is that . [the active managers] can forecast expected returns better than others. This means a significant ability to exploit market inefficiencies to outperform their benchmarks, presumably by virtue of skill, knowledge, and insight." This view of hedge fund management has a direct impact on the potential capacity of the hedge fund industry. To figure out the capacity of the hedge fund industry, we start by quoting from Cochrane [1999]: ". the average investor must hold the market so portfolio decisions must be driven by differences between an investor and the average investor." If hedge funds are exploiting market inefficiencies, this means that other investors are supplying those inefficiencies. This means that, unfortunately, we can't all profit from exploiting inefficiencies. Therefore, there is a natural cap on the potential size of the hedge fund industry, assuming that hedge funds are indeed exploiting inefficiencies rather than taking in risk premiums. Click here for full article
    Hilary Till, Premia Risk Consultancy, Inc.
  • Facts and Fantasies About Commodity Futures

    We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and December of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation. Click here for full article
    K. Geert Rouwenhorst, Gary Gorton
    Yale School of Management, University of Pennsylvania
  • Fund of Hedge Funds Portfolio Selection: A Multiple-Objective Approach

    This paper incorporates investor preferences for return distributions' higher moments into a Polynomial Goal Programming (PGP) optimisation model. This allows us to solve for multiple competing hedge fund allocation objectives within a mean-variance-skewness-kurtosis framework. Our empirical analysis underlines the existence of significant differences in the return behaviour of different hedge fund strategies. Irrespective of investor preferences, the PGP optimal portfolios contain hardly any allocation to long/short equity, distressed securities, and emerging markets funds. Equity market neutral and global macro funds on the other hand tend to receive very high allocations, primarily due to their low co-variance, high co-skewness and low co-kurtosis properties. More specifically, equity market neutral funds act as volatility and kurtosis reducers, while global macro funds act as portfolio skewness enhancers. In PGP optimal portfolios of stocks, bonds, and hedge funds, where equity exposure tends to be traded off for hedge fund exposure, we observe a similar preference for equity market neutral and global macro funds. Click here for full article
    Ryan J. Davies, Harry M. Kat, and Sa Lu
  • Weighing the Cost of Illiquidity

    Illiquidity is a common feature of alternative investments, but the diversity of hedge fund investments - including OTC derivatives - present special challenges. Hilary Till of Premia Capital Management reviews developments in quantitative techniques for evaluating the effect on performance. Click here for full article
    Hilary Till, Premia Capital Management
  • Regulatory Analysis of Use of Security Futures Products by Investment Advisers, Investment Companies, Hedge Funds, Commodity Pools and Commodity Trading Advisors

    OneChicago, LLC has asked Gardner Carton & Douglas LLP to summarize the regulatory implications for funds and their advisors of investing or trading in security futures products ("SFPs"). SFPs are unique in that they are both securities and futures. Funds and investment managers must understand how the use of SFPs may affect their existing registrations and/or exemptions or trigger the need for new registrations or exemptions. To navigate the analysis, we have created separate links for each type of fund or advisor. To view a summary of the regulatory implications of using SFPs, click on to the link that corresponds to the situation that is relevant to you. Of course, if more than one situation is relevant to you, you should review each relevant link. The accompanying regulatory analysis is not intended to be exhaustive. It does not include an analysis of the implications of using SFPs under the Securities Act of 1933 or Securities Exchange Act of 1934. Further, this analysis is not legal advice, which may often turn on specific facts. Readers should seek specific legal advice from qualified counsel before acting with regard to the subjects mentioned here. Click here for full article
    David Matteson, Gardner Carton & Douglas
  • Managed Futures Can Save Your Tail

    Some investors who are unfamiliar with managed futures are nervous about the volatility of the asset class. Unbeknownst to them, they may be missing an opportunity to reduce the overall risk of loss in their investment portfolios. Historically, diversified investment portfolios perform better and are less volatile when they include managed futures investments. Considering that returns from managed futures tend to be highly volatile, these assertions are counterintuitive. A clearer understanding of how this happens is obtained by studying the nature of managed futures' returns and their correlation to stocks and bonds, especially during times of stress for financial markets. Click here for full article
    Steven Koomar, KV1 Asset Management LLC
  • Hedge Fund Performance and Persistence in Bull and Bear Markets

    The paper tests the performance of 2894 hedge funds in a time period that encompasses unambiguously bullish and bearish trends whose pivot is commonly set at March 2000. Our database proves to be fairly trustable with respect to the most important biases in hedge fund studies, despite the high attrition rate of funds observed in the down market. We apply an original ten-factor composite performance model that achieves very significance levels. The analysis of performance indicates that most hedge funds significantly out-performed the market during the whole test period, mostly thanks to the bullish sub-period. In contrast, no significant under-performance of individual hedge fund strategies is observed when markets headed south. The analysis of persistence yields very similar results, with most of the predictability being found among middle performers during the bullish period. However, the Market Neutral strategy represents a remarkable exception, as abnormal performance is sustained throughtout and significant persistence can be found between the 20% and 69% best performers in this category, probably thanks to an extreme adaptability and a very active investment behavior. Click here for full article
    Daniel Capocci, Albert Corhay, and Georges Hubner
    University of Liege (Belgium)
  • The Continuing Case for Emerging Markets

    Emerging markets have not yet fully made their way back onto investors' radar screens. Those who have not looked at the asset class since the turmoil of the late 1990s may be surprised by what they find a mere five years later. Largely unnoticed, emerging markets have outperformed developed markets over the past one-, three- and five-year periods. Investment inflows into the asset class finally showed renewed signs of life in late 2003, following net outflows over the previous five years. This lack of investor interest was in stark contrast to the acceleration of foreign direct investment (FDI) during the same period. Click here for full article
    Everest Capital
  • Alternative RAPMs for Alternative Investments

    The paper highlights the inadequacies of the traditional RAPMs (Risk-Adjusted Performance Measures) and proposes AIRAP (Alternative Investments Risk Adjusted Performance), based on Expected Utility theory, as a RAPM better suited to Alternative Investments. AIRAP is the implied certain return that a risk-averse investor would trade off for holding risky assets. AIRAP captures the full distribution, penalizes for volatility and leverage, is customizable by risk aversion, works with negative mean returns, eschews moment estimation or convergence requirements and can dovetail with stressed scenarios or regime-switching models. A modified Sharpe Ratio is proposed. The results are contrasted with Sharpe, Treynor and Jensen rankings to show significant divergence. Evidence of non-normality and the tradeoff between mean-variance merits vis-à-vis high moment risks is noted. The dependence of optimal leverage on risk aversion and track record is noted. The results have implications for manager selection and fund of hedge funds portfolio construction. Click here for full article
    Milind Sharma, Merrill Lynch
  • A Detailed Analysis of the Construction Methods and Management
    Principles of Hedge Fund Indices - Are All Hedge Fund Indices
    Created Equal?

    His analysis highlights the strengths and weaknesses of the various hedge fund indices available in the market. Click here for full article
    Mathieu Vaissii, EDHEC
  • Beware of Systematic Style Biases

    Marc Goodman, Kenneth Shewer and Richard Horwitz make the case that the style-based tailwinds that equity hedge funds have enjoyed over the past few years will shift, and could become dangerous headwinds for the unaware investor. Click here for full article
    Marc Goodman, Kenneth Shewer and Richard Horvitz
    Kenmar Global Investment
  • Squeezing the Best from Hedge Fund Diversification

    Marc Goodman, Kenneth Shewer and Richard Horwitz explore whether hedge funds and fund of funds provide risk-efficient diversification, and how institutional investors can best allocate assets to achieve a superior risk/return relationship. Click here for full article
    Marc Goodman, Kenneth Shewer and Richard Horvitz
    Kenmar Global Investment
  • What Drives Hedge Fund Returns?

    Hedge Funds are seen as an alternative asset class, but what does this really mean? We argue in this report that the long-run returns from hedge funds should differ little from other financial assets. However, their risk characteristics are significantly different, particularly when differentiated by their investment style. It is this characteristic that distinguishes them from conventional assets. Hedge funds are not higher risk and they are not necessarily lower risk: they simply have a different risk profile. As such they should be part of every asset allocation. Click here for full article
    Michael Howell, CrossBorder Capital Limited
  • Hedge Funds Selling Beta as Alpha

    There are two ways to make money in financial markets. Beta - One way to make money in financial markets is to take on a systematic risk for which the market compensates you. This type of risk is known as beta. For instance, equities have a higher expected return than cash over time for the simple reason that they are a more risky investment than cash. The same is true of long duration bonds versus cash, corporate bonds versus treasuries, mortgages versus treasuries, emerging market debt versus developed market debt, etc. At any given point in time, risky financial assets may be expensive or cheap, but over time, they should return more than less risky assets. Betas are easy to capture (i.e. naïve investment strategies can capture betas). Over significant periods of time, betas have positive returns. However, they have low return to risk ratios (we estimate that, over long time-frames, betas have annual Sharpe ratios ranging from 0.2 to 0.3), and for the most part, they are correlated to one another (in part because risk itself is inherent in each of them). Alpha - The other way to make money in financial markets is by taking it away from other market participants. This is known as alpha. Alpha is zero-sum. For every buyer, there is a seller, and so for every alpha trade, there is both a winner and a loser. Examples of alpha strategies include market-timing and active security selection. Only investors who are smarter than the market will be able to reliably provide alpha. Click here for full article
    Greg Jansen, Bridgewater Associates
  • Commentary on the Japanese Market

    The recovery seen in the Japanese market over the last couple of months begs the question, "is this the start of a new secular bull market or a cyclical uplift in the extraordinary oversold position we saw at the end of the fiscal year?" We do not have the definitive answer. Fortunately as a hedge fund of funds, we do not need to time our entry into the market but to be positioned to protect funds regardless of market direction and to make money where we can. We are, however, in a position to reflect on some of the prevalent views amongst our own managers and make some observations of our own. Click here for full article
    Nick Bullman, Chairman of Investor Select Advisors
  • Is Asset Allocation Still Working?

    As the speculative bubble of '98-'99 gave way to the bear market of '00-'01, pension sponsors found that traditional diversification methods have not hedged as much of the market decline as hoped - providing little absolute return protection. In particular, pension surpluses have been shrinking to the point where many organizations will be faced with a need to contribute additional funds to their pension plans just as their earnings are falling due to the economic slow-down. Therefore, it's not surprising that investors are increasingly drawn to a new strategy that's relatively unaffected by the markets and the economic environment: market neutral investing. With strong positive returns and low levels of volatility, market neutral strategies are making their way into the asset allocation plans of a growing number of institutional and other qualified investors. Incorporating investment techniques that, in isolation, have historically been considered "risky", investors are discovering that certain market neutral strategies are, in fact, less risky than traditional equity investments. Click here for full article
    Edgar E. Peters, Panagora Asset Management
  • Timing Multiple Markets: Theory and Evidence

    I extend the classical market timing model of Merton (1981) to the case of multiple risk factors and show that the equilibrium value of a market timer's forecasting ability can be written more generally as a weighted-sum of Arrow-Debreu-type contingent claim prices. Following these results I develop a class of return-based parametric tests to evaluate the ability of a portfolio manager to 'time multiple markets'. I apply these tests to evaluate the performance of 'fund of funds' hedge fund managers. I show that, both individually and on aggregate, fund of funds managers do not exhibit timing ability with respect to a variety of hedge fund styles. However, I argue that this result is due to frictions created by the hedge funds into which these vehicles invest. Click here for full article
    George O. Aragon
    The Wallace E. Carroll School of Management - Boston College
  • Portfolio Optimization and Hedge Fund Style Allocation Decisions

    This paper attempts to evaluate the out-of-sample performance of an improved estimator of the covariance structure of hedge fund index returns, focusing on its use for optimal portfolio selection. Using data from CSFB-Tremont hedge fund indices, we find that ex-post volatility of minimum variance portfolios generated using implicit factor based estimation techniques is between 1.5 and 6 times lower than that of a value-weighted benchmark, such differences being both economically and statistically significant. This strongly indicates that optimal inclusion of hedge funds in an investor portfolio can potentially generate a dramatic decrease in the portfolio volatility on an out-of-sample basis. Differences in mean returns, on the other hand, are not statistically significant, suggesting that the improvement in terms of risk control does not necessarily come at the cost of lower expected returns. Click here for full article
    Noël Amenc and Lionel Martellin
    EDHEC Risk and Asset Management Research Centre
  • The Brave New World of Hedge Fund Indices

    That hedge funds have started to gain widespread acceptance while remaining a somewhat mysterious asset class enhances the need for better measurement and benchmarking of their performance. One serious problem is that existing hedge fund indices provide a somewhat confusing picture of the investment universe. In this paper, we present detailed evidence of strong heterogeneity in the information conveyed by competing indices. We also attempt to provide remedies to the problem and suggest various methodologies designed to help build a "pure style index", or "index of the indices", for a given style. Finally, we present evidence of the ability of pure style indices to improve benchmarking of hedge fund returns. Our results can be extended to traditional investment styles such as growth/value, small cap/large cap. Click here for full article
    Noël Amenc and Lionel Martellin
    EDHEC Risk and Asset Management Research Centre
  • The Pros and Cons of 'Drawdown' as a Measure of Risk for Investments

    A key measure of track record quality and strategy "riskiness" in the managed futures industry is drawdown, which measures the decline in net asset value from the historic high point. In this discussion we want to look at its strengths and weaknesses as a summary statistic, and examine some of its frequently overlooked features. Click here for full article
    David Harding, Georgia Nakou and Ali Nejjar
    Winton Capital Management
  • Trend Following: Performance, Risk, and Correlation Characteristics

    The growth in demand for hedge funds since 1995 has been significant. During this period, the assets invested in hedge funds grew from an estimated $100 billion to over $500 billion. Ultimately, the sustainability of this growth depends upon the relative and absolute investment performance ofthe hedge fund industry. Hedge funds provide sophisticated investors with access to virtually every investable asset class combined with the expertise needed to manage these complex investments. These investors receive positive returns, enhanced diversification when combined with stocks and bonds, low volatility, and protection against significant drawdowns..This paper discusses systematic trend following, a hedge fund style that has a 20 year track record of producing positive annual returns with low to negative correlation to most other asset classes and hedge fund strategies. Exhibit I compares the ZCM/MAR Trend Following Index versus the S&P 500 and the Lehman Treasury Bond Index since 1983. Click here for full article
    Michael S. Rulle, Presiden, Graham Capital Management
  • Risk Considerations Unique to Hedge Funds

    Hilary Till continues in the spirit of her August 2002 Quantitative Finance feature on measuring risk-adjusted returns in alternative investments. Click here for full article
    Hilary Till, Premia Capital Management
  • Managed Futures and Hedge Funds: A Match Made in Heaven

    In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolio?s standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50% of the alternatives allocation is allocated to managed futures, this again will not have any negative sideeffects on skewness and kurtosis. Click here for full article
    Harry M. Kat, The University of Reading (UK)
  • Hedge Fund Diversification: How Much Is Enough?

    There are many benefits to investing in hedge funds, particularly when using a diversified multi-strategy approach. Over the recent years, multi-strategy funds of hedge funds have flourished and are now the favorite investment vehicles of institutional investors to discover the world of alternative investments. More recently, funds of hedge funds that specialize within an investment style have also emerged. Both types of funds put forward their ability to diversify risks by spreading them over several managers. However, diversifying a hedge fund portfolio also raises a number of issues, such as the optimal number of hedge funds to really benefit from diversification, and the influence of diversification on the various statistics of the return distribution (e.g. expected return, skewness, kurtosis, correlation with traditional asset classes, value at risk and other tail statistics). In this paper, using a large database of hedge funds over the 1990-2001 period, we study the impact of diversification on naively constructed (randomly chosen and equally weighted) hedge fund portfolios. We also provide some insight into style diversification benefits, as well as the inter-temporal evolution of diversification effects on hedge funds. Click here for full article
    François-Serge Lhabitant and Michelle Learned
    Thunderbird, the American Graduate School of International Management
  • Managed Futures: A Real Alternative

    Managed Futures investments performed well during the global liquidity crisis of August 1998. In contrast to other alternative investment strategies, the performance of Managed Futures was good in that year and had once more demonstrated their diversification potential. More assets did subsequently flow into Managed Futures, but 1999 did turn out to be one of the worst performing years for the industry. Since then, the performance as well as the acceptance of Managed Futures has improved. As the global stock markets are declining, an increasing number of investors is getting attracted to the strategy. The following article will take a closer look at this asset class. Click here for full article
    Gildo Lungarella, Harcourt AG
  • Hedge Funds with Style

    The popular perception is that hedge funds follow a reasonably well defined market-neutral investment style. While this long- short investment strategy may have characterized the first hedge funds, today hedge funds are a reasonably heterogeneous group. They are better defined in terms of their freedom from the constraints imposed by the Investment Company Act of 1940, than they are by the particular style of investment. We study the monthly return history of hedge funds over the period 1989 through to January 2000 and find that there are in fact a number of distinct styles of management. We find that differences in investment style contribute about 20 percent of the cross sectional variability in hedge fund performance. This result is consistent across the years of our sample and is robust to the way in which we determine investment style. We conclude that appropriate style analysis and style management are crucial to success for investors looking to invest in this market. Click here for full article
    Stephen J. Brown, NYU Stern School of Business
    William N. Goetzmann, Yale School of Management
  • Stocks, Bonds and Hedge Funds: Not a Free Lunch!

    We study the diversification effects from introducing hedge funds into a traditional portfolio of stocks and bonds. Our results make it clear that in terms of skewness and kurtosis equity and hedge funds do not combine very well. Although the inclusion of hedge funds may significantly improve a portfolio's mean-variance characteristics, it can also be expected to lead to significantly lower skewness as well as higher kurtosis. This means that the case for hedge funds includes a definite trade-off between profit and loss potential. Our results also emphasize that to have at least some impact on the overall portfolio, investors will have to make an allocation to hedge funds which by far exceeds the typical 1-5% that many institutions are currently considering. Click here for full article
    Guarav S. Amin and Harry M. Kat
    The University of Reading (UK)
  • Returns-Based Analyses of Hedge Funds

    This column will discuss the state of the art in applying returns-based analyses to hedge funds. It will pay particular attention to those hedge fund strategies where the use of derivatives and dynamic trading strategies can lead to highly assymetric outcomes. Click here for full article
    Hillary Till, Premia Capital Management
  • How to Incorporate Hedge Funds and Active Portfolio Management into an Asset Allocation Framework

    Hedge funds and other actively managed strategies contain two fundamental sources of risk: 1) Systematic risk - the risk associated with exposure to market-wide influences such as the broad equity or fixed-income market, and 2) Active risk - the risk associated with the performance of active managers relative to their market benchmarks. The conventional asset allocation approach employed by most plan sponsors and consultants fails to integrate these two sources of risk. This can lead to the formation of inefficient portfolios. In this article we propose a risk allocation framework that focuses on risk exposures instead of asset class exposures. Click here for full article
    Brett H. Wander and Dennis M. Bein
    Analytic Investors
  • Private Placement Life Insurance
    The New Alternative in Insurance

    Within this report, we attempt to illustrate a simple bridge between hedge fund and insurance language and products, attempting to uncover the edge that exists in combining these fundamental vehicles of traditional and alternative investment worlds. Click here for full article
    Brad Cole and Christine Kailus
    Cole Partners
  • Alternative Asset Strategies:
    Early Performance in Hedge Fund Managers

    This paper investigates the effects of age on hedge fund performance. In particular, we seek to ascertain whether hedge funds perform better during the early stages of their development. Existing studies seem to lack practicality and conclusiveness, with some studies failing to address adequately the issues of survivor and market biases. Survivor bias results from the tendency of hedge funds with poor performance to drop from available databases, causing industry performance returns to appear better than they are in reality. Market bias suggests that the recent success of many hedge funds results from strong general market performance and not necessarily from hedge fund managers' skills. Unfortunately, the lack of complete and consistent data makes addressing these biases difficult. As hedge funds disappear from databases, survivor bias becomes embedded in available data. In addition, since most hedge fund databases only have significant information for the past five to ten years (coincident with one of the strongest U.S. equity market periods) market bias would also seem to be inherent in the data. In order to attempt to address these issues, this study has compiled information from various sources, including "deceased" funds, to create a more comprehensive database of available hedge fund information. Additionally, hedge fund returns were calculated according to age rather than vintage so that not all "early" returns come from the same market period. Where appropriate, subsets of this database were used. In all cases, individual hedge fund return data and not hedge fund style or hedge fund index data was used.1 Based upon this data, our conclusion is that despite the biases found in the data, investors may gain enhanced returns by investing in young hedge funds if proper due diligence is completed. Hedge funds under three years of age tend to perform better than do older hedge funds without necessarily adding to the volatility of returns. Click here for full article
    Patricia Jen, Chris Heasman, and Kit Boyatt
  • Tail or Dog - The Pond's Getting Crowded

    Given the tremendous rise in hedge fund assets, one of the most common queries we receive from clients today is: Have hedge funds grown to the point where they are no longer the market tail but the entire dog? And if hedge funds have become the market dog, does the dog now have fleas? That is has the proliferation of hedge funds created yet one more bubble that needs to be popped before the market can resume even a vague semblance of normal behavior? Click here for full article
    Steve Galbraith and Mary Viviano
    Morgan Stanley
  • A Risk Too Big to Comprehend

    Innovative financial engineers in alternative investments are knitting a web of complex interdependencies, yet no one has a masterplan. Click here for full article
    Jonathan Spring, President, Spring Investor Services
  • Measure for Measure

    In a previous article Hillary Till touched upon the difficulty of using standard measures to evaluate certain hedge fund strategies. Here, after reviewing these difficulties, she discusses state-of-the-art solutions. Click here for full article
    Hillary Till, Principal, Premia Capital Management, LLC
  • A Mutually Rewarding Enterprise?

    Randy Warsager examines the treasures and the pitfalls awaiting those who make the transition from traditional to hedge fund manager. Click here for full article
    Randy Warsager
  • Are Investors Over-Invested In Equities?
    Professor Fernando Diz, Syracuse University
  • Managed Futures: Out of Favor, or Outta Here?

    Selling managed futures to institutional investors is like trying to get the National Bowling Championships on primetime network TV. While the networks are making unprecedented allocations of primetime to sports coverage, bowling gets a continually smaller slice. In fact, I've heard of one venture capitalist who is buying up all the bowling alleys in the country in order to launch a new craze, Ballroom Hurdle Dancing. Really, it is easy to pick on managed futures. In fact, the only reasons more people are not kicking managed futures is because they are too busy gagging on their distressed debt, high tech and value equity investments. The Barclay Systematic Traders index which some consider to be the core CTA index was -3.63% for 1999 and is -1.70% through September 2000. But is managed futures a strategy that is just out of favor or are the wheels falling off the cart? Through a series of interviews with database providers, investors, distributors and managers, we estimate a net outflow of assets due to poor performance and redemptions somewhere between of between 35% to 50% over the last eighteen months. We also feel the number of players has been trimmed by about 30%. Our source for these numbers was not purely scientific, but as a 20-year participant in the futures industry, we have had to do some digging - enough to make us believe that this group is truly at a crossroads. Herein, we cut through the carnival of marketing jargon to find the real drivers running CTA-land. Click here for full article
    Brad Cole, President, Cole Partners
  • Managing Investor Drawdowns Through a Risk Control Plan:
    A New Model for Evaluating Manager Performance

    Tushar Chande, President
    LongView Capital Management, L.L.C.
  • The Benefits of a Long Volatility Investment Approach in a Multi-Fund Portfolio
    Alan R. Kaufman
    Chief Investment Officer, Trilogy Capital Management Group, L.L.C.
  • Risk Management: A Practical Approach to Managing a Portfolio of
    Hedge Funds for a Large Insurance Company

    Norman Chait, CFA, AIG Global Investment Corporation


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