Major Hedge Fund Research Articles

Long- and Short-Run Dynamics between South African Hedge Funds and the Equity Market

The hedge fund industry in South Africa has undergone positive changes in terms of both regulation and structure since 2007. These changes have provided an opportunity to further utilize hedge fund strategies within a portfolio management framework. This is especially significant when considering the diversification potential that hedge funds may have and their ability to generate an alternative source of return, both of which are important when considering tactical and strategic asset allocations. There is therefore a need to model the interrelationships between the major hedge fund strategies and the local equity market in order to understand the dynamic linkages that may be present in both the long and short term. We conducted cointegration analysis within the VAR framework on monthly data spanning from 2007 to 2018. The analysis of long-term dynamics indicated that there is no cointegration between the All Share Total Return Index and the hedge fund strategy return indexes as measured under a Johansen cointegration methodology. Pairwise Granger causality tests supported the cointegration findings with no directional causal impacts found. The analysis of short-term dynamics via impulse responses indicated limited causality between the hedge fund indexes and the equity market, while variance decomposition showed few spill-over effects from the equity market to the hedge fund indexes. The overall findings imply that a South African investor could achieve diversification benefits in both the short and long term by adding hedge funds to an equity-centric portfolio. The findings also provide evidence that hedge funds can be used as effective components within tactical and strategic asset allocation. <b>TOPICS:</b>Real assets/alternative investments/private equity, emerging markets, risk management, VAR and use of alternative risk measures of trading risk, quantitative methods, statistical methods <b>Key Findings</b> ▪ There is no long-term equilibrium relationship between the returns of South African domiciled hedge funds and the equity market. This is supported by both cointegration and Granger causality analyses. ▪ Hedge funds provide investors with diversification benefits in both the short and long term when added to an equity-centric portfolio. ▪ The results support the use of hedge funds in both tactical and strategic asset allocation.

Real Estate Risk and Hedge Fund Returns

Extant literature has focused on the performance of hedge funds that invest in a wide range of investment strategies; however, an explicit analysis of funds that follow a real estate investment strategy is lacking. In this paper, we fill this void and explore a new dimension of hedge funds’ investment strategy relating to their exposure to the real estate market. We augment existing literature by introducing a real estate source of variation to proxy for investments in the securitized and direct real estate markets. Using fund level data from 1994 to 2011 from a major hedge fund data vendor, we identify 1,230 hedge funds as having significant exposure to the direct and securitized real estate market. We document that funds with significant real estate exposure have lower incentive fees, longer redemption periods, and higher high water mark levels. Additionally, hedge funds that have significant exposure to real estate are predominantly classified as fund of hedge funds implying a diversification strategy through real estate investments. Finally, we test for the economic impact across funds with varying levels of real estate exposure, and show that funds with significant real estate exposure significantly underperform funds that do not have real estate exposure.

The Global Financial Crisis and the Case for MEFAA Strategic Asset Allocation

Major institutional investment managers, such as, major hedge funds and large university endowments, have based their investment portfolios upon tactical asset allocation among multiple asset classes with low correlation with the goal of achieving superior risk-adjusted returns. However, during the current financial crisis, many of these asset classes experienced high degrees of correlation as they all decreased in value. In addition, many alternative asset classes not only decreased in value but also were illiquid in nature, impeding asset class re-allocation efforts. This paper examines a new strategic asset allocation framework called Monetary Environmental Flow Analysis™ (MEFA™) which can offer downside protection in such environments using only extremely liquid investment vehicles. The result over time is long-term returns comparable to equities but lower draw-downs in financial crisis environments. These strategies are tested over the period 1996-2014 with live signals for them from 2006 and 2007. Several of the strategies have been tested back to the 1970’s.

Hedge Fund Replication Using Shrinkage Methodologies

In this article, the authors replicate major Hedge Fund Research, Inc., style indexes using alternative methods. These methods include stepwise regression, ridge regression, the lasso method, the elastic net, dynamic linear regression, principal component regression, and partial least squares regression. They find generally that, across the major hedge fund style indexes, the best replication results are obtained with methods that employ shrinkage of parameters. <b>TOPICS:</b>Real assets/alternative investments/private equity, style investing, statistical methods, performance measurement

Understanding hedge fund alpha using replication methodologies

Abstract: In this paper we estimate alpha for major hedge fund indexes. To set the stage for estimating alpha, we examine several alternative methods for replicating Hedge Fund Research Inc. hedge fund indexes. The replication methods include stepwise regression,variations of the lasso shrinkage method, principal component regression, partial least squares regression, and dynamic linear regression. We find that the lasso methods and dynamic regression are superior for generating hedge fund index replications and that the performance of the replications corresponds closely to that of the respective actual indexes. Using these superior replications provides us with a solid platform for estimating alpha. We find that at the height of the financial crisis the alphas computed with our methods generally were negative, in early 2009 when the stock market was rising alphas were generally positive, and inthe current environment of low volatility and low interest rates the alphas computed with our methods generally are close to zero and tend to exhibit low volatility.

Hedge Fund Alpha under Different Equity Correlation Regimes: An Extension of the Fama-French Five-Factor Model

This paper investigates the effect of S&P 500 cross-sectional correlation on the alpha characteristics of hedge fund strategies. It decomposes the returns of the four major hedge fund trading strategies in the Hedge Fund Research, Inc. (“HFR”) database using Fama and French’s [1993] five-factor model plus an additional equity correlation factor that allows for the isolation of three unique equity-market correlation regimes. The empirical analysis centers on the use of newly introduced dichotomous variables to isolate correlation regimes using panel data regressions. Over the period of 1990-2010, we find that equity-oriented hedge fund strategies generate approximately twice the alpha during low correlation regimes relative to normal correlation regimes. We present this finding as evidence to support our hypothesis that “stock-picking” skills are enhanced during low equity-market correlation environments.

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

While the impact of backfill bias, survivor bias 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 under reported. Most major hedge fund databases are based 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 analysis (e.g., strategy, fee level, etc.). In this analysis we compare performance characteristics of two major databases often used in hedge fund analysis (CSFB/Tremont and CISDM). More specifically, we 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 level. These differences, however, are often relatively small. In the end, the impact of database usage and the necessity to ‘deconstruct’ one’s database depends, in part, on whether one views the glass as half full or half empty.

Refusing Impact: Aesthetic Economy and Given Time

Reading the 1200 closely printed pages of Ayn Rand’s Atlas Shrugged—in other words, wasting a great deal of time that might have been used more productively—is a reminder that the politics of refusal are not the preserve of the Left. “Refusal” might at first seem an odd term to associate with Rand, who champions greed, selfishness, and material success over what she sees as a wasteland of lumpen, non-productive whingers. Yet her epic free-market fantasy centers on a utopia populated by refuseniks—industrialists, bankers, academics, engineers, artists—who have fled to a secret anti-commune to escape a regime bent on destroying the American economy through its utilitarian, bureaucratic, and welfarebased directives, all of which are designed to serve a coterie of muddleheaded, puritanical conformists. Sympathetic readers of Rand, who include a generation of laissez-faire economists and bankers headed by Alan Greenspan, and members of the Tea Party (with whom Rand’s work is enjoying a current vogue), regard her as an iconic figure of resistance in a world dedicated to a left-liberal slave mentality. Yet Rand’s rationalism is removed from the conservative agenda of the Tea Party, being intellectual, atheistic, feminist, and anti-family (none of the key players in the novel are encumbered by children). Rand doesn’t preach economic freedom supported by social and religious strictures, but defends the freedom of intelligent and productive individuals from any societal force that impedes their progress. An axiom of the economic theory following from her philosophy is that state intervention in the affairs of trade is always a mistake. This puts Greenspan—one of the group of Rand adepts who read Atlas Shrugged as it was being written—in an ethically compromising position. As Chairman of the Federal Reserve, Greenspan was a key mover in exempting the trade in financial derivatives from regulation through the Commodity Exchange Act. The availability of unregulated over-the-counter derivatives was a main cause of the global financial crisis of 2008. Greenspan’s response to this crisis—the federal bailout of banks, insurance companies, and major hedge funds, which made up the group of institutions judged “too big to fail”—showed that his free-market convictions failed to extend to his own interests. Like George W. Bush, whose Troubled Asset Relief Program bought up toxic assets to the tune

Efficient hedge fund style allocations: A rules-based model

The hedge fund literature has predominantly focused on the return and risk characteristics as well as the portfolio properties of different hedge fund styles. However, relatively little is known about how hedge fund investors should allocate their capital across various hedge fund styles. The aim of this study is to develop a rules-based framework that can be used by investors to optimize their hedge fund style allocation. We construct four hedge fund style indices using a sample of 6088 hedge funds from the Lipper TASS Hedge Fund Database over the January 1995–September 2010 time period. We also develop technical and fundamental indicators on the basis of the style return drivers from earlier hedge fund studies. We use these indicators to generate trading recommendations through a style allocation model that systematically over- and underweights the four major hedge fund styles. The empirical results indicate that our hedge fund style allocation model delivers an outperformance of up to 1 per cent per year over an equally weighted portfolio.

Hedge Fund Return–Based Style Estimation: A Review of Comparison Hedge Fund Indices

The data dependency of empirical financial research is of common concern to both academics and practitioners. This is especially true for hedge funds because no single, commonly accepted database exists and because many of the databases may hold different sets of reporting managers. Each database uses current reporting managers as the basis for the construction of hedge fund indices, and these index returns reflect the characteristics of the funds reporting to the relevant database. Unlike historical returns derived from current databases, however, historical returns from most major hedge fund indices do not contain backfill or survivor bias. At the same time, performance characteristics may differ between indices because each index is constructed based on a different set of rules (e.g., equal weighted, asset weighted, and so on). In this article, the authors conduct a series of empirical tests similar to those previously conducted in academic studies. The authors use only those hedge fund indices that reflect the average returns of the entire set of reporting managers; that is, the indices representing overall industry returns. Results indicate that return-based style analyses, often used as a basis for hedge fund analysis, are impacted both by the period of analysis as well as the hedge fund index used. Moreover, results indicate that the addition of variables beyond those designed to capture underlying equity, interest rate, and credit risk have little impact on the explanatory power of these hedge fund universe indices beyond a very low level of statistical significance.

Hedge Fund Return-Based Style Estimation: A Review on Comparison Hedge Fund Indices

The data dependency of empirical financial research is of common concern to both academics and practitioners. This is especially true for hedge funds since no one single commonly accepted database exists and since many of the databases may hold different sets of reporting managers. Each database uses current reporting managers as the basis for the construction of hedge fund indices and these index returns reflect the characteristics of the funds reporting to the relevant database. However, unlike historical returns derived from current databases, historical returns from most major hedge fund indices do not contain backfill or survivor bias. At the same time, performance characteristics may differ between indices since each index is constructed based on a different set of rules (e.g., equal weighted, asset weighted, etc.). In this analysis we conduct a series of empirical tests, similar to those previously conducted in academic studies. In this analysis we use only those hedge fund indices which reflect the average returns of the entire set of reporting managers; that is, the indices representing overall industry returns. Results indicate that return based style analyses, often used as a basis for hedge fund analysis, are impacted both by the period of analysis as well as the hedge fund index used. Moreover, results indicate that the addition of variables beyond those designed to capture underlying equity, interest rate, and credit risk have little impact on explanatory power of these hedge fund universe indices beyond a very low level of statistical significance.

Hedge Fund Replication: The Asymmetric Way

This article introduces the concept of asymmetric hedge fund replication based on the risk factor model approach. The presented methodology is founded on downside risk management and offers an enhancement of existing hedge fund replication techniques. From a conceptual perspective, asymmetric hedge fund replication enables investors to achieve superior risk-adjusted performance in cases in which precise target tracking is not imperative. Along with the introduction of the asymmetric hedge fund replication, a new classification framework of replication methodologies is discussed, in which the replication objective is the center point. The out-of-sample performance of the presented approach is examined in an exemplary empirical replication of two major hedge fund sector indices with a popular factor model setting used in previous studies. Finally, aMonte Carlo study is conducted in which the authors simulate hedge fund returns and examine the out-of-sample performance. The comparison to standard hedge fund replication reveals the characteristic risk-return profile of the asymmetric approach. In sum, the risk-adjusted performance increases at the cost of target replication accuracy.The results of the short study support all aspects of the authors’ conceptual hypothesis and justify more extensive investigations. <b>TOPICS:</b>Real assets/alternative investments/private equity, factor-based models, simulations, performance measurement

The Effect of S&amp;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

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

What is the consequence of the missing compliance function at hedge funds? Fraud is! Analysis, lessons and solutions

PurposeThe purpose of this paper is to offer case studies of hedge fund fraud, solutions that could mitigate hedge fund fraud risk, and a proposal for the industry to establish a hedge fund information depository (HFID) where participants/stakeholders could provide information on any hedge fund on regular basis.Design/methodology/approachFour major hedge fund fraud cases, Bayou Funds, Lipper Holdings, Manhattan Investment Fund and Maricopa Investment Corporation are used as examples of the complete absence of independent oversight and the application of HFID.FindingsThe paper finds that investors in the four funds lost more than $1.3 billion. In all four fraud cases, independent oversight and compliance function were conspicuously missing. In each fraud case there was at least one serious alert (warning) that took place at least 14 months prior to SEC first filing against the fund.Research limitations/implicationsSome hedge fund industry stakeholders may reluctantly join HFID due to concern over possibly disclosing information deemed crucial for their own competitive advantage.Practical implicationsHad third parties become aware of the alerts, they could have made a different investment or business decision. Most importantly, this depository would allow all hedge fund industry stakeholders (accountants, administrators, auditors, investors, marketers, prime brokers, custodians and regulators) to communicate with one another regularly.Originality/valueThe paper makes two proposals: the founding of a hedge fund information depository; and outsourcing of the compliance function for hedge funds where it is more cost effective.

Hedge fund information depository: a case study of a pre‐emptive solution to fund manager fraud

PurposeThe objective of this research is to educate investors and hedge fund industry stakeholders about a hedge fund manager's alarming activities prior to recognition of the fraud by the authorities. The lessons serve as red flags to stakeholders in the hedge fund industry such as prime brokers, auditors, administrators, accountants, custodians and government regulators, and especially investors conducting due diligence on hedge funds. A far‐reaching proposal is for the industry to found a hedge fund information depository (HFID) where participants/stakeholders provide information on any hedge fund on a regular basis. Such an information clearing‐house would facilitate a long overdue timely communication among hedge fund industry constituents. The services would be available for a fee. This service elevates transparency in the hedge fund community to an unprecedented level and could ultimately mitigate a manager's fraud.Design/methodology/approachA major hedge fund fraud case, Lancer Management Group, is used an example and application of HFID.FindingsInvestors in the Lancer funds lost more than $500 million. In the case of Lancer, there were several “alerts” or “triggers” many months before the actual filing of the SEC complaint against the fund. Hedge fund manager fraud could be mitigated through the establishment of the information depository. Had the depository been in place, some Lancer funds stakeholders could have made different decisions.Research limitations/implicationsSome hedge fund industry stakeholders may reluctantly join HFID. Researching the willingness of hedge fund industry stakeholders to join HFID would be a good extension of the current research.Practical implicationsHad a third party become aware of the alerts, this third party could have made a different investment decision. Most importantly, this depository would allow all the hedge fund industry stakeholders (accountants, administrators, auditors, marketers, prime brokers, custodians) to contemporaneously communicate with one another.Originality/valueThe approach and the solution are both unique. In addition, the topic is very controversial and timely, yet few business professionals explore research projects on fund manger fraud. HFID would be of great value to hedge fund industry stakeholders, especially investors.

Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration

ABSTRACTMandatory disclosure is a regulatory tool intended to allow market participants to assess operational risk. We examine the value of disclosure through the controversial SEC requirement, since overturned, which required major hedge funds to register as investment advisors and file Form ADV disclosures. Leverage and ownership structures suggest that lenders and equity investors were already aware of operational risk. However, operational risk does not mediate flow‐performance relationships. Investors either lack this information or regard it as immaterial. These findings suggest that regulators should account for the endogenous production of information and the marginal benefit of disclosure to different investment clienteles.

A Conditional Approach to Hedge Fund Risk

In this study, we apply a two-step conditional Bayesian approach to hedge fund risk. In the first step, a mixture of two normal distributions is estimated for a core asset, one distribution being identified as linked to a quiet regime, the other one to a hectic regime. The conditional probabilities of each regime are then inferred and a mixture of distributions is deduced for peripheral assets. In our application, the core asset is alternatively chosen as the S&P index or the Baa/Treasuries yield spread and the peripheral assets are the major hedge funds strategies over the period 1990-2004. The methodology has several advantages given specific features of hedge funds returns, notably non- linear exposure to standard assets returns and short sample history. We identify significant changes in the distribution (mean and standard deviation) of hedge fund returns across regimes. Results are less clear-cut for the correlation with standard assets, as modifications can be imputed to a certain extent to a form of selection bias. We finally present an application of the methodology for stress tests on hedge funds portfolios.

Risk Profiles of Distressed Hedge Funds

This article examines differences in average estimated risk premiums of individual distressed hedge funds as compared to those of their surviving counterparts, along with a unique measure of performance in order to provide evidence of why the distressed funds eventually dissolved. The sample period is selected to cover the sharp downturn in U.S. equity markets of 2000 and beyond, when many individual hedge funds dissolved. Sample data are derived from a unique database of the five major hedge fund providers existing during the sample period. The estimation technique is performed on a sample of 212 distressed hedge funds and 1,555 surviving funds of various investment styles. The main results generally show that for the diverse hedge fund styles the average risk premiums of the distressed funds are greater in absolute value than those of their surviving peers; moreover, these differences generally correspond to significantly lower average performance values for the distressed funds. In short, the hedge funds with the greatest exposure to the risk factors are the funds most at risk of dissolution. These results are of particular importance for individual investors as economic warning signals in monitoring the performance and risk characteristics of the funds comprising their investment portfolios. <b>TOPICS:</b>Real assets/alternative investments/private equity, portfolio construction, risk management, performance measurement

A Conditional Approach to Hedge Fund Risk

This article applies a two-step conditional Bayesian approach to hedge fund risk. First, a mixture of two normal distributions is estimated for a core asset; one distribution being identified as linked to a “quiet” regime and the other to a “hectic” regime. The conditional probabilities of each regime are then inferred and a mixture of distributions is deduced for peripheral assets. The core asset is alternatively chosen as the S&P index or the Baa/Treasuries yield spread whereas the peripheral assets are chosen to be the major hedge funds strategies over the period 1990–2004. This methodology has several advantages given specific features of hedge funds returns, notably non-linear exposure to standard assets returns and short sample history. Significant changes in the distribution (mean and standard deviation) of hedge fund returns are identified across regimes. Results are less clear-cut for the correlation with standard assets, as modifications can be imputed to a certain extent to a form of selection bias. An application of this methodology to stress tests on hedge funds portfolios is presented.