Fund Styles Research Articles

Style chasing by hedge fund investors

This paper examines whether investors chase hedge fund investment styles. We find that better-performing and more popular styles are rewarded with higher inflows in subsequent periods. This indicates that investors compare hedge fund styles in terms of recent performance and popularity, and they subsequently reallocate funds from less successful to more successful styles. Furthermore, we find evidence of competition between individual hedge funds of the same style. Funds outperforming the other funds in their styles and funds whose inflows exceed the average flows in their styles experience higher inflows in subsequent periods. One of the reasons for competition among same-style funds is investors’ search for the best managers. The high minimum investment required to invest in a hedge fund limits investors’ diversification opportunities and makes this search particularly important. Finally, we show that hedge fund investors’ implementation of style chasing in combination with intra-style fund selection represents a smart strategy.

Measuring fund style, performance and activity: a new style-profiling approach

We construct new measures of fund style, performance and activity from linear combinations of off-the-shelf stock-market indices. A fund's benchmark portfolio is a linear combination of two or more reference portfolios that in a least-squares sense most closely approximates the fund's portfolio. The resulting linear combination scalar is itself a measure of fund style and the distance between a fund and its benchmark is a measure of fund activity. Our approach has a number of advantages over existing characteristic-matching methods. We illustrate our approach using a data set of US institutional funds.

Style and performance of international socially responsible funds in Europe

This paper analyses the performance and investment styles of internationally oriented Socially Responsible Investment (SRI) funds, domiciled in eight European markets, in comparison with characteristics-matched conventional funds. To the best of our knowledge, this is the first multi-country study, focused on international SRI funds (investing in Global and in European equities), to combine the matched-pairs approach with the use of robust conditional multi-factor performance evaluation models, which allow for both time-varying alphas and betas and also control for home biases and spurious regression biases.In general, the results show that differences in the performance of international SRI funds and their conventional peers are not statistically significant. Regarding investment styles, SRI and conventional funds exhibit similar factor exposures in most cases. In addition, conventional benchmarks present a higher explaining power of SRI fund returns than SRI benchmarks. Our results also show significant differences in the investment styles of SRI funds according to whether they use “best-in-class” screening strategies or not. When compared to SRI funds that employ simple negative and/or positive screens, SRI “best-in-class” funds present significantly lower exposures to small caps and momentum strategies and significantly higher exposures to local stocks.

Which Hedge Fund Styles Hedge Against Bad Times?

We investigate an important question for institutional investors — namely, which hedge fund investing styles help to hedge against bad times? We define good versus bad times as (1) up and down equity market regimes derived from the 200-day moving average of the SP in contrast, other styles remain substantially exposed to — or become more exposed to — particular risk factors and correspondingly suffer large losses during bad times. In the context of “balanced” 40-30-30 ortfolios that allocate across U.S. stocks, bonds, and individual hedge fund styles, we find that the Global Macro, Managed Futures, and Multi-Strategy styles provide large investors with especially valuable hedges against bad times.

Evaluation of Malaysian mutual funds in the maximum drawdown risk measure framework

PurposeThis paper aims to evaluate the risk‐adjusted performance of the management styles of Malaysian mutual funds using nine modified performance evaluation measures generated by the maximum drawdown risk measure (M‐DRM) based on the modern portfolio theory. The purpose is to report the findings in a manner which is realizable by the average investors and portfolio managers.Design/methodology/approachThis paper evaluates the performance of more than 400 Malaysian mutual funds using risk‐adjusted returns over the two sub‐periods of 2000‐2005 and 2006‐2011. The M‐DRM, as a different measure from downside risk, is applied to improve nine risk‐adjusted performance measures of Sortino, Treynor, M‐squared, Jensen's alpha, information ratio (IR), MSR, upside partial ration (UPR), FPI, and leverage factor. It proposes a new single‐factor model to test the maximum drawdown beta and alpha in the M‐DRM framework.FindingsThe evidence clearly indicates that the replacement framework in terms of MDB, the maximum drawdown beta, and the maximum drawdown CAPM can be replaced by the conventional frameworks in terms of MVB, beta, and the CAPM and also MSB, downside beta, and D‐CAPM for modifying nine performance evaluation measures from the management styles of Malaysian mutual funds.Practical implicationsThe research evidence reported in this paper can be applied as input in the process of decision making by small and average investors and portfolio managers who are seeking the possibility of participating in the global stock market through mutual funds.Originality/valueThis paper is the first study to estimate a new regression model in the M‐DRM framework to evaluate the performance of Malaysian mutual funds. In addition, it proposes nine modified performance evaluation measures in the M‐DRM framework for the first time.

Systematic Global Macro: Performance, Risk and Correlation Characteristics

Hedge funds have experienced significant growth over the last few decades. Assets under management have grown from an estimated $100 billion in 1995 to more than $1.7 trillion as of 4th Quarter 2012. As a rapidly maturing investment alternative, hedge funds can offer investors increased opportunities to receive positive returns, enhance diversification, lower volatility and improve overall risk-adjusted returns.This paper discusses one particular hedge fund style known as “systematic global macro,” first reviewing this style’s risk and performance characteristics, and then discussing why it should continue to be a successful and essential component of a diversified portfolio that invests across a variety of hedge fund strategies.

A Structural Model of Dynamic Market Timing

This paper derives and analyzes dynamic timing strategies of a fund manager with private information. Endogenous timing strategies generated by various information structures and skills, and associated fund styles, are identified. Endogenous fund returns are characterized in the public information of an uninformed observer. Timing components are identified. The paper provides foundations for regression analyses of fund returns and tests of market timing. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Efficient Hedge Fund Style Allocations: A Rules-Based Model

Efficient Hedge Fund Style Allocations: A Rules-Based Model

Investment style positioning of UK unit trusts

We investigate the investment style positioning of UK equity unit trusts (mutual funds) over the 24-year period from 1987 to 2010 and assess if fund manager claims to follow a particular style strategy are evidenced in practice. Generally, UK unit trusts do not, in fact, consistently track declared styles but subject their funds to style switching or rotation. Nor do funds switch to become simple index trackers, as has widely been reported, but exhibit a mix of behaviour that we refer to as ‘market-momentum styling’. Our contribution is to offer a coherent, end-to-end picture of the evolution of investment styles over an economic cycle. In so doing we evidence that fund style positioning is subject to rotation and becomes subordinated to past portfolio performance or style momentum. Even this result is conditional as we go on to demonstrate that style investment is very likely to be driven by broader economic conditions, thereby creating market-momentum styling by default. This is arguably not a style at all and calls into question the intent behind fund ‘strategies’.

Performance evaluation of socially responsible mutual funds using style analysis

PurposeThe purpose of this paper is to evaluate the performance of socially responsible funds by closely examining funds' investment styles.Design/methodology/approachThe authors apply William Sharpe's method of style analysis to evaluate the performance of 94 US socially responsible mutual funds. By using the fund style as a benchmark, the authors are able to separate the performance attributed to style and selection.FindingsThe authors observe that underperformance of socially responsible funds is more pronounced and common than identified in the previous literature. Proponents of socially responsible investing argue that screening process provides an opportunity to fund managers to identify best companies in terms of future financial performance. The paper finds that active management of mutual funds is an important determinant of their performance in socially responsible investing industry. This paper provides evidence supporting that active management of socially responsible funds add value.Originality/valueThis study will help investors in allocating their portfolios among many of the available SR funds. The result – actively managed SR funds outperform their passive counterparts – will be valuable for those investors who are willing to invest in socially responsible funds but are concerned about the financial performance.

Hedge fund contagion and risk-adjusted returns: A Markov-switching dynamic factor approach

We provide an empirical analysis of two important phenomena influencing the hedge fund industry—contagion and time variation in risk adjusted return (alpha)—in a flexible unified framework. After accounting for standard hedge fund pricing factors, we quantify the common latent factor in hedge fund style index returns and model its time-varying behavior using a dynamic factor framework featuring Markov regime-switching. We find that three regimes—crash, low mean and high mean—are necessary to provide a complete description of joint hedge fund return dynamics. We also document significant time variation in the alpha generating ability of all hedge fund investment styles. The period following the stock market crash of 2000 is dominated by the persistent low return state while the long bull market of 1990s is associated with the strongest performance of the industry generating high positive returns. We also investigate drivers of the regime shifts in the common latent pricing factor and find that both flight to safety and large funding liquidity shocks play an important role in explaining the abrupt shift of the common factor to the crash state. ► We quantify the common latent pricing factor in hedge fund style index returns. ► Our dynamic factor model incorporates Markov regime-switching. ► Three regimes—crash, low-mean and high mean—describe latent factor dynamics. ► Significant time variation in the risk-adjusted return (alpha) generating ability ► Both flight to safety and funding liquidity play an important role in contagion.

The value added of hedge fund styles in multi‐asset portfolios

PurposeAcademic research has shown that diversification today may not only include stocks and bonds but also alternative investments like hedge funds. However, practical and effective methods to identify the hedge fund styles that really enhance the risk return characteristics of a traditional portfolio as well as optimal allocation sizes are not available. The aim of the paper is to try to close this gap by proposing a portfolio optimization approach based upon the traditional market exposures of the different hedge fund strategies.Design/methodology/approachFor this purpose, the paper first measures the bull and bear market betas of the main hedge fund strategies (equity market neutral, event driven, global macro, relative value, and managed futures). Based on the strategy characteristics, the authors then develop a systematic framework that calculates what percentage of each basic asset should be substituted for by hedge fund strategies to achieve the maximum results. The paper uses hedge fund index data from Hedge Fund Research and Barclay Hedge for the January 1999‐April 2011 sample period.FindingsThe empirical results show that this approach leads to an improvement in the annualized return of the optimized portfolio.Originality/valueThe paper adds to the existing literature by showing that it is possible to substitute traditional assets with hedge fund indices based on their exposures (beta) in varying market environments as a way to optimize the overall portfolio.

The Role of Financial Leverage in the Performance of Core, Value-Add and Opportunistic Private Equity Real Estate Funds

We examine the performance of 162 global private equity real estate investment funds across the core, value-add and opportunistic investment style categories over the most recent property cycle (2001-2011). We employ a multi-factor asset pricing model to measure the impact on the funds’ total excess returns of the underlying real estate market, broad managerial skill captured by Jensen’s alpha, leverage and, for the first time, specific managerial skill as it relates to timing leverage decisions to anticipated future market trends. We find evidence consistent with the hypotheses that i) fund performance is almost directly proportional to the return on the underlying real estate market, ii) managerial skill as measured by Jensen’s alpha can be virtually fully explained by fund style, leverage, sector and geography, iii) leverage cannot be viewed as a long-term strategy to enhance performance, but iv) in the short term, managers do seem to add significantly to fund excess returns by effectively timing leverage choices to the expected future market environment.

Efficient hedge fund style allocations: A rules-based model

The hedge fund literature has predominantly focused on the return and risk characteristics as well as the portfolio properties of different hedge fund styles. However, relatively little is known about how hedge fund investors should allocate their capital across various hedge fund styles. The aim of this study is to develop a rules-based framework that can be used by investors to optimize their hedge fund style allocation. We construct four hedge fund style indices using a sample of 6088 hedge funds from the Lipper TASS Hedge Fund Database over the January 1995–September 2010 time period. We also develop technical and fundamental indicators on the basis of the style return drivers from earlier hedge fund studies. We use these indicators to generate trading recommendations through a style allocation model that systematically over- and underweights the four major hedge fund styles. The empirical results indicate that our hedge fund style allocation model delivers an outperformance of up to 1 per cent per year over an equally weighted portfolio.

Plan Format and Participation in 401(k) Plans: The Moderating Role of Investor Knowledge

There is continuing concern that many people are not saving enough for retirement. The authors conduct three studies to determine whether simple alterations to the format of 401(k) plans can increase plan participation rates, especially among people with low levels of financial knowledge. In Study 1, offering a larger number of funds for investment reduces plan participation among low-knowledge investors, unless the plan also offers a target retirement date (i.e., life-cycle fund) option. In Study 2, the authors find those with low knowledge are more likely to participate if the funds offered for investment are grouped by asset class rather than listed alphabetically. In Study 3, the authors find that participation increases when fund descriptions include star ratings (but not fund style boxes). They also find that star ratings increase decision satisfaction among low-knowledge investors because of a reduction in perceived task difficulty. Limitations, implications, and further research are discussed.

Selectivity and timing performance of UK investment trusts

This study examines the selectivity and timing performance of 218 UK investment trusts over the period July 1981 to June 2009. We estimate the Treynor and Mazuy (1966) and Henriksson and Merton (1981) models augmented with the size, value, and momentum factors, either under the OLS method adjusted with the Newey–West procedure or under the GARCH(1,1)-in-mean method following the specification of Glosten et al. (1993; hereafter GJR-GARCH-M). We find that the OLS method provides little evidence in favour of the selectivity and timing ability, consistent with previous studies. Interestingly, the GJR-GARCH-M method reverses this result, showing some relatively strong evidence on favourable selectivity ability, particularly for international funds, as well as favourable timing ability, particularly for domestic funds. We conclude that the GJR-GARCH-M method performs better in evaluating fund performance compared with the OLS method and the non-parametric approach, as it essentially accounts for the time-varying characteristics of factor loadings and hence obtains more reliable results, in particular, when the high frequency data, such as the daily returns, are used in the analysis. Our results are robust to various in-sample and out-of-sample tests and have valuable implications for practitioners in making their asset allocation decisions across different fund styles.

Forecasting the performance of hedge fund styles

This article predicts the relative performance of hedge fund investment styles using time-varying conditional stochastic dominance tests. These tests allow for the construction of dynamic trading strategies based on nonparametric density forecasts of hedge fund returns. During the recent financial turmoil, our tests predict a superior performance for the Global Macro investment style compared with the other strategies of ‘Directional Traders’. The Dedicated Short Bias investment style is stochastically dominated by the other directional styles. These results are confirmed by simple nonparametric tests constructed from realized excess returns. Further, by utilizing a cross-validation method for optimal bandwidth parameter selection, we discover the factors that have predictive power regarding the density of hedge fund returns. We observe that different factors have forecasting power for different regions of the returns distribution and, more importantly, that the Fung and Hsieh factors have power not only for describing the risk premium but also, if appropriately exploited, for density forecasting.

Tailing Tail Risk in the Hedge Fund Industry

This paper aims to assess dynamic tail risk exposure in the hedge fund sector using daily data. We use a copula function to model both lower and upper tail dependence between hedge-fund and broad-market returns as a function of market uncertainty. We proxy the latter by means of a single index that combines the options-implied market volatility, the volatility risk premium, and the swap and term spreads. We find substantial time-variation in both lower- and upper-tail dependence, even for hedge fund styles that exhibit little unconditional tail dependence. In particular, dependence between hedge fund and equity market returns decreases in both tails significantly with market uncertainty. There are only a few styles that feature neither unconditional nor conditional tail dependence, e.g., convertible arbitrage and equity market neutral. We also fail to observe any tail dependence with bond and currency markets, though we find strong evidence that the lower-tail risk exposure of macro hedge funds to commodity markets increases with liquidity risk. Finally, further analysis shows mixed evidence on how much hedge funds contribute to systemic risk.

Betting Against Beta and the Cross Section of Hedge Fund Returns

A factor capturing the returns of strategies exploiting the low beta anomaly has signi ficant explanatory power in the time-series and cross-section of hedge fund returns. Controlling for the exposure towards this factor drives risk-adjusted returns (alpha) of most hedge fund style returns to zero. In the cross-section, hedge funds with a high loading on low beta strategies outperform funds with a low loading by 0.88% monthly on a risk-adjusted basis in the period from 1999-2008. In line with theory, the cross-sectional dispersion in the exposure to low beta strategies is driven by the access to leverage and the contractual relationship between hedge fund managers and investors.

A Structural Model of Dynamic Market Timing: Theory and Estimation

This paper derives and analyzes dynamic timing strategies of a fund manager with private information. Endogenous timing strategies generated by various information structures and skills, and associated fund styles are identified. Endogenous fund returns are characterized in the public information of an uninformed observer. Econometric methods for style analysis are developed. New tests of timing skill are proposed and their detection ability is analyzed. An application to a universe of hedge fund indices shows significant timing ability in specific categories of hedge fund styles.