Hedge Fund Strategies Research Articles

Dispute the patent, short the stock: Empirical analysis of a new hedge fund strategy

A new US patent legislation, called the America Invents Act, became effective in 2011. The reform strived toward facilitating the patent system. But soon it was also blamed for facilitating immoral third party profits. Urges for revision of the America Invents Act became even louder since hedge fund manager Kyle Bass had publicly outlined his questionable investment strategy: he challenges the validity of important drug patents, while shorting the owner's shares in order to eventually cash out on negative stock movements.The following questions aroused public interest the most: Does the mere filing of a patent opposition already result in negative stock returns? And is it really possible to earn money following such a strategy? The paper on hand is the first to empirically answer these questions. Event study methodology using three years of data from the United States Patent Trial and Appeal Board was employed.Findings were that the mere filing of a patent opposition in fact produces statistically significant negative returns. The result is robust with the abnormal return being −30 base points. In addition, multiple linear regression results confirm the conjecture that the higher the importance of the disputed patent, the higher the negative abnormal return on the filing date will be. However, transaction cost simulations prove that this strategy is still highly speculative and cannot be considered a real threat to patent holders or the US intellectual property system. The only ones who should start worrying are the few patent owners who really rely on absolutely unjustified and tenuous patent protection.

Hedge Fund Strategies and Time-Varying Alphas and Betas

This article compares the time-varying estimates of alphas and betas for hedge funds in bear and bull market periods. The time-varying models show that most hedge fund strategies vary their beta risk exposure in accordance with changing market conditions. Most strategies display significant positive alphas for the whole period, but none generates significant alpha in the combined bear periods. The authors also investigate a set of other beta risk factors and find that these risk factors are more significant in bull periods. Hence, in bull periods, they are able to identify a set of risk factors for hedge fund strategies, while the picture is less clear for the exposure in bear periods. However, many strategies seem to be positively correlated with the return on high-yield bonds.

Proshares Hedge Replication ETF

At the start of 2014, Joanne Hill was preparing to present at a conference focused on alternative investments for financial advisers. Exhibit 1 provides selected slides from the presentation. Hill wants to showcase how Hedge Replication ETF (HDG) provided an exposure to hedge funds at low fees, with full transparency and providing daily liquidity. But she had to overcome some resistance in the audience because most hedge fund strategies had underperformed the overall stock market in recent years. Could 2014 be a comeback year for hedge fund strategies? Excerpt UVA-F-1714 Feb. 19, 2015 ProShares Hedge Replication ETF At the start of 2014, Joanne Hill was preparing to present at a conference focused on alternative investments for financial advisers. As ‎head of institutional investment strategy at ProShares, Hill had been part of the research and development team behind the firm's lineup of exchange-traded funds (ETFs). ProShares was a leader in packaging liquid alternative strategies in ETFs, using combinations of securities and derivatives products. Hill's presentation on that day was titled “Hedge Fund Replication: A Closer Look,” and it was focused on one of ProShares's liquid alternative strategy products: the Hedge Replication ETF (HDG). Exhibit 1 provides selected slides from the presentation, which can also be watched online. Hill wanted to showcase how HDG provided an exposure to hedge funds at low fees, with full transparency and providing daily liquidity. But she had to overcome some resistance in the audience because most hedge fund strategies had underperformed the overall stock market in recent years. For example, HDG's return had been 4.4% in 2013 (with volatility of 4.8%), while the S&P 500 index had returned 32.4% over the same period (with 11% volatility). Could 2014 be a comeback year for hedge fund strategies? ProShares: The Alternative ETF Company ProShares, based in Bethesda, Maryland, had established itself as the world's largest manager of short and leveraged exchange-traded funds, which the firm labeled as “geared” ETFs. Its affiliate, ProFunds, was founded in 1997, offering leveraged and inverse mutual funds across a range of equity and bond indexes. In 2006, ProShares introduced geared ETFs, the first of their kind ever offered. These geared ETFs sought to deliver multiples of the performance of the index or benchmark they tracked. Ultra (or leveraged) ETFs had daily objectives to produce 2× or 3× the daily return of an index. Short (or inverse) ETFs sought to deliver −1×, −2×, or −3× daily exposures and were designed to go up when market indices went down and vice versa. To accomplish their objectives, geared ETFs used collateralized positions in swaps, futures contracts, and other derivative instruments. Some ProShares ETFs tracked broad equity indices, some were sector specific, and still others were linked to bond, commodity, and currency indexes. These ETFs could be purchased and sold like stocks and allowed investors to take hedging and speculative positions without directly using any derivatives. . . .

Proshares: The Alternative ETF Company

In 2014, ProShares CEO Michael Sapir was meeting with Steve Cohen, managing director and head of the ProShares Strategy Group, whose agenda centered on the progress the firm was making in moving from its core offering of geared ETFs into establishing itself as the leading alternative ETF company. Since 2009, the firm had launched an array of ETFs and Sapir and Cohen were reviewing the current lineup, the assets under management (AUM), and net flows across ProShares' different ETF categories. Could ProShares get another $25 billion in AUM in these more strategic alternative ETFs? Excerpt UVA-F-1729 Nov. 24, 2015 ProShares: The Alternative ETF Company In the summer of 2014, Michael Sapir, the CEO of ProShares, was reviewing the progress in the firm's lineup of exchange-traded funds (ETFs). With its headquarters located in Bethesda, Maryland, the firm was far from Wall Street and was a nontraditional financial company in many respects. Since its first ETF launch in 2006, the firm had successfully democratized access to short and leveraged strategies by offering them in ETFs to individual investors, advisers, and institutions. These “geared” ETFs aimed to deliver two or three times the daily return or the inverse of the return of their underlying indices covering all the major asset classes such as domestic equities (including different market caps, styles, or sectors), international equities, fixed income, commodities, and currencies. ProShares ranked in the top 10 of the largest ETF sponsors in the United States. Sapir was meeting with Steve Cohen, managing director and head of the ProShares Strategy Group whose agenda centered on the progress the firm was making in moving from its core offering of geared ETFs into establishing itself as the leading alternative ETF company. Offering alternative ETFs was a broad concept that encompassed both nontraditional asset classes and investment strategies (Exhibit 1). Although these investments aimed to provide unique sources of risk and return, correlation benefits, and the potential for a better Sharpe ratio in a portfolio, they also might provide potential downside protection in falling markets. These alternative strategies, used for some time by institutional investors, tended to have favorable long-term returns relative to risk. Many of these strategies used leverage, shorting, and derivatives. Since 2009, the firm had launched an array of ETFs that included alternative equity (specialty equity and dividend growers), fixed income strategies (hedged and global fixed income), tactical products to benefit from changes in inflation and market volatility (inflation and volatility), and ETFs that replicated hedge fund strategies (hedge strategies). (See Exhibit 2 for the full product list.) Sapir and Cohen were reviewing the current lineup of ETFs, the assets under management (AUM), and net flows across ProShares' different ETF categories (Exhibit 3). ProShares had become the world's largest manager of geared ETFs with more than $ 25billion in AUM (Exhibit 4). Could it get the next $ 25 billion in AUM in these more strategic alternative ETFs? . . .

Theq-factor and the Fama and French asset pricing models: hedge fund evidence

PurposeThe purpose of this paper is to test the new Fama and French (2015) five-factor model relying on a thorough sample of hedge fund strategies drawn from the Barclay’s Global hedge fund database.Design/methodology/approachThe authors use a stepwise regression to identify the factors of theq-factor model which are relevant for the hedge fund strategy analysis. Doing so, the authors account for the Fung and Hsieh seven factors which prove very useful in the explanation of the hedge fund strategies. The authors introduce interaction terms to depict any interaction of the traditional Fama and French factors with the factors associated with theq-factor model. The authors also examine the dynamic dimensions of the risk-taking behavior of hedge funds using a BEKK procedure and the Kalman filter algorithm.FindingsThe results show that hedge funds seem to prefer stocks of firms with a high investment-to-assets ratio (low conservative minus aggressive (CMA)), on the one hand, and weak firms’ stocks (low robust minus weak (RMW)), on the other hand. This combination is not associated with the conventional properties of growth stocks – i.e., low high minus low (HML) stocks – which are related to firms which invest more (low CMA) and which are more profitable (high RMW). Finally, small minus big (SMB) interacts more with RMW while HML is more correlated with CMA. The conditional correlations between SMB and CMA, on the one hand, and HML and RMW, on the other hand, are less tight and may change sign over time.Originality/valueTo the best of the authors’ knowledge, the authors are the first to cast the new Fama and French five-factor model in a hedge fund setting which account for the Fung and Hsieh option-like trading strategies. This approach allows the authors to better understand hedge fund strategies becauseq-factors are useful to study the dynamic behavior of hedge funds.

The q-factor model and the redundancy of the value factor: An application to hedge funds

We test the new Fama and French five-factor model on a sample of hedge fund strategies. This model embeds the q-factor asset pricing model which lies on the CMA and RMW factors. We find that the HML factor is not redundant for many strategies, as conjectured by Fama and French in their setting. HML seems to embed risk dimensions which are not included in the Fama and French new factors. In contrast to Fama and French, the α puzzle is robust to the addition of CMA and RMW. Furthermore, hedge funds seem to prefer, on the one hand, firms which invest a lot to firms which invest less, and, on the other hand, weak firms over robust ones. Finally, our results are not sensitive to the addition of the Fung and Hsieh seven-factor model. However, the explanatory power of the eleven-factor model is much higher for some hedge fund strategies involved in arbitrage.

Hedge funds risk and connectedness

This paper focused on measuring the volatility spillovers and parametric Value-at-Risk (VaR) models for hedge fund strategies. In reference to the first, a volatility spillover index was created to measure the connectedness and relationships between strategies. Results suggest that during periods of distress, volatility spillovers tend to increase across strategies. Equity-Hedge and Event-Driven strategies seem to be the most connected, while the Equity-Market-Neutral strategy exhibits the least connectedness with other strategies. With regard the second, unconditional and conditional parametric VaR models under Gaussian and t-distributions were measured. In general, conditional GARCH-type models outperform their unconditional counterparts, particularly at the onset of the recent financial crisis. This suggests that GARCH-type VaRs are better in protecting against downside risk. Moreover, conditional Gaussian models are more suitable for mild periods, while those under the t-distribution effectively capture risk in extremely volatile period. Finally, to unravel the connection between the two measures, common hits between hedge fund strategies were examined. The results validate the results of the volatility spillover index.

Hedge Fund Replication: A Model Combination Approach

Recent years have seen increased demand from institutional investors for passive replication products that track the performance of hedge fund strategies using liquid investable assets such as futures contracts. In practice, linear replication methods suffer from poor tracking performance and high turnover. We propose a model combination approach to index replication that pools information from a diverse set of pre-specified factor models. Compared with existing methods, the pooled clone strategies yield consistently lower tracking errors, generate less severe portfolio drawdowns, and require substantially smaller trading volume. The pooled hedge fund clones also provide economic benefits in a portfolio allocation context.

Sovereign Funds and External Asset Manager Fees: The Governance Connection

Sovereign wealth funds (SWFs) vary widely in how they use external managers, but nearly all SWFs make significant use of external managers, particularly for alternative asset classes that are difficult to access or demand labor-intensive investment strategies, such as private equity, venture capital, and hedge fund strategies. Many SWFs — and those interested in the performance of SWFs, including government officials and citizens — are now asking whether the returns, net of fees, are worth the fees charged by these external managers. However, while external asset managers — and hedge fund and private equity managers in particular — have been criticized for their high fees (and, in 2015 in particular, high fees often coupled with poor performance), the governance and management of asset owners themselves may contribute to the problem.

Editor’s Letter

1. Hossein Kazemi 1. Editor-in-Chief This issue of The Journal of Alternative Investments deals with three broad topics: regulation, structured products, and hedge fund strategies. Since the 2007–2008 financial crisis, few topics have attracted more attention than financial regulation and

A Primer on Alternative Risk Premia

The concept of alternative risk premia can be viewed as an extension of the factor investing approach. Factor investing is a term that is generally dedicated to long-only equity risk factors. A typical example is the value equity strategy. Alternative risk premia designate non-traditional risk premia other than long exposure to equities and bonds. They may concern equities, rates, credit, currencies or commodities and correspond to long/short portfolios. For instance, the value strategy can be extended to credit, currencies and commodities. This paper provides an overview of the different alternative risk premia to be found in the academic and professional spheres. Using a database of commercial indices, we estimate the generic cumulative returns of 59 alternative risk premia in order to analyze their risk, diversification power and payoff function. From this, it is clear that the term "alternative risk premia" encompasses two different types of risk factor: skewness risk premia and market anomalies. We then reconsider portfolio allocation in light of this framework. Indeed, we show that skewness aggregation is considerably more complex than volatility aggregation, and we illustrate that the volatility risk measure is less appropriate and pertinent when managing a portfolio with these risk premia. The development of alternative risk premia shall also affect the risk/return analysis of non-linear strategies, e.g. hedge fund strategies. In particular, using alternative risk factors instead of traditional risk factors leads to an extension of the alternative beta framework. Therefore, we apply the previously estimated risk premia to a universe of hedge fund indices. To that end, we develop a model selection based on the lasso regression to identify the most pertinent risk premia for each hedge fund strategy. It appears that many traditional risk factors, with the exception of long equity and credit exposure on developed markets, vanish when we include alternative risk premia.

Hedge Fund Tail Risk:An Investigationin Stressed Markets

This article develops several risk measures that capture the tail risk of single hedge fund strategies and the tail risk contribution of these hedge fund strategies to the overall portfolio tail risk, conditional on the level of market distress. The authors show that, during the recent global financial crisis, all of the different hedge fund strategies contributed to the tail risk of the portfolio of hedge funds, mostly because of the hedge fund strategies’ exposure to liquidity and credit risk.

The Market Liquidity Timing Skills of Debt‐oriented Hedge Funds

ABSTRACTWe investigate the liquidity timing skills of debt‐oriented hedge funds following the 2008 credit crisis, which demonstrated the importance of understanding liquidity conditions to manage the market exposure of investments. We base the analysis on the estimated co‐movements of fixed income and equity market liquidity. Our findings, which are statistically robust, show evidence of liquidity timing ability in the fixed income market for all debt‐oriented hedge fund strategy categories. Joint market liquidity timing skill, however, is only found in some categories. Our findings suggest that debt‐oriented hedge fund managers use a sophisticated set of timing strategies in their investment managements.

Hedge Fund Tail Risk: An Investigation in Stressed Markets, Extended Version with Appendix

This paper develops several risk measures that captures the tail risk of single hedge fund strategies and the tail risk contribution of these hedge fund strategies to the overall portfolio tail risk, conditional on the level of market distress. We show that, during the recent global financial crisis, all the different hedge fund strategies are contributing to the tail risk of the portfolio of hedge funds, mostly because of the hedge fund strategies' exposure to liquidity and credit risk.

Entwicklungslinien in der Portfoliotheorie und im Asset Management

The paper first gives an overview of the theory of finance and then focuses on the field of asset management. The portfolio model of Markowitz serves as a starting point. It has deeply influenced financial theory although it is hardly implementable because of estimation errors in expected returns. Therefore, possible solutions and extensions are considered. Following a general discussion of active versus passive management, the article presents active approaches derived from return anomalies, factor premiums and hedge fund strategies. The article concludes with an outlook on challenges for asset management in the future.

Stop-outs under serial correlation and the triple penance rule

At what loss should a portfolio manager be stopped-out? What is an acceptable time under water? We demonstrate that, under standard portfolio theory assumptions, the answer to the latter question is strikingly unequivocal: On average, the recovery spans three times the period involved in accumulating the maximum quantile loss for a given confidence level. We denote this principle the “triple penance rule”. We provide a theoretical justification to why investment firms typically set less strict stop-out rules to portfolio managers with higher Sharpe ratios, despite the fact that they should be expected to deliver superior performance. We generalize this framework to the case of first-order auto-correlated investment outcomes, and conclude that ignoring the effect of serial correlation leads to a gross underestimation of the downside potential of hedge fund strategies, by as much as 70%. We also estimate that some hedge funds may be firing more than three times the number of skillful portfolio managers, compared to the number that they were willing to accept, as a result of evaluating their performance through traditional metrics, such as the Sharpe ratio. We believe that our closed-form compact expression for the estimation of downside potential, without having to assume IID cashflows, will open new practical applications in risk management, portfolio optimization and capital allocation. The Python code included confirms the accuracy of our analytical solution.

Hedge Fund Performance Attribution at Strategy Level Under Different Market Conditions

We investigate US hedge funds’ performance across different economic and market conditions for the longest period to date, 1990-2014. The paper examines the impact of multiple business cycles and rising/falling markets on exposures and excess returns delivered to investors. We use a twin nonlinear multi-factor agile model with pre-defined and undefined structural breaks, based on a regime switching process conditional on different states of the market. During difficult market conditions the majority of hedge fund strategies do not provide significant alphas to investors. At such times hedge funds reduce both the number of their exposures to different asset classes and their portfolio allocations. Some strategies even reverse their exposures. Directional strategies share more common exposures under all market conditions compared to non-directional strategies. Factors related to commodity asset classes are more common during these difficult conditions whereas factors related to equity asset classes are most common during good market conditions. Falling stock markets are harsher than recessions for hedge funds.

Practical Applications of Liquid Absolute Return Funds: An Alternative to Alternatives?

Liquid absolute return funds have been a key beneficiary of regulatory changes, resulting in substantial inflows. Critics of these vehicles—which bring hedge fund strategies to the masses—are pointing to their performance during the recent market turmoil as proof that unsophisticated investors should not venture there. In <b>Liquid Absolute Return Funds: <i>An Alternative to Alternatives?</i></b>, published in the Fall 2015 issue of <b><i>The Journal of Wealth Management</i></b>, <b>Joachim Klement</b> of <b>Wellershoff &amp; Partners</b> examines the performance of liquid alt funds and explains how they may be viewed in a portfolio context. He warns investors to look out for limited track records and owner concentration, and he discusses the trade-off between liquidity and fees. <b>TOPICS:</b>Mutual funds/passive investing/indexing, real assets/alternative investments/private equity, statistical methods, performance measurement

Macroeconomic shocks, forward-looking dynamics, and the behavior of hedge funds

Abstract We investigate how hedge funds’ strategies react, as a group, to macroeconomic risk and uncertainty. Adopting the methodology of Beaudry et al. (2001), we track the behavior of the cross-sectional dispersions of hedge fund strategies’ returns, market betas and alphas over the business cycle. The pattern of strategies’ betas supports Beaudry et al.’s conjecture: hedge funds reduce their risk-taking (betas) during times of macroeconomic uncertainty, which makes their strategies more homogeneous and thus contributes to increased systemic risk in the financial system. However, the cyclical behavior of the cross-sectional dispersions of strategies’ returns and strategies’ alphas is not in line with Beaudry et al.’s conjecture. These dispersions tend to increase during episodes of rising macroeconomic uncertainty, which suggests the prevalence of the Black’s (1976) leverage effect during financial turmoil and the fact that the exposure of hedge fund strategies to risk factors is quite different from each other. Finally, although remaining important, procyclicality seems to have declined through time in the hedge fund industry, which suggests that a learning process is at play.

Fund Hiring Rules and Investment Firms

Investment manager firm concentration for traditional equity and fixed income strategies has grown as a result of the increase in large funds’ share of overall pension funds and is now increasing in hedge fund and private equity strategies. Funds’ practice of buying from the same few large providers at increasing rates runs contrary to their competition to produce alpha, as research demonstrates that smaller firms add more value. From the firm’s perspective, continuing to remain a small institutional investment management firm is a riskier business strategy. Small firms rationally desire growth, including additional products and mergers, to achieve the scale buyers require, contrary to specialized boutique business models.