Hedge Fund Performance Research Articles

Hedge Funds and Leverage: Financial Crisis Consequences

Leverage is an essential component of hedge funds industry and performance. Then we can propose a definition of hedge funds based on their use of leverage. Leverage could be of investment and derivatives. Most of the time, leverage is an information given by the funds managers themselves. But we cannot check it and have to trust hedge funds when they deign to give it. Using Sharpe regression style method (1992), we will extract, from prices only, a quantitative leverage measure, which reveals us the part of performance due to leverage.

Why Do Hedge Fund Managers Outperform?

We rationalize the persistent performance of hedge funds with a simple model that takes into account the peculiarities of this industry. We show how incentive fees and the lack of benchmarking opportunities combine with the income-maximizing behaviors of managers to effectively align the interests of investors and managers. Through fee revisions, hedge funds manipulate their attractiveness toward investors and control their size. Therefore, performance-diluting flows do not occur and performance persists. The predictions of our model are consistent with the literature and are confirmed by our analysis of a unique dataset of hedge fund fee revisions. Our findings contribute to the regulatory debate by demonstrating that performance-based remunerations are beneficial to both investors and managers.

Hedge Fund Market Risk Exposures: A Survey

Résumé Cet article présente un résumé des études récentes consacrées à l’attribution de la performance des Hedge Funds. Ces fonds poursuivent des stratégies dynamiques à effet de levier important et investissent massivement en dérivés et en actifs non-liquides. En conséquence, ils présentent des relations linéaires et non-linéaires avec les principaux indices de marchés. Cette étude examine les facteurs de risque capables de capturer les co-mouvements linéaires et non-linéaires des Hedge Funds avec les indices de marché. Ce papier discute essentiellement de la significativité de facteurs optionnels et distributionnels. Les primes multi-moments amélioreraient considérablement le pouvoir explicatif des modèles généralement utilisés dans l’évaluation des rendements des Hedge Funds.

On the Dynamics of Hedge Fund Strategies

Hedge fund managers are largely free to pursue dynamic trading strategies, and standard static performance appraisal is no longer accurate for evaluating hedge funds. Accordingly, this article presents some new ways of analyzing hedge fund strategies following a dynamic linear regression model. Statistical residual diagnostics are considered to assess the appropriate use of the model. The authors unveil dynamic alphas and betas for each investment style during the period of January 1994 to December 2008.They examine the in-sample goodness-of-fit and out-of-sample predictability on hedge fund performance. By simulating a hypothetical trading strategy, they demonstrate that the model-based predictability helps to implement a profitable fund selection process. Finally, timing skills can be directly examined with a dynamic model; they find significant evidence for market timing, volatility timing, and liquidity timing, which is consistent with the timing literature about hedge funds.

Contrarian Hedge Funds and Momentum Mutual Funds

We study how hedge fund performance is related to the presence of mutual funds operating in the same asset class. We argue that hedge funds are able to exploit the constraints of the mutual funds related to both the high correlation between flows and value of investment and their tendency to cater to investors by invest in stocks that are 'hot'. Hedge funds exploit these features of the mutual funds, especially the domestic ones. We show that the performance of the hedge funds is significantly higher when mutual fund market coverage is higher. This effect is mostly concentrated among domestic mutual funds and is stronger the higher investment horizon of the hedge funds. A high presence of the mutual fund industry helps to explain 28% of the yearly hedge fund performance. Hedge funds are more likely to be 'alpha' in the presence of a high degree of mutual fund market coverage and their probability of survival is higher. Hedge funds employ contrarian strategies at the very moment in which mutual funds ride market expectations. The degree by which hedge funds react to changes in public information is directly related to the degree of mutual fund market coverage.

Hedge funds and their interaction with market parameters

The performance of hedge funds and other financial institutions has been carefully studied during the last financial crisis. In our study which spans through a time period of 31 December, 1999 to 21 June, 2011, the relationship between global hedge fund indice and Federal Reserve’s effective interest rate, and the relationship between the 10 year-term Treasury bill and the M2 monetary supply variables as the United States' economy indicator was tested with vector autoregression analysis (VAR). Based on the results obtained, the indices stastistically and significantly reflect the developments guiding the U.S. economy and then became effective on our present variables. Key words: Hedge funds, vector autoregression analysis (VAR).

The Effect of S&P 500 Correlation on Hedge Fund Alpha

This article investigates the effect of S&amp;P 500 Index correlation on the performance of hedge funds. Specifically, the authors separate the alpha and beta components of the four major hedge fund trading strategies in the Hedge Fund Research (HFR) database across three mutually exclusive equity–market correlation regimes. Using panel data regression, they isolate correlation regimes using dichotomous variables that add or detract from the alphas. They find that equity–oriented hedge fund strategies generate over twice the alpha during low–correlation regimes relative to normalcorrelation regimes. Their analysis provides a practical approach for optimizing allocations to hedge fund strategies that are expected to benefit from “stock–picking”skills during low equity-correlation environments. Furthermore, the proposed framework can be useful in identifying individual managers likely to benefit from this effect. <b>TOPICS:</b>Real assets/alternative investments/private equity, statistical methods, performance measurement, manager selection

Revisiting 'Stylized Facts' About Hedge Funds

This paper shows that several previously documented stylized facts about hedge fund performance are sensitive to database selection and associated biases. Based on a novel database aggregation, we show that qualitative and quantitative differences in conclusions about average performance stem from database differences in the coverage of dead funds and the completeness of assets under management information. Investors that consider chasing returns should heed our finding that there is no performance persistence for certain rebalancing frequencies and databases. Drawing on our results and a detailed appendix that describes our database aggregation, we make recommendations to hedge fund database users and researchers about hedge fund database selection, construction and comparison.

Hedge fund attributes and volatility around equity offerings

The purpose of this paper is to explore the potential influence of hedge fund attributes on idiosyncratic volatility (IVOL) in excess stock returns for 705 firms undergoing seasoned equity offerings (SEOs). This investigation is important due to the pervasive concerns about the impact of hedge funds on volatility. We choose a time frame from 1999 to 2005 covering two periods that could impact IVOL differently: the internet-technology bubble period and the post-bubble period. Our time frame includes the breakpoint year of 2000 that marks a downward trend in IVOL from 2000 to 2008. We explore this IVOL drop for a sample of SEOs and find that the decline in IVOL for this sample can be primarily related to the rapid increase in the hedge fund industry size and to the increasing use of leverage by hedge funds. This trend is also related to the increasing use of a relative value (arbitrage) strategy and the decreasing use of an event-driven strategy. IVOL for our sample also appears to decrease with greater hedge fund performance except when hedge funds are riding the pre-SEO stock price run-up. The downward shift in IVOL for our SEO sample around their offering dates is better explained by hedge fund attributes than by non-hedge fund attributes. In conclusion, our findings suggest that the rapid increase in the hedge fund industry offer an explanation for the mysterious decline in IVOL that has been witnessed since 2000.

Experienced Hedge Fund Activists

Using a sample of 269 activist events from 1994 to 2005, we show that targets of experienced hedge fund activists earn higher long-term stock returns than targets of less experienced activists or a matched target sample. Hedge fund expertise includes past industry experience in the hedge fund’s industry of specialization or prior portfolio management/ leadership experience at similar hedge funds. Experienced activists also boast better overall hedge fund performance. Investigating the sources of performance, we find that more experienced activists follow a well defined course of action by initially putting the target firm “on notice” that the hedge fund may become more aggressive. If target firm performance does not improve quickly, these activists typically turn hostile by initiating and often winning proxy fights, making proxy threats, forcing targets to sign standstill agreements, and/or agitating for and frequently getting the sale of the target firm. Importantly, ours is the first study to document large-scale evidence that hedge fund activism can lead to superior long-term target firm and hedge fund performance and to document the source of this outperformance. These results provide compelling evidence of skill among certain hedge fund managers – those with the experience and expertise to engage in activism.

The Impact of Portfolio Disclosure on Hedge Fund Performance, Fees, and Flows

This study investigates the impact of portfolio disclosure on hedge fund performance. Using a regression discontinuity design, I investigate the effect of the disclosure requirements that take effect when an investment company's assets exceed $100 million; when that occurs, a fund is required by the U.S. Securities and Exchange Commission to submit form 13F disclosing its portfolio holdings. Consistent with the argument that portfolio disclosure reveals 'trade secrets' and also raises front running costs thus harms the funds that disclose, I find that there is a drop in fund performance (about 4 percent annually) after a fund begins filing form 13F, as well as an increase in return correlations with other hedge funds in the same investment style. The drop in performance cannot be explained by a change in the assets under management or a mean reversion in returns. Consistent with the idea that funds with illiquid holdings tend to employ sequential trading strategies, which increase the likelihood of being taken advantage of by free riders and front runners, the drop in performance is more dramatic for funds that have more illiquid holdings. In addition, I find that the incentive fees paid to fund managers are 1 percent higher when portfolio disclosure is required, which supports the hypothesis that investors' monitoring of portfolio holdings disciplines adverse risk-taking by fund managers and allows for higher convexity in the optimal compensation structure. Finally, there is a drop in flows into funds that file 13F, which suggests that hedge fund investors negatively value 13F disclosure. Overall, this study suggests that the cost of portfolio disclosure is economically large. It contributes to the policy debate over what constitutes optimal disclosure.

Measuring the Performance of Hedge Funds Using Two-Stage Endogenous Benchmarks

Measuring the Performance of Hedge Funds Using Two-Stage Endogenous Benchmarks

The Peer Performance of Hedge Funds

We propose to evaluate an investment fund’s performance by the percentage of peers the fund outperforms and underperforms, after correction for luck. We call these measures the fund’s outperformance ratio and underperformance ratio. When applied to hedge funds, we find that fund size tends to increase the underperformance ratio, but the effect is lower for funds with a longer track record. Our results also indicate that the outperformance ratio is a better predictor of future fund performance than alternative peer performance measures, and that, the best forecast performance is obtained when combining the outperformance ratio with a relative or peer alpha measure.

Home Bias and Local Contagion: Evidence from Funds of Hedge Funds

This paper analyzes the geographical preferences of hedge fund investors and the implication of these preferences for hedge fund performance. We find that funds of hedge funds overweight their investments in hedge funds located in the same geographical areas and that funds of hedge funds with a stronger local bias exhibit superior performance. However, this local bias of funds of funds adversely impacts the hedge funds by creating excess comovement and contagion within geographic areas. Overall, our results suggest that while funds of funds benefit from local advantages, their local bias creates market segmentation that could destabilize financial markets.

Dedicated Short Bias Hedge Funds:Diversification and Alpha during Financial Crises

During the recent financial crisis dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This article, prompted by this recent episode, investigates DSB hedge fund performance over an extended sample period, from January 1994 to December 2008. Performance and risk evaluation are carried out on an equally weighted DSB hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. The authors conclude that DSB hedge funds are a significant source of diversification for equity market investors and produce statistically significant levels of alpha. Their findings are robust to the specification of traditional and alternative risk factors, nonlinearity, and the omission of the crisis periods, which are particularly favorable for the DSB strategy. <b>TOPICS:</b>Real assets/alternative investments/private equity, options, financial crises and financial market history, statistical methods

Hedge funds, fund attributes and risk adjusted returns

We use proprietary data to examine factors that lead hedge fund managers to offer hurdle rates and investigate relative hedge fund performance based on risk-adjusted returns. Using data from 3,571 hedge funds over a 15 year period, we find that funds that do not offer a hurdle rate outperform those that do. Funds offering a high watermark charge substantially higher performance fees. Further, emerging market, fixed income, and funds of funds are significantly more likely to offer a hurdle rate than other types of funds. Performance fees have a positive impact on the likelihood of offering a hurdle rate. Fund leverage and management fees are negatively associated with hurdle rates. The cross-sectional regressions show that funds, which offer a hurdle rate, underperform those that do not. Funds that charge a high performance fee appear to outperform those that charge a relatively low fee. The results are consistent with the view that those managers who wish to improve risk-adjusted returns should not focus on hurdle rates.

The alpha and omega of fund of hedge fund added value

In spite of a somewhat disappointing performance throughout the crisis, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing outflows. Can this phenomenon be explained by the failure of fund of hedge fund managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry? We introduce a return-based attribution model allowing for a full decomposition of fund of hedge fund performance. The results of our empirical study suggest that funds of hedge funds are funds of funds like others. Strategic allocation turns out to be a crucial step in the investment process, in that it not only adds value over the long-term, but most importantly, it brings resilience precisely when investors need it the most. Fund picking, on the other hand, turns out to be a double-edged sword.

Diversification in the hedge fund industry

We provide evidence of a significant relation between diversification and performance in the hedge fund industry. Measuring diversification across four distinct dimensions, we find a significant positive relation between hedge fund performance and diversification across sectors and asset classes. We show that on a risk adjusted basis, hedge funds that diversify across sectors and asset classes outperform other funds by an average of 1.1% per year. However, diversification across styles and geographies exhibits a significant negative association with hedge fund returns. Funds that diversify across styles and geographies underperform other funds by an average of 1% per year. For fund of hedge funds, we find a significant positive relation between performance and diversification across sectors. However, diversifying across asset classes and geographies is found to exhibit a negative relation with fund performance. Finally, we find that the motive to engage in diversification is consistent with managerial incentive structure in the hedge fund industry.

Investible Benchmarks and Hedge Fund Liquidity

A lack of commonly accepted benchmarks for hedge fund performance has permitted hedge fund managers to attribute to skill those returns that may actually accrue from market risk factors and illiquidity. Recent innovations in hedge fund replication permit us to estimate the extent of this misattribution. Using an option-based model, we find evidence that hedge fund returns in excess of a benchmark may not even compensate investors for liquidity options they grant to managers when they accept restrictions on their right to redeem their investments. Coupled with the competition from hedge fund replication vehicles, this analysis may motivate hedge fund investors to demand relaxed redemption terms from hedge fund managers. <b>TOPICS:</b>Real assets/alternative investments/private equity, performance measurement

Hedge Fund Database “Deconstruction”: Are Hedge Fund Databases Half Full or Half Empty?

While the impact of backfill bias, survivor bias, and other database construction issues (e.g., onshore versus offshore) on hedge fund performance have received considerable research attention, the impact on hedge fund performance of differences in the underlying quality or number of reporting managers in various hedge fund databases has often been underreported. Most major hedge fund databases rely on manager-based reporting. As a result, database quality is dependent on managers’ updating requested data. In addition, hedge fund databases were created and grew at different times. Thus, large differences in the number of managers reporting as well as differences in other fund platform characteristics may exist between various databases. If these databases contained enough manager breadth and depth, results at the portfolio level could be similar across various databases; however, differences may still exist at the average manager level, especially for small subsets of analyses (e.g., strategy, fee level, etc.). In this analysis, the authors compare performance characteristics of two major databases often used in hedge fund analysis (CSFB/Tremont and CISDM). More specifically, they compare performance results at the strategy level for 1) all reporting funds, 2) funds denominated only in U.S. dollars, and 3) a cleaned set of funds with duplicates removed (e.g., multiple share classes or currencies). Results show some return and risk differences between the two databases at the portfolio and average manager levels. These differences, however, are often relatively small. In the end, the impact of database usage and the necessity of “deconstructing” one’s database depends, in part, on whether one views the glass as half full or half empty. <b>TOPICS:</b>Real assets/alternative investments/private equity, information providers/credit ratings, performance measurement