Hedge Fund Investment Research Articles

A Transparent View into Hedge Fund Portfolios

Faced with the challenge of minimal disclosure, investors in hedge funds seek alternatives to increase transparency in order to better manage the risk and return profile of their portfolio. In this article, the author explores the possibility of extracting additional insight from investor risk reports relevant to each fund. The author follows a bottom-up approach by constructing a replicating portfolio from building blocks that are either listed instruments or synthetic positions. Findings indicate that even limited transparency can accurately capture the risk characteristics of each fund and to a certain extent, their return profile, revealing key metrics at granular levels. When viewing results at the portfolio level, consisting of just six funds, the level of accuracy becomes particularly high. <b>TOPICS:</b>Real assets/alternative investments/private equity, portfolio construction, risk management, performance measurement

Hedge Funds: Where Investors Get It Wrong (and Right)

The decision by the California Public Employees’ Retirement System (CalPERS) and other institutional money managers to eliminate or drastically reduce their investments in hedge funds has again raised the suggestion that hedge fund investment is a poor choice for both institutional investors and individuals alike. The reasons given are generally twofold: Hedge funds have not performed up to expectations and the related costs (fees and due diligence) and external perception (public acceptance) are not worth the effort of investing in them.

Defining Liquid Alternative Investments

Most alternative investments, such as private equity or hedge funds, have historically been offered mainly as illiquid and less-than-transparent private placements sold to high-net-worth and institutional investors. Liquid alternative investments are innovative products that democratize alternative investments by allowing all investors to easily access these strategies in an exchange-traded and transparent format. This article introduces limited partnerships and then discusses the need for, and the format of, liquid alternative investments that are offered as registered products under the UCITS or Investment Company Act of 1940. Although there has been substantial growth in liquid alternatives in recent years, the regulations that restrict manager flexibility are likely to constrain both the risk and return of these liquid vehicles relative to traditional hedge fund investments. <b>TOPICS:</b>Private equity, real assets/alternative investments/private equity, mutual funds/passive investing/indexing, legal/regulatory/public policy

The influence of investor identity and contract terms on firm value: Evidence from PIPEs

Abstract Financial relationships can alleviate the adverse effects of asymmetric information and agency costs on outside stakeholders. We examine announcement returns to PIPE transactions, conditional on the contract terms and identity of the investor. We find that the influence of contract terms on announcement returns depends on investor identity. For PIPEs with hedge fund investors, the inclusion of control terms associates with much larger announcement returns. In contrast, announcement returns for PIPEs, involving strategic investors, are less dependent on the existence of control terms. We find the opposite for liquidity terms. Namely, announcement returns are dramatically different for strategic investors with and without liquidity terms, while inclusion of liquidity terms is less influential when PIPEs involve hedge funds. Our findings suggest that investor identity and contract terms jointly influence market reactions to PIPEs.

A Tail of Two Cities: On the Downside Risk and Loss Profile of Asian and North American Hedge Funds

This paper analyzes the downside risk and loss profiles of hedge funds in North America and Asia to identify any significant differences between the geographic markets and determine how these differences have converged or diverged over time. An attempt is made to understand the performance drivers that differentiate Asian from North American hedge funds. In the downside-risk analysis of 2,631 North American and 994 Asian hedge funds from January 1995 to February 2013, event-driven investment strategies for both geographic regions perform better than the other hedge fund investment strategies in relation to both risk and return, and downside risk. More diversified funds such as multi-strategy hedge funds do not necessarily perform better than single-manager strategies in relation to downside risk, while relative value strategies exhibit the most similar characteristics across the two geographies. Following their lackluster performance during the Asian Financial Crisis, Asian hedge funds improved their risk-adjusted performance, particularly during the recent Global Financial Crisis when their loss profile reached a level similar to that of their North American peers. Lastly, “nearby” funds, i.e., funds whose managers are located in the same investment geography, have slightly worse loss profiles than “distant” funds in both geographic markets, which result is slightly contrary to extant empirical evidence.

Kevin R. Mirabile: Hedge Fund Investing

Kevin R. Mirabile: Hedge Fund Investing

Hedge Fund Investments in Bankruptcy

The authors investigate the role and impact of hedge fund investors on bankrupt firms. They find that hedge funds provide liquidity for troubled firms and help enhance their profitability. Comparing the performances in post-bankruptcy to pre-bankruptcy levels, bankrupt firms with hedge fund involvement tend to be in better shape compared to the ones without any type of vulture investor involvement. On the other hand, firms having hedge funds among their investors show comparable results to those with other vulture investors, such as private equity funds. In addition, the improvements appear to take place only in the short run. The involvement of hedge funds does not guarantee better stock performance. Hedge funds appear to be more financial than strategic players, as they rarely help troubled firms go through a systematic restructuring to achieve sustainable improvements.

Hedge Fund Investments in Bankruptcy

Hedge Fund Investments in Bankruptcy

Style Chasing by Hedge Fund Investors

Style Chasing by Hedge Fund Investors

Polynomial goal programming and the implicit higher moment preferences of US institutional investors in hedge funds

Polynomial goal programming (PGP) is a flexible method that allows investor preferences for different moments of the return distribution of financial assets to be included in the portfolio optimization. The method is intuitive and particularly suitable for incorporating investor preferences in higher moments of the return distribution. However, until now, PGP has not been able to meet its full potential because it requires quantification of “real” preference parameters towards those moments. To date, the chosen preference parameters have been selected somewhat “arbitrarily”. Our goal is to calculate implied sets of preference parameters using investors’ choices of and the importance they attribute to risk and performance measures. We use three groups of institutional investors—pension funds, insurance companies, and endowments—and derive implied sets of preference parameters in the context of a hedge fund portfolio optimization. To determine “real” preferences for the higher moments of the portfolio return distribution, we first fit implied preference parameters so that the PGP optimal portfolio is identical to the desired hedge fund portfolio. With the obtained economically justified sets of preference parameters, the well-established PGP framework can be employed more efficiently to derive allocations that satisfy institutional investor expectations for hedge fund investments. Furthermore, the implied preference parameters enable fund of hedge fund managers and other investment managers to derive optimal portfolio allocations based on specific investor expectations. Moreover, the importance of individual moments, as well as their marginal rates of substitution, can be assessed.

Liquid Alternatives: Equity Long/Short Mutual Funds

The fact is non-traditional mutual funds are not really substitutes for hedge funds. To be sure, individual styles of non-traditional funds…share many basic characteristics with their corresponding hedge fund styles….A fund that needs to be ready for redemptions at a moment’s notice or that is heavily restricted on the leverage it employs is always going to have a difficult time achieving the same level of excess returns as a hedge fund pursuing a similar strategy without such restrictions in place….We repeat: non-traditional mutual funds are not hedge funds. - CIO Reports, Monthly Outlook, Private Banking & Investment Group, Merrill Lynch Wealth Management, April 2013, pp. 1-2. For the first time since Morningstar began its alternative investment survey, institutions are beginning to use alternative mutual funds to replace some hedge fund investments. - “Institutions Are Warming to Alt Mutual Funds”; TheMutualFundWire.com; July 10, 2013

Return or position-based value at risk?

The emergence of managed account platforms for investing in hedge funds has given the investor access to a range of new risk measures. This study analyses the accuracy of various value at risk (VaR) methodologies in the context of hedge fund investing. In our sample of data, we found that position-based VaR provides the best risk assessment measure for short horizons (up to five days). For longer term horizons (five days or more), position-based VaR can sometimes be inaccurate. Our interpretation is that, despite being based on actual underlying positions, position-based VaR is not designed to capture the dynamic of hedge fund portfolios. Over longer term horizons, VaR calculated using historic returns still provides a rough but reliable risk indicator for the investor. Our study also highlights the importance of regular monitoring of any risk model’s accuracy in its specific context.

The Delisting Bias in Hedge Fund Databases

As is well known, hedge fund databases suffer from various types of serious biases. While many of these biases have been addressed, the delisting bias is much more difficult to control. In this article, the authors use information from three hedge fund databases to provide direct estimates of this bias. Based on the fact that funds delisted in one database often continue to report returns to another, they estimate the delisting bias is at least 35 bps per annum. Their analysis also provides estimates of frequencies and average losses for different delisting reasons. The delisting bias largely explains the puzzling differences between the performance of the direct hedge fund investments and that implied by funds of hedge funds. The authors estimate that the performance of hedge fund indices should be adjusted downward by about 50 bps to account for the delisting bias. <b>TOPICS:</b>Real assets/alternative investments/private equity, statistical methods, performance measurement

Opaque Trading, Disclosure, and Asset Prices: Implications for Hedge Fund Regulation

We investigate the effect of ambiguity about hedge fund investment strategies on asset prices and aggregate welfare. We model some traders (mutual funds) as facing ambiguity about the equilibrium trading strategies of other traders (hedge funds). This ambiguity limits the ability of mutual funds to infer information from prices and has negative effects on market outcomes. We use this analysis to investigate the implications of regulations that affect disclosure requirements of hedge funds or the cost of operating a hedge fund. Our analysis demonstrates how regulations affect asset prices and welfare through their influence on opaque trading.

Crystallization - The Hidden Dimension of Hedge Fundss Fee Structure

We investigate the implications of variations in the frequency with which hedge funds update their high-water mark on incentive fees paid by hedge fund investors. Using data on Commodity Trading Advisors (CTAs), we perform simulations and a bootstrap approach to analyse the effect. We find a statistically and economically significant effect of the crystallization frequency on the total fee load. Funds’ total fee load increases significantly as the crystallization frequency increases. Our findings indicate that the total fee load depends not only on the management fee and incentive fee, but also on the crystallization frequency set by the manager.

The Alternative Investment Fund Managers Directive and Hedge Fundss Systemic Risk Regulation in the EU

In the aftermath of the financial crisis, hedge fund regulation was put at the top of the European regulators’ agenda for their alleged contribution to financial instability. This paper studies the recently enacted Alternative Investment Fund Managers Directive (AIFMD) in the EU and its attempt to address potential systemic externalities of hedge funds. To include all relevant pan-European regulations addressing the sources of potential systemic risks of hedge funds, a systematic review of the recently enacted laws, regulations and implementing measures has been conducted. The analysis is predicated upon the methodology of law and economics with a consequentialist approach according to which the merits of the AIFMD and relevant regulations will be evaluated in terms of the achievement of the intended goals. The legislative process of the AIFMD suggests that hedge fund regulation in the EU was a politically motivated overreaction to their perceived contribution to financial instability. The aim of the AIFMD is mostly achieving the single market objectives, rather than addressing systemic risks. The EU regulators’ emphasis on investor protection can also be understood in light of the aim of creating a single European market for financial services. However, since the investors in hedge funds are professional investors, the AIFMD’s focus on investor protection in hedge fund regulation seems to be a misallocation of limited regulatory resources. Despite the fact that the impetus for the enactment of the AIFMD mostly involved the concerns about their systemic aspects and their contribution to the financial instability, hedge fund regulation in the EU only marginally addresses systemic risks that hedge funds can potentially pose to the financial system. In addition, the AIFMD's focus on capital requirements, leverage limits, and remuneration policies and practices, and requirements for AIFM's depositaries does not address the real concerns about hedge funds which are their interconnectedness with Large Complex Financial Institutions (LCFIs), and their potential herd behavior. Rather, imposing such limits is likely to undermine the benefits of hedge funds to European financial markets. Moreover, since the business model of a hedge fund can substantially differ from that of private equity, real estate funds, infrastructure funds or commodity funds, the one-size-fits-all regulatory approach adopted in the AIFMD will likely have adverse effects on hedge funds and undermine their benefits to the financial markets. Furthermore, hedge fund regulation is likely to put EU hedge funds in competitive disadvantage compared with their global competitors by overburdening EU hedge funds. Overall, it is primarily estimated that such direct and heavy-handed regulation of hedge funds imposing substantial costs to the industry can encourage regulatory arbitrage resulting in the ineffectiveness of the EU hedge fund regulation in the long run. This paper also sheds light on potential future regulations supplementing the AIFMD and possible future amendments thereto. It suggests that the EU’s regulatory policy towards hedge funds particularly in areas involving direct regulation of hedge funds arising from investor protection concerns should be revised. Instead, the regulatory focus should be shifted towards indirect regulation of hedge funds targeting their interconnectedness with LCFIs and their potential herd behavior. Otherwise, it is suggested that with the level of protection offered to investors of the AIFs, the AIFMD or the competent authorities of the Member States can loosen the statutory limits for investing in hedge funds.

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.

Advancing Style Analysis and Risk Modeling by Incorporating Model Uncertainty with Bayesian Model Averaging

Investors have increasing interests in sophisticated yet transparent analytic tools to handle model uncertainty, tail risk and market dynamics. This paper demonstrates how macroeconomic factor models, based on Bayesian model averaging (BMA), can help address the challenges in some specific investment analytic tasks from three perspectives: (1) selecting risk factors and estimating risk factor exposure in risk allocation, (2) modeling the dynamic exposure of multiple asset classes to systematic risk; and (3) forecasting risk/return profiles of hedge fund investment strategies.

Hedge funds

Purpose – The paper's aim is to explore the impact of statistical arbitrage and high-frequency trading as hedge fund investment strategies that have a significant impact on the environment of corporations. Design/methodology/approach – The paper is a meta-analysis of the role of investment strategies within complex systems. Findings – The growth of hedge fund investment activity based on statistical arbitrage tends to produce a vulnerability; more funds using the strategy helps to create the profitable outcomes that the strategy relies upon. However, the growth also reduces the time lines of profitability and produces an underlying instability based on overlapping holdings and the use of leverage. The shortened timelines also create a further impetus towards technological competition and promotes high frequency trading, which then introduces further vulnerabilities based on “stop-loss cascades”. Research limitations/implications – Much of the trading creates a superficial form of liquidity, which gives a limited sense of market vulnerabilities. The basis of complex interactions between high frequency traders is also not clearly understood. Researchers and agents of policy ought to pay greater attention to the issues than is currently the case. Originality/value – The area is one that is under-researched.

One Step Forward for Hedge Fund Investors: The Removal of the Solicitation Ban and the Challenges that Lie Ahead

The JOBS Act accomplished what many thought to be inconceivable. After being excluded from the privilege of advertising for eight decades, Congress has finally lifted the solicitation ban for emerging companies, hedge funds, and various other private vehicles. With respect to the hedge fund industry, which is the primary focus of this article, there have been numerous discussions among commentators regarding the anticipated effects of this law. These discussions range from measuring the extent to which the JOBS Act will facilitate capital formation, to whether it will undermine this goal by leading to an influx of fraudulent investment schemes. In contrast, this article focuses on the anticipated effects that advertising will have on hedge fund investors, which can include wealthy individuals, pension plans, insurance companies, banks, and various other classes of institutions. This article argues that advertising could actually enhance investor protection for this subset of investors as it will likely improve transparency, promote healthy competition, and in some cases, make it more difficult for fraudulent advisers to induce prospective investors. And while the removal of the solicitation ban is generally a step in the right direction for hedge fund investors, this article concludes with a brief discussion of the regulatory challenges that still remain, and explains why these hurdles may be exacerbated with the removal of the ban. Such challenges include the inherent conflicts of interest and the lack of standardization with respect to hedge fund valuations, the fraud loophole created by smaller funds that escape oversight under the Advisers Act, and the potential increase in speculation that could significantly compromise investor confidence.