Long-only Funds Research Articles

Practical Applications of Implementation Matters: Relaxing Constraints Can Improve the Potential Returns of Factor Strategies

Practical Applications Summary In Implementation Matters: Relaxing Constraints Can Improve the Potential Returns of Factor Strategies, which appeared in the 2019 Quantitative Special Issue of The Journal of Portfolio Management, Jack Davies, Dave Gibbon, Sara Shores, and Josephine Smith (all of BlackRock, Inc.) investigated the differences in the performance of various factor strategy portfolios when investment constraints were placed on investment vehicles. They created several hypothetical portfolios based on momentum and value strategies, and imposed constraints representative of five types of investment vehicles: private funds, UCITS, 130/30 funds, long-only funds, and long-only ETF. The authors found that, in general, the hypothetical implementations with fewer constraints performed better. These findings suggest that investors should pay attention to the real-world restrictions placed on the investment vehicles they choose when pursuing style-factor investment strategies.

All Style Hedge Fund Analysis with Constant- and Time-Varying Factor Loading Models

Driven by vast historical growth and the recent crises, the hedge fund industry has undergone several changes. This thesis presents studies on the analysis of hedge fund returns within changing market states by applying different constant, asymmetric and time-varying factor loading models. Considered models include the CAPM, Fama-French 3-factor model, Carhart 4-factor model, Fama-French 5-Factor model, Agarwal-Naik 8-factor model and the Fung-Hsieh 7- and 8-factor models. In addition, and unlike previous research, 94 hedge fund strategy styles have been analysed individually to test whether the model performances differ among approaches. The first full-sample analysis exhibits generally low explanatory power whereby the more sophisticated models perform superiorly. Equity strategies, especially long-only funds, exhibit high adjusted R-Squared among all models, while fixed income, fundamental and technical hedge funds result in low significance. The CUSUM control chart based crisis/non-crisis dummy cannot substantially improve the explanatory power of the models. Hedge fund alpha and factor significance varies considerably among strategies and the power of the models remains similarly poor. Asymmetric up/down models exhibit slightly improved explanatory power while the significance of alpha diminishes. Replacing the conditional up/down variable by the crisis/non-crisis setting resulted in inferior results. Empirical analysis with asymmetric higher-moment models approves the asymmetries in hedge fund returns partially. Moreover, a time-varying approach substantially improves the explanatory power of all models while hedge fund alpha further diminishes. All dynamic models exhibit significant exposures on macro state variables for a high proportion of funds. To summarise, it has been shown how simple models can be fitted to increase the explanatory power. As a result, the adjusted R-Squared were improved by 73%. On a strategy level, equity funds are explained the best while fixed income, fundamental and technical hedge funds are the most difficult to analyse.

Equity style allocation: A nonparametric approach

In this article we provide a framework to assist with style allocation in Asian equity funds. We implement a nonparametric methodology to capture short-term stable time-varying relationships of otherwise long-term unstable relationships between numerous macroeconomic variables and style returns. We find that a nonparametric forecasting methodology produces positive performance after allowing for transaction costs, while the equivalent parametric forecasts are negative. The model can be implemented through tilting a funds style exposure to enhance performance. Even in the context of a long-only fund, the style exposures of the proposed model can be implemented as long–short exposures relative to a benchmark. Because the model is presented as a self financing market-neutral model, its implementation can be leveraged directly in a market-neutral fund or indirectly as (leveraged) style exposures in a long-only fund.

Style factor timing: An application to the portfolio holdings of US fund managers

This study develops a style rotation model based on quarterly forecasts of style factor (SF) returns, across four style categories, generated using market and macroeconomic data. The prescriptions from this model are tested on a sample of US active equity mutual funds’ portfolio holdings. An annual buy-and-hold style timing strategy investing in the factor with the highest forecast return each quarter achieves an average annual excess return of 7.26%, significant at the 1% level during 1981–2011. However, a fund-of-fund (FoF) timing strategy investing in the funds with the greatest exposure (i.e. the preferred funds) to the style predicted to outperform over the following year does not generate statistically significant Daniel, Grinblatt, Titman and Wermers (DGTW)-adjusted performance. The lack of performance is primarily because the long-only funds are by nature unable to fully exploit the long-short SF returns. This highlights the issue of using long-short portfolio returns, particularly when evaluating fund performance.

Style Factor Timing: An Application to the Portfolio Holdings of US Fund Managers

This study develops a style rotation model based on quarterly forecasts of style factor returns, across four style categories, generated using market and macroeconomic data. The prescriptions from this model are tested on a sample of U.S. active equity mutual funds’ portfolio holdings. An annual buy-and-hold style timing strategy investing in the factor with the highest forecast return each quarter achieves an average annual excess return of 7.26%, significant at the 1% level over 1981-2011. However, a fund-of-fund timing strategy investing in the funds with the greatest exposure (i.e., the preferred funds) to the style predicted to outperform over the following year does not generate statistically significant DGTW-adjusted performance. The lack of performance is primarily because the long-only funds are by nature unable to fully exploit the long-short style factor returns. This highlights the issue of using long-short portfolio returns, particularly when evaluating fund performance.

Concentration in the South African equity market and its implied restrictions on the long only equity fund manager’s opportunity set

South Afric's Equity market provides a large (in terms of volume) but concentrated investment environment. Domestic pension funds are restricted from diversifying globally and are thus faced with a restricted set of investment opportunities. This article describes and quantifies the extent of the concentration on the JSE historically and at present. The article describes the consequent limitations on long-only equity portfolio construction and the implications for the domestic long-only fund manager subject to various active weight limits. The analysis shows that the higher the allowable active bet sizes, the less consistently asset managers are able to implement their views and the less symmetric their response to forecasted excess returns can be. Consequently, the less competitive a long-only fund manager can be alongside hedge funds and similarly constrained long-short managers.

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).

130/30 Funds: What is Behind the Commercial Offensive?

High-conviction funds, beta-one funds, short extension funds, limited-shorting funds, long-enhanced funds, active extension funds, hedge-fund lite: there is a wide range of terms for what is most frequently called 130/30. Broadly, this strategy initially invests 100% in an index, sells short 30%, and uses the proceeds from the shorts to buy an additional 30% likely to beat the benchmark. In this paper, we examine some crucial points related to these funds: their theoretical foundation, the optimal level of shorting, the distinction between the quantitative and fundamental approaches, whether these funds are natural extensions of long-only funds, and finally the risk of neglecting their risk.

Using Fixed Income in Hedge Funds

Managing a hedge fund has distinct differences from managing a typical long-only fund, such as being able to short and take on leverage. And yet the two have many similarities. Those who manage both types of funds are able to realize synergies but must beware the potential conflicts of interest. The U.S. fixed-income market, which is central to many funds, is influenced by numerous factors, including interest rates and the U.S. twin deficit problem.

Battle for Alphas: Hedge Funds versus Long-Only Portfolios

The study reported here empirically examined whether the alphas of hedge funds and those of long-only portfolios present different distributions and are derived from different risk factors. Adjusted for return volatility differences, hedge funds seem to offer more consistent alphas for potential transfer to either equity or bond asset classes than do long-only portfolios—even under extreme market conditions. Potential explanations for the findings include lack of data reliability and differences between hedge funds and actively managed long-only funds in compensation, investment constraints, and structures. Factors related to market index returns do not adequately detect hedge funds' risk postures beyond a fund's exposure to the market-directional risk of standard asset classes. Risk factors derived from asset prices in financial markets do provide timely and systematic descriptions of the risks underlying trading strategies used by hedge funds. The multifactor style-risk analysis presented here can effectively monitor a hedge fund's exposure to systematic versus idiosyncratic risks and volatility-risk factors over time.