Hedge Fund Investment Research Articles

Investing in Hedge Funds: Risks, Returns and Performance Measurement

Hedge funds are collective investment vehicles that are often established with a special legal status that allows their investment managers a free hand to use derivatives, short sell, and exploit leverage to raise returns and cushion risk. We review various issues relating to the investment in hedge funds, which have become popular with high net-worth individuals and institutional investors, as well as discuss their empirical risk and return profiles. The concerns regarding the empirical measurements are highlighted, and meaningful analytical methods are proposed to provide greater risk transparency in performance reporting. We also discuss the development of the hedge fund industry in Asia.

Investing in Hedge Funds: Risks, Returns and Pitfalls

Hedge funds are collective investment vehicles fast becoming popular with high net worth individuals as well as institutional investors. These are funds that are often established with a special legal status that allows their investment managers a free hand to use derivatives, short sell, and exploit leverage to raise returns and cushion risk. Given that that they have substantial latitude to invest, it is instructive to examine the performance of hedge funds compared to other forms of managed funds. This paper provides an overview of hedge funds and discusses their empirical risk and return profiles. It also poses some concerns regarding the empirical measurements. Given the complexity of hedge fund investments, meaningful analytical methods are required to provide greater risk transparency and performance reporting. Hedge fund performance is also beset by a number of issues generating practical risks. These risks are not fully addressed by the usual risk-adjusted performance measures in the literature. A penalty function to discount these extraneous risk dimensions is proposed. The paper concludes that further empirical work is required to provide informative statistics about the risk and return of hedge funds.

A Unique View of Hedge Fund Derivatives Usage: Safeguard or Speculation?

We study the volatility timing ability and selectivity skill revealed by the call, put, and common equity positions of hedge fund investment advisers over the 1999--2006 period. We find that hedge funds' option positions are associated with significantly higher than normal subsequent realized volatility on the underlying security. For instance, hedge funds greatly increased their usage of puts amidst the unraveling of the Nasdaq technology bubble. We also find a strong positive (negative) relation between call (put) holdings and subsequent abnormal stock returns. These relations persist even after the holdings disclosures become publicly available. A real-time feasible tracking portfolio of stocks based upon publicly observable hedge fund option holdings earns annualized abnormal returns of 14.8%. Net of fees, hedge funds also deliver higher benchmark-adjusted portfolio returns and lower market risk during quarters of greater option usage. Overall, the results suggest that hedge funds use derivatives to profit from private information about stock fundamentals.

REGULAR(IZED) HEDGE FUND CLONES

AbstractThis article addresses the problem of portfolio construction in the context of efficient hedge fund investments replication. We propose a modification to the standard Sharpe “style analysis” by introducing a constraint on the asset weights 1‐norm and 2‐norm. This constraint regularizes the optimization problem, allows efficient selection of relevant factor's and has significant effects on the stability of the resulting asset mix and the risk–return characteristics of the replicating portfolio. The empirical results suggest that the norm‐constrained replicating portfolios exhibit significant correlations with their benchmarks, often higher than 0.9; have a fraction, which is about half to two‐thirds, of active positions relative to those determined through the standard method; and are obtained with turnover, which is in some instances about one‐fourth of that for the standard method.

Speculative capital and currency carry trades

In this paper, we study a two-country general equilibrium model with partially segmented financial markets, where hedge funds emerge endogenously. Empirically, we show that the hedge fund investment strategy predicted by our model, which we call the “risk-adjusted carry trade” strategy, explains more than 16% of the overall hedge fund index returns and more than 33% of the fixed income arbitrage sub-index returns. The flow of new money to hedge funds affects market interest rates, exchange rates, and both the hedge funds’ contemporaneous and expected future returns as predicted by the model.

Hedging Equity Market Risk in Hedge Fund Investing: A New Approach

We argue that investors in funds of hedge funds underestimate the traditional equity market beta of these perceived absolute return investment vehicles. Hence, during times of financial crisis, when the correlations of most asset categories with each other increase dramatically, the traditional equity market beta can have an adverse effect on fund of funds performance. Because investors in such environments are rarely able to redeem their fund of fund holdings due to either a general low liquidity (e.g., notice and redemption periods or lock-ups), or extraordinary circumstances (e.g., maximum redemptions, gates, side-pockets), we posit that the only way to decrease unwanted exposure is through overlay strategies. The academic literature so far has focused on the multifactor approach to estimate equity exposure in hedge fund portfolios. We compare different hedging approaches: a pure value-at-risk (VaR)-based approach, a technical market risk signal approach, and a combination of both over the May 2004-September 2009 period using weekly data from an investable hedge fund index. Our results suggest that using a risk overlay system for funds of hedge funds decreases the downside risk of hedge fund investing significantly during economic crises.

An Early Look at the Deutsche Bank Alternative Investment Survey, 2002–2009

This article presents a time-series analysis of the evolution of hedge fund investor characteristics and expectations based on the Deutsche Bank Alternative Investment Survey (DBAIS): 2002–2009. Interesting findings include the following: 1) new hedge fund allocations are primarily determined by a common factor, rather than by specific views on particular strategies; 2) allocations to credit-sensitive strategies are negatively correlated with allocations to noncredit strategies;3) investor strategy allocations tend to chase returns and do a poor job of timing future strategy returns; and 4) the use of managed accounts has dramatically increased.

The Risk-Return Relationship of Pension Funds With Investments in Hedge Funds

ABSTRACT This article investigates if investing in local hedge funds improves the risk-return relationship of Brazilian pension funds. Investment in hedge funds by pension funds is growing elsewhere, with an increasing utilization of a multiplicity of hedge funds specialized in specific strategies or niches. We analyzed the performance of a typical pension fund allocation in Brazil as well as alternate allocations that included hedge funds. We used robust estimates of the covariance matrix to mitigate the errors in variables that are problematic in the inputs of the optimization. The results show that hedge funds improve the risk-return relationship of the typical pension fund allocation, contribute to a higher accumulated return at the end of a one-year period, and reduce portfolio rebalancing. Investments in hedge funds ease reaching the typical 6% annual return target with less risk exposure.

Hedge Fund Stock Trading in the Financial Crisis of 2007-2009

Hedge funds significantly reduced their equity holdings during the recent financial crisis. In 2008Q3-Q4, hedge funds sold about 29% of their aggregate portfolio. Redemptions and margin calls were the primary drivers of selloffs. Consistent with forced deleveraging, the selloffs took place in volatile and liquid stocks. In comparison, redemptions and stock sales for mutual funds were not as severe. We show that hedge fund investors withdraw capital three times as intensely as mutual fund investors do in response to poor returns. We relate this stronger sensitivity to losses to share liquidity restrictions and institutional ownership in hedge funds.

The financial crisis, investor activists and corporate strategy: will this mean shareholders in the boardroom?

The concept of stakeholder engagement is gaining increasing attention in the mainstream media and may feature as part of a corporation’s strategy for corporate social responsibility. Not only are boards considering how they might engage with key stakeholders, but stakeholders are also pursuing greater participation in the strategic decisions of companies in which they invest. While this is an emerging concept in companies governed by unitary boards, as in North America, the issue of stakeholder engagement in various forms is also entering debate in other countries around the world. In general, however, the idea of shareholder or stakeholder representation on the boards of most UK and Commonwealth companies is anathema. Forces now influencing the development of strategies for stakeholder engagement and the rise of active investors include changing corporate governance rules which give investors more power in the election of directors, the increasing role of pension plans and hedge fund investment groups which have produced investors who keep a close eye on company performance and value, and a sluggish or turbulent stock market as a result of the financial crisis initiated by the credit crunch in the sub-prime mortgage markets. In this paper the phenomenon of stakeholder representation is examined and results of a recent survey conducted among a large sample of New Zealand directors are presented. The findings suggest that these traditionally oriented boards are increasingly inwardly focused and are without an agenda for building and managing shareholder and stakeholder relations. Accordingly, such boards are unlikely to regard stakeholder engagement as a serious strategic issue and are thus also likely to miss significant opportunities in the changed business environment to benefit from stakeholder support.

Hedge fund investing: Beware of special relationships: The remorse of Beacon Hill Asset Management Investors

Beacon Hill Asset Management (BHAM) is a hedge fund that specializes in investing and trading mortgage-backed securities (MBS). The fund exploits arbitrage opportunities in the MBS market and does not take interest rate risk. The background of the fund management team is excellent, and its performance is stellar. Assets under management exceed US$2.0 billion. The investors include the top financial institutions. What could go wrong? The pressure to honor the commitment in a symbiotic relationship with the major investor in the fund advisory firm coerces the fund managers into committing fraudulent activities that they may not have committed otherwise. Asset Alliance Corp., a New York-based investment firm, payed $40 million for a 50 per cent ownership stake in BHAM in 1998. The purchase agreement included a claw-back provision. The provision stipulated that should BHAM fail to deliver the performance, BHAM must return up to half of the prior earnout fees to Asset Alliance. The Securities Exchange Commission (SEC) complaint alleged that the BHAM misrepresented the valuation of the securities in order to show steady and positive returns. The partners concealed the magnitude of the actual losses in order to save the operation of BHAM. The absence of a compliance officer and/or independent board facilitated the fraudulent activities, and investors' losses exceeded $400 million. In late 2004 the SEC settled the case and expected the disgorgement, prejudgment interest and penalties to be distributed to the fund investors. Investors in hedge funds and industry stakeholders should demand some form of independent oversight and investigate any special relationship the fund has with a third party, through the due diligence process.

Risk Management of Hedge Funds: Role of Funding and Redemption Options on Leverage

We develop a model of hedge fund returns, which reflect the contractual relationships between a hedge fund, its investors and its prime brokers. These relationships are modelled as short option positions held by the hedge fund, wherein the “funding option” reflects the short option position with prime brokers and the “redemption option” reflects the short option position with the investors. Given an alpha producing human capital, the hedge fund0s ability to deploy leverage is shown to be sharply constrained by the presence of these short options. We show that the hedge funds typically have an optimal level of leverage. Optimal leverage is shown to differ across hedge funds reflecting their de-levering costs, Sharpe ratios, correlation of assets, secondary market liquidity of their assets, and the volatility of the assets. Using a minimum level of unencumbered cash level as a risk limit, we show how a hedge fund can optimally allocate its risk capital across different risk-taking units to maximize alpha in the presence of these short option positions. Implications of our analysis for hedge fund investors and policy makers are summarized.

Speculative Capital and Currency Carry Trades

In this paper, we study a two-country general equilibrium model with partially segmented financial markets, where hedge funds emerge endogenously. Empirically, we show that the hedge fund investment strategy predicted by our model, so called “risk-adjusted carry trade” strategy, explains more than 16% of a broad hedge fund index returns and more than 33% of a fixed income arbitrage sub-index returns. The flow of new money to hedge funds affects market interest rates, exchange rate, the both the hedge fund’s contemporaneous and expected future returns as predicted by the model.

The price of liquidity in constant leverage strategies

In this paper we develop a formula for the Liquidity Premium of constant leverage strategies (CLS). These financial products are path dependent options where the underlying typically is a hedge fund portfolio. We describe and explain the functionality of CLSs, showing a closed form expression for the price of a CLS on a hedge fund assuming a Geometric Brownian Motion, discrete rebalancing for the hedge fund investment as well as stochastic interest rates. The risk of default before the next rebalancing date leads to a liquidity premium for the CLS which increases with the volatility of the underlying hedge fund portfolio and the leverage of the strategy. An increasing rebalancing period first leads to a higher liquidity premium, however, as the rebalancing period is extended further the liquidity premium begins to shrink again.

Applying a Global Optimisation Algorithm to Fund of Hedge Funds Portfolio Optimisation

Portfolio optimisation for a Fund of Hedge Funds (?FoHF?) has to address the asymmetric, non-Gaussian nature of the underlying returns distributions. Furthermore, the objective functions and constraints are not necessarily convex or even smooth. Therefore traditional portfolio optimisation methods such as mean-variance optimisation are not appropriate for such problems and global search optimisation algorithms could serve better to address such problems. Also, in implementing such an approach the goal is to incorporate information as to the future expected outcomes to determine the optimised portfolio rather than optimise a portfolio on historic performance. In this paper, we consider the suitability of global search optimisation algorithms applied to FoHF portfolios, and using one of these algorithms to construct an optimal portfolio of investable hedge fund indices given forecast views of the future and our confidence in such views.

Risk Management Framework for Hedge Funds: Role of Funding and Redemption Options on Leverage

We develop a model of hedge fund returns, which reflect the contractual relationships between a hedge fund, its investors and its prime brokers. These relationships are modelled as short option positions held by the hedge fund, wherein the 'funding option' reflects the short option position with prime brokers and the 'redemption option' reflects the short option position with the investors. Given an alpha producing human capital, the hedge fund’s ability to deploy leverage to magnify its alpha is shown to be sharply constrained by the presence of these short options, which have a high probability of being exercised in “bad states” of the world, either due to poor performance or due to macroeconomic developments that are performance-independent. We show that the hedge funds typically have an optimal level of leverage that trades off rationally the ability to increase alpha with the risk of early exercise of short options, which may precipitate the liquidation of the fund. Optimal leverage is shown to differ across hedge funds reflecting their de-levering costs, Sharpe ratios, correlation of assets, secondary market liquidity of their assets, and the volatility of the assets. Using a minimum level of unencumbered cash level as a risk limit, we show how a hedge fund can optimally choose aggregate risk capital and then allocate its risk capital across different risk-taking units to maximize alpha in the presence of these short option positions. Implications of our analysis for hedge fund investors and policy makers are summarized. Our framework can be easily modified to study portfolio selection problem facing any fund, which has granted redemption rights to its investors (money market funds, long-only funds, etc).

Financial Regulatory Reform and Private Funds

This white paper comments on the Obama administration's June 2009 proposal for the regulation of hedge fund investment advisers.

President's working group on financial markets: best practices for the hedge fund industry

PurposeThe purpose of this paper is to summarize two separate reports on best hedge fund industry practices issued on January 15, 2009 by the Asset Managers' Committee and the Investors' Committee of the President's Working Group on Capital Markets.Design/methodology/approachThe paper provides a detailed summary of the two reports.FindingsThe Asset Managers' Committee Report sets forth a standard of best practices for the hedge fund industry aimed at reducing systemic risk and fostering investor protection. It recommends that hedge fund managers adopt comprehensive best practices in all aspects of their businesses, including the following five key areas: disclosure; valuation; risk management; trading and business operations; and compliance, conflicts and business practices. The Investors' Committee Report sets forth guidelines intended to “enhance market discipline, mitigate systemic risk, augment regulatory safeguards regarding investor protection, and complement regulatory efforts to enhance market integrity”. The Report provides recommendations to investors for evaluating hedge funds and overseeing hedge fund investments within a portfolio. It is divided into: a Fiduciary's Guide aimed at assisting plan trustees, banks, consultants and others with portfolio oversight responsibilities, in determining whether a hedge fund investment would be suitable for the organization they represent; and an Investor's Guide aimed at providing recommendations to investors who have decided to add hedge funds to their investment portfolio.Originality/valueThe paper provides a concise, informative guide by experienced securities lawyers with hedge fund expertise.

The Twin Towers of Financialization: Entanglements of Political and Cultural Economies

Financialization, a moment in the genealogy of capital, does extend and refine accumulation, but it also elaborates mutual indebtedness as a more general feature of human sociality from labor to lived experience. More than a shift from one axis to another, it is the way that capital speaks its social relations. Risk becomes not simply a form of calculation, a way of knowing, but also invites a kind of being. The boundaries between being and value, sheer quality ceaseless quantity have become blurred. The heroic entrepreneur, whose genius inspires mass assemblies, yields to the arbitrager and hedge fund managers who stealthily stalk opportunity. The model of agency and social life by which small investments of capacity can be leveraged to substantial and increasingly volatile effects, whether this entails deployments of special forces, infrastructure repair, hedge fund investments, or political action termed terrorist, points to the efficacy of the derivative across seemingly disconnected practical domains. Conceptually speaking, financialization discloses the power of a derivative discourse that joins and travels through interdisciplinary worlds. Its intellectual force permits a fuller circulation of critical thought and engagement.

Polynomial Goal Programming and the Implicit Higher Moment Preferences of U.S. Institutional Investors in Hedge Funds

Polynomial goal programming (PGP) has been successfully introduced in the hedge fund allocation literature. The method is intuitive, and flexible enough to incorporate investor preferences in higher moments of the return distribution. However, until now, PGP could not be used to its full effectiveness because it requires quantification of real preference parameters toward those moments. Previously, those parameters were chosen without elaborate research. Our goal in this paper is to identify implied sets of preference parameters by using investors' choice 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 we derive implied sets of preference parameters in the context of a hedge fund portfolio optimization. To extract implied investor preference parameters, we determine optimal hedge fund portfolios according to the criteria set by those fund of hedge fund sponsors. We then fit implied preference parameters so that the PGP optimal portfolio is identical to the desired hedge fund portfolio. We can thus determine real preferences for the higher moments of the portfolio return distribution. With the obtained economically justified sets of preference parameters, we can use the well established PGP framework 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 managers to combine different hedge fund strategies optimally according to investor expectations. Finally, we can assess the importance of individual moments, as well as their marginal rates of substitution.