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THIRD-PARTY RESEARCH

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  • 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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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."
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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.
    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%).
    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.
    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.
    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.
    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.
    Christopher Finger and Luis O'Shea
    Riskmetrics
  • 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.
    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, 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, 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
    Deutsche Bank's Hedge Fund Capital Group
  • The Right Place for Alternative Betas in Hedge Fund Performance: An Answer to the Capacity Effect Fantasy
    Walter Gehin, Mathieu Vaissie
    Edhec Risk and Asset Management Research Centre
  • Hedge Fund Returns: You Can Make Them Yourself!
    Harry Kat, Helder P. Palaro
  • The Big One... The Asian Dollar
    CrossBorder Capital
  • Is Indexing Suitable for Hedge Fund Investing?
    by Jim Tomeo, Rob Covino, and Brian Chung
    SSaris Advisors, LLC
  • Hedge Funds Have Alpha is a Hypothesis Worth Testing
    by Ron Surz
    PPCA
  • The Scrap Steel Standard
    CrossBorder Capital
  • On The Role Of Hedge Funds In Institutional Portfolios
    by Hilary Till
    Premia Risk Consultancy, Inc.
  • Investable Hedge Fund Indices
    Jacobson Fund Managers Ltd
  • The Role of Long/Short Equity Hedge Funds in Investment Portfolios
    by R. McFall Lamm, Jr.
    DB Absolute Return Strategies
  • The Capacity Implications of the Search for Alpha
    by Hilary Till
    Premia Risk Consultancy, Inc.
  • Facts and Fantasies About Commodity Futures
    by K. Geert Rouwenhorst, Gary Gorton
    Yale School of Management, University of Pennsylvania
  • Fund of Hedge Funds Portfolio Selection: A Multiple-Objective Approach
    by Ryan J. Davies, Harry M. Kat, and Sa Lu
  • Weighing the Cost of Illiquidity
    by 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
    by David Matteson
    Gardner Carton & Douglas
  • Managed Futures Can Save Your Tail
    by Steven Koomar
    KV1 Asset Management LLC
  • Hedge Fund Performance and Persistence in Bull and Bear Markets
    by Daniel Capocci, Albert Corhay, and Georges Hubner
    University of Liege (Belgium)
  • The Continuing Case for Emerging Markets
    Everest Capital
  • Alternative RAPMs for Alternative Investments
    by Milind Sharma
    Merrill Lynch
  • Beware of Systematic Style Biases
    by Marc Goodman, Kenneth Shewer & Richard Horvitz
    Kenmar Global Investment
  • Squeezing the Best from Hedge Fund Diversification
    by Marc Goodman, Kenneth Shewer & Richard Horvitz
    Kenmar Global Investment
  • What Drives Hedge Fund Returns?
    by Michael Howell
    CrossBorder Capital Limited
  • Hedge Funds Selling Beta As Alpha
    by Greg Jansen
    Bridgewater Associates
  • Commentary on the Japanese Market
    by Nick Bullman
    Chairman of Investor Select Advisors
  • Is Asset Allocation Still Working?
    by Edgar E. Peters
    Panagora Asset Management
  • Timing Multiple Markets: Theory and Evidence
    by George O. Aragon
    The Wallace E. Carroll School of Management - Boston College
  • Portfolio Optimization and Hedge Fund Style Allocation Decisions
    by Noël Amenc and Lionel Martellin
    EDHEC Risk and Asset Management Research Centre
  • The Brave New World of Hedge Fund Indices
    by 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
    by David Harding, Georgia Nakou and Ali Nejjar
    Winton Capital Management
  • Trend Following: Performance, Risk, and Correlation Characteristics
    by Michael S. Rulle
    President of Graham Capital Management
  • Risk Considerations Unique to Hedge Funds
    by Hilary Till
    Premia Capital Management
  • Managed Futures and Hedge Funds: A Match Made in Heaven
    by Harry M. Kat
    The University of Reading (UK)
  • Hedge Fund Diversification : How Much Is Enough?
    by François-Serge Lhabitant and Michelle Learned
    Thunderbird, the American Graduate School of International Management
  • Managed Futures: A Real Alternative
    by Gildo Lungarella
    Harcourt AG
  • Hedge Funds with Style
    by Stephen J. Brown
    NYU Stern School of Business
    and
    William N. Goetzmann
    Yale School of Management
  • Stocks, Bonds and Hedge Funds : Not a Free Lunch!
    by Guarav S. Amin and Harry M. Kat
    The University of Reading (UK)
  • Returns-Based Analyses of Hedge Funds
    by Hillary Till
    Premia Capital Management
  • How to Incorporate Hedge Funds and Active Portfolio Management into an Asset Allocation Framework
    by Brett H. Wander and Dennis M. Bein
    Analytic Investors
  • Tail or Dog - The Pond's Getting Crowded
    by Steve Galbraith and Mary Viviano
    Morgan Stanley
  • Traditional Long-Only Managers Move Into Hedge Fund Arena
    RoundTable Panelists:
    Mark Anson (CalPERS)
    Jeffrey James (Driehaus Capital Management)
    Paul Wick (J&W Seligman & Co.)
  • A Risk Too Big to Comprehend
    by Jonathan Spring
  • Measure for Measure
    by Hillary Till
  • A Mutually Rewarding Enterprise?
    by Randy Warsager
  • Are Investors Over-Invested In Equities?
    by Professor Fernando Diz
    Syracuse University
  • Managed Futures: Out of Favor, or Outta Here?
    by Brad Cole
    President, Cole Partners
    Chicago, Illinois
  • Managing Investor Drawdowns Through a Risk Control Plan:
    A New Model for Evaluating Manager Performance

    by Tushar Chande
    President, LongView Capital Management, L.L.C.
  • The Benefits of a Long Volatility Investment Approach in a Multi-Fund Portfolio:
    by 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

    by Norman Chait, CFA
    AIG Global Investment Corporation

 

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