Evolution and innovation of hedge fund strategies: A systematic Review of literature and framework for future research

Hedge funds' extensive use of derivatives, short-selling, and leverage and their dynamic trading strategies create significant non-normalities in their return distributions. Hence, the traditional performance measures fail to provide an accurate characterization of the relative strength of hedge fund portfolios. This paper uses the utility-based nonparametric approach of Levy and Leshno (2002) and the utility-based parametric measure of Goetzmann, Ingersoll, Spiegel, and Welch (2007) to determine which hedge fund strategies outperform the U.S. equity and/or bond markets. The results from the realized and simulated return distributions indicate that the Long/Short Equity Hedge and Emerging Markets hedge fund strategies outperform the U.S. equity market, and the Long/Short Equity Hedge, Multi-strategy, Managed Futures, and Global Macro hedge fund strategies dominate the U.S. Treasury market.

The Complete Guide to Hedge Funds & Hedge Fund Strategies is a thorough and inclusive book that examines hedge funds both pre- and post crisis while addressing all aspects of this alternative asset class. The fundamentals of the hedge fund industry as well as a detailed examination of every strategy are covered with examples, figures, and tables. The author also addresses UCITS compliant hedge funds, regulation, corporate governance in a post crisis world and how the Dodd–Frank Act provisions have affected the hedge fund industry.

As the year goes by, many market participants form as to the effect of certain months on financial markets. Be it the summer doldrums, where trading volume decreases and price action subsides to the January effect, where most expect equity prices to rise in the month. These and other expectations have permeated the financial community and have more or less been accepted as common occurrence. Recently, research has demonstrated a December effect in hedge fund returns where returns are greater in this month than other months. Taking the positive effect of December on hedge fund returns into consideration, the question arises whether any other seasonal effects can be found to exist in the hedge fund space. Using the Hedge Fund Research indexes as representative of most hedge fund strategies, it is demonstrated through quarterly and monthly dummy variable regressions that various months have differing effects on the various hedge fund strategies. Also, a panel regression is performed to find cyclical behaviour between years, demonstrating that even years have a more negative impact of hedge fund strategies than odd years. These findings suggest that there are numerous seasonal effects on hedge fund strategies with implications for hedge fund portfolio construction and risk management.

As in the case of traditional investments, hedge funds are often compared on a risk adjusted basis. Risk adjustment is of particular importance for hedge fund analysis since two funds may differ solely by leverage, such that they may differ on an absolute return basis, but be similar on a risk adjusted basis. While leverage should theoretically not affect the level of risk adjusted return within a strategy, it is possible that funds which use higher levels of leverage may in fact trade differently than funds using lower levels of leverage. In this article, the effect of leverage on hedge fund risk and return is analyzed. In brief, results are presented on the level of leverage used in various hedge fund strategies. Results are also provided on the degree to which leverage above or below the median fund leverage results in superior or inferior risk adjusted performance within a particular hedge fund strategy. Overall the results show that while different hedge fund strategies may use different amounts of leverage, within a particular hedge fund strategy, there is little evidence of a significant difference between risk adjusted performance of funds with above-median and below-median leverage.

The hedge fund industry in South Africa has undergone positive changes in terms of both regulation and structure since 2007. These changes have provided an opportunity to further utilize hedge fund strategies within a portfolio management framework. This is especially significant when considering the diversification potential that hedge funds may have and their ability to generate an alternative source of return, both of which are important when considering tactical and strategic asset allocations. There is therefore a need to model the interrelationships between the major hedge fund strategies and the local equity market in order to understand the dynamic linkages that may be present in both the long and short term. We conducted cointegration analysis within the VAR framework on monthly data spanning from 2007 to 2018. The analysis of long-term dynamics indicated that there is no cointegration between the All Share Total Return Index and the hedge fund strategy return indexes as measured under a Johansen cointegration methodology. Pairwise Granger causality tests supported the cointegration findings with no directional causal impacts found. The analysis of short-term dynamics via impulse responses indicated limited causality between the hedge fund indexes and the equity market, while variance decomposition showed few spill-over effects from the equity market to the hedge fund indexes. The overall findings imply that a South African investor could achieve diversification benefits in both the short and long term by adding hedge funds to an equity-centric portfolio. The findings also provide evidence that hedge funds can be used as effective components within tactical and strategic asset allocation. <b>TOPICS:</b>Real assets/alternative investments/private equity, emerging markets, risk management, VAR and use of alternative risk measures of trading risk, quantitative methods, statistical methods <b>Key Findings</b> ▪ There is no long-term equilibrium relationship between the returns of South African domiciled hedge funds and the equity market. This is supported by both cointegration and Granger causality analyses. ▪ Hedge funds provide investors with diversification benefits in both the short and long term when added to an equity-centric portfolio. ▪ The results support the use of hedge funds in both tactical and strategic asset allocation.

Funds of hedge funds are diversified investment vehicles that provide investors with diversification either across managers within a specific hedge fund strategy or across a wide range of hedge fund strategies. In this paper, we contrast the performance of funds of hedge funds that diversify across managers (but stay within a single hedge fund strategy) versus those that diversify across managers and hedge fund strategies. Our empirical results provide strong evidence in favor of the later. Funds of hedge funds that diversify across both managers and strategies outperform those funds that diversify across managers but stay within a single hedge fund strategy.

Diversification of risk is a potential benefit of investing in hedge funds. Using CSFB/Tremont hedge fund indices, this chapter shows that hedge fund strategies have different returns, volatility, and exposures to various systematic risk factors during tranquil times. This relation has led to the growth of the hedge industry and in particular funds of hedge funds, which provide diversification benefits by investing across different hedge fund styles. However, during financial crises, different hedge fund strategies are exposed to similar systematic risk factors. Most of the strategies become exposed to market liquidity and credit risk factors. Moreover, during the financial crises of 1998 and 2007–2008, all strategies were loading positively on the latent factor that induced positive correlation among hedge fund strategy residuals. As a result, diversification benefits incurred due to investing in different hedge fund strategies evaporated during these financial crises.

Hedge funds have traditionally served wealthy individuals and institutional investors with the promise of delivering protection of capital and uncorrelated positive returns irrespective of market direction, allowing them to better manage portfolio risk. However, the financial crisis of 2008 has heightened investor sensitivity to the high fees, illiquidity, lack of transparency, and lockup periods typically associated with hedge funds. Hedge fund replication products, or clones, seek to answer these challenges by providing daily liquidity, transparency, and immediate exposure to a desired hedge fund strategy. Nonetheless, although lowering cost and adding simplicity by using a common set of factors, traditional replication products might offer lower risk-reward performance compared to hedge funds. This research explores hedge fund replication further by examining the importance of constructing clones with specific factors relevant to each hedge fund strategy, and then compares the strategy specific clone risk and reward performance against both actual hedge fund performance and hedge fund clones constructed using a more general set of common factors. Testing shows that using strategy specific factors to replicate common hedge fund strategies can offer superior risk-reward performance compared to previous general model clones.

Foreword. Introduction. Chapter 1 Recent Hedge Fund Scandals. Palm Beach, Florida. KL Financial, March 2005. Amaranth Advisors, September 2006. Bernie Madoff, December 2008. Lesson # 1: Relationships Do Not Trump Due Diligence. Lesson # 2: Investing in Hedge Funds: Hire Experts. Lesson # 3: Did Not Know What We Were Investing In, Is Not An Excuse. Conclusion: So Called Experts, Fund of Funds, Have Failed. Chapter 2 The Players. Flow of Capital in the Hedge Fund Industry. Chapter 3 Hedge Funds. Incentives and the Disincentives of the Hedge Fund Fee Structure. Education of the Future Hedge Fund Manager. Training Grounds of the Hedge Fund Manager. The Chart Readers. The Quants. The Global Macro Trader. From a Moth to a Butterfly. Andrew Lahde's Goodbye Letter. Chapter 4 Hedge Fund Strategies. Long Short Equity. Event Driven. Global Macro. Fixed Income Arbitrage. Relative Value Arbitrage. Effect of 2008 on these Strategies and Looking Forward. Chapter 5 Hedge Fund Service Providers & Regulators. Building a Business. Chapter 6 Funds of Hedge Funds. Philosophy and Services. Failure of Fiduciary Duties. Statistical Bucketing by Strategy. Due Diligence and the Analyst. What's in a Name. The AIMA Due Diligence Questionnaire. Where are the Experienced Professionals? The (Lack of) Ongoing Due Diligence. Multi-Strategy Hedge Funds. Chapter 7 An Expert Failure. Uselessness of Historical Data Crunching. Quest for Steady Returns-Systematic Destruction of Alpha. Bucketing by Asset Class and Geography - A Flawed Concept. Alpha versus Beta-Trader Generates Alpha, not The Strategy. Specialized Strategies. 10% to 20% Allocation Rule. Managing a Hedge Fund Manager. Bookrunner Versus a Proprietary Trader. So-Called Hedge Fund Experts. Hedge Funds - House of Second or Third Chances? Why Does a Losing Hedge Fund Manager Shut down His Fund? Why Does the Industry Keep Funding a Failed Trader? Conclusion. Chapter 8 Remodeling the Funds of Hedge Funds. Traders Managing Trading Investments. Differentiate Between Alpha and Beta Strategies. Bucketing Based on Trader Methodology. Appropriate Risk Template by Strategy. Manager Stop loss and Linked Redemptions. Not 10% Majority Every Time. On-Going Due Diligence - It is Not Just About Returns. Chapter 9 Correct Risk Due Diligence. Position Concentration? So What. Management of Stop Loss Limits - The Be-All and End-All. Over-Leverage and Illiquidity. Hedging - Will the Market Let You Short? Chapter 10 Interviewing a Hedge Fund Manager. Relationship. Strategy Related Questions. What Qualifies You to Execute This Strategy? Work Experience. Risk Appetite. Thinker, Adapter, Entrepreneur? Discipline and Character. Chapter 11 Hedge Fund Industry's Role in 2008 Market Crisis. Borrowers, Bankers and Investors. Don't Blame the Products, Blame the Users. Failed Due Diligence on Part of Investors. Failure of Fiduciary Responsibilities by Brokers and Lies by Borrowers. No Hedge Fund Has Been Bailed Out. Systemic Risk and Derivative Transactions. Regulating Hedge Funds. Chapter 12 The End. Robert Allen Stanford's Ponzi Scheme. Hedge Fund Industry Offers More Disclosure. Similar Problems with the Pension Funds, Endowments, SWFs. Bibliography. Index.

Funds of hedge funds are diversified investment vehicles that provide investors with diversification either across managers within a specific hedge fund strategy or across a wide range of hedge fund strategies. In this article, the authors contrast the performance of funds of hedge funds that diversify across managers (but stay within a single hedge fund strategy) versus those that diversify across managers and hedge fund strategies. Their empirical results provide strong evidence in favor of the latter. Funds of hedge funds that diversify across both managers and strategies outperform those funds that diversify across managers but stay within a single hedge fund strategy. <b>TOPICS:</b>Real assets/alternative investments/private equity, portfolio construction, performance measurement

Funds of hedge funds are diversified investment vehicles that provide investors with diversification either across managers within a specific hedge fund strategy or across a wide range of hedge fund strategies. In this paper, we contrast the performance of funds of hedge funds that diversify across managers (but stay within a single hedge fund strategy) versus those that diversify across managers and hedge fund strategies. Our empirical results provide strong evidence in favor of the later. Funds of hedge funds that diversify across both managers and strategies outperform those funds that diversify across managers but stay within a single hedge fund strategy.

Tail risk of hedge funds: an extreme value application

As exchange-traded funds (ETFs) have become an important investment tool to hedge risk, an appealing new type of ETF has been developed called “hedge fund ETFs” (HETFs). HETFs give retail or long-only institutional investors an opportunity to invest in various hedge fund strategies but with the advantages that ETFs offer, such as instant liquidity and transparency. The authors investigate the performance of HETFs and find that they broadly underperform hedge fund benchmarks and exhibit subpar risk-adjusted returns. The authors’ analysis reveals that much of this underperformance is explained by a lack of prior hedge fund experience by HETF managers and heavy investment by HETFs in other ETFs. The sample of HETFs conditioned on managers with hedge fund experience and little investment in other ETFs does not exhibit the same underperformance. The authors’ results highlight two factors investors should be cognizant of when considering these new investment products—manager experience and investment in other ETFs. TOPICS:Exchange-traded funds and applications, real assets/alternative investments/private equity, manager selection Key Findings • Since 2009, hedge fund ETFs have underperformed risk models by 2.14% per year and benchmarks by 4.41% per year. • Most of the underperformance of hedge fund ETFs appears to be explained by two factors—lack of manager skill and heavy investment in other ETFs. • Investors looking to invest in hedge fund strategies—such as long-only institutional investors and unaccredited investors—should look for hedge fund ETFS that have managers with previous hedge fund experience or for funds that do not predominately invest in other ETFs.

This report is a brief of the actual research and discusses two ways of asset allocation in Hedge Funds to generate alpha over the fund of hedge funds. The fund of hedge funds have fallen out of favour for investors seeking alternative investments as they have lagged the general market returns. This paper looks at TWO effective ways of allocating capital in various hedge fund strategies and discusses the various risk and return statistics over the two popular Fund of Funds Indices by Barclays and EDHEC. The Barclays and EDHEC indices have been chosen due to their availability during the research and quality of underlying data. The original paper delves in more details with breakdown of allocation across strategies (If you are an Investment Professional or academic who would like to discuss the original research, please contact me on my email address in the report with your name, professional details and your query).One of the strategies involves allocating equal weight across all the hedge fund strategies with rebalancing. The second strategy is a risk weighted portfolio of hedge fund indices based on the variance. This report uses data for last 10 years (Jan 2002 till Apr 2012). Both the strategies have done well in comparison to fund of hedge funds (measured through performance of FOF benchmark indices). The Equal Weight Portfolio returned 91.5% over the period with annualised volatility of 5.31% while Risk Weighted Hedge Fund Portfolio returned 70% with annualised volatility of 3.41%. While the Barclays Fund of Funds Index returned 32.75% with annualised volatility of 5.43% and EDHEC Fund of Funds Index returned 43% with annualised volatility of 5.19%. That is an excess return of nearly 2 times for the Equal Weight Index with similar volatility and excess return of approximately 37% for Risk Weighted Portfolio with 1/3rd less volatility against the Barclays Fund of Funds Index. The report discusses various risk and return statistics in greater detail. The report also touches upon the superiority of the Risk Weighted Portfolio against the Equal Weighted portfolio in providing a better risk adjusted return over the whole period (See the cumulative alpha graph in the report).

Since it is well known that hedge fund returns exhibit non-linear option-like exposures to standard asset classes, traditional linear factor models offer limited help in capturing the risk-return tradeoffs offered by hedge funds. This paper employs a combination of passive buy-and-hold strategies and option-based strategies to characterize the risks of different hedge fund strategies. Although, in practice, these hedge funds can follow a myriad of dynamic trading strategies, we find that adding a few simple option writing/buying strategies to the linear multi-factor model enables us to capture a significant proportion of the variation in the hedge fund returns over time. We verify the ability of our approach to capture important hedge fund risk exposures by conducting out-of-sample analysis. Our approach can provide valuable insights into the nature of risks involved in investing in different hedge fund strategies.