* Performance, experience and size

The following paper is the first to use quantile regression to analyze the impact of experience and size of funds of hedge funds (FHFs) on performance. In comparison to OLS regression, quantile regression provides a more detailed picture of the influence of size and experience on FHF return behaviour.

Hence, it allows us to study the relevance of these factors for various return and risk levels instead of average return and risk, as is the case with OLS regression. Because FHF size and age (as a proxy for experience) are available in a panel setting, researchers can perform estimations in an unbalanced stacked panel framework.

This study analyzes time series and descriptive variables of 649 FHFs drawn from the Lipper TASS Hedge Fund database for the time period January 1996 to August 2007. Our empirical results suggest that experience and size have a negative effect on performance, with a positive curvature at the higher quantiles. At the lower quantiles, however, size has a positive effect with a negative curvature. Both factors show no significant effect at the median.

Detail: The Performance of Funds of Hedge Funds: Do Experience and Size Matter?

* Funds of funds

Since the after-fee returns in funds-of-funds are, on average, lower than hedge fund returns, it appears that funds-of-funds do not add value. However, researchers in Columbia Business School and BlackRock show that funds-of-funds should not be evaluated relative to hedge fund returns from reported databases.

Instead, the correct fund-of-funds benchmark is the return an investor would achieve from direct hedge fund investments on her own without recourse to funds-of-funds. They use certainty equivalent concepts and revealed preference arguments to estimate attributes of the true, implied true fund-of-funds benchmark distribution. Since the benchmark characteristics seem reasonable, they conclude that, on average, funds-of-funds deserve their fees-on-fees.

Detail: Do Funds-of-Funds Deserve Their Fees-on-Fees?

* Equilibrium thinking?

An agent model being developed by the Yale economist John Geanakoplos, along with two physicists, Doyne Farmer and Stephan Thurner, looks at how the level of credit in a market can influence its overall stability.

Obviously, credit can be a good thing as it aids all kinds of creative economic activity, from building houses to starting businesses. But too much easy credit can be dangerous.

In the model, market participants, especially hedge funds, do what they do in real life — seeking profits by aiming for ever higher leverage, borrowing money to amplify the potential gains from their investments. More leverage tends to tie market actors into tight chains of financial interdependence, and the simulations show how this effect can push the market toward instability by making it more likely that trouble in one place — the failure of one investor to cover a position — will spread more easily elsewhere.

That’s not really surprising, of course. But the model also shows something that is not at all obvious. The instability doesn’t grow in the market gradually, but arrives suddenly. Beyond a certain threshold the virtual market abruptly loses its stability in a “phase transition” akin to the way ice abruptly melts into liquid water. Beyond this point, collective financial meltdown becomes effectively certain. This is the kind of possibility that equilibrium thinking cannot even entertain.

Detail: This Economy Does Not Compute

* “Quant” investing

What is quantitative or “quant” investing? In short, it is where mathematical models rather than manager’s discretion make investment decisions.

What do quant managers do apart from running sophisticated computer programs? An analogy with cars may help here. No matter how sophisticated a car, it still needs a driver and sometimes a mechanic. The driver must know when to brake and when to accelerate. Quant managers provide both functions – they control risks as well as fix things such as data errors when they occur. Most importantly, every car needs to be designed and engineered in the first place – the most important part of a quant manager’s job.

In the case of a good quant, it should get better!” Ignore established and successful quants at your peril. However, behind any computer program there is always a human brain. Investing in a quant approach is the best way to profit from human ingenuity but without the danger of human error.

Detail: Why quant?

* Impact of Incentive Fees

Factor models are frequently applied to hedge fund returns in an attempt to separate the return from identified risk factors (beta) and from manager skill (alpha). More recently, these same techniques have been used to replicate the returns from hedge fund strategies with varying degrees of success.

In the following paper, researchers show that due to the particular nature of hedge fund incentive contracts, the use of net of fee returns can lead to considerably biased estimates of factor exposures which can distort the picture of fund manager performance. The solution they propose is to model the gross returns of hedge funds and the incentive fees independently, which gives a truer representation of the underlying return generating process.

Using a large sample of hedge funds, they quantify the effect of this bias on both performance attribution and replication. They find that using net of fee returns understates the return attributable to beta by up to 58 basis points per annum.

Following from this they find that some of the additional beta exposure can be captured by basing replication on gross rather than net returns. They also investigate the risk taking behaviour of fund managers conditional upon the delta of their incentive option and find that contrary to previous studies, there does appear to be evidence of increased risk taking for those managers who find themselves significantly below their high water mark.

Detail: The Gross Truth About Hedge Fund Performance and Risk: The Impact of Incentive Fees

* Emerging Market funds

Hedge funds should be well equipped to take advantage of opportunities in emerging markets due to their flexibility in investment strategy and lockup periods. However, the findings in the following paper show that, at the strategy-level, emerging market hedge funds have only been able to generate risk-adjusted returns in the most recent period when analyzing data between 1994 and 2004.

Also, the strategy in question does not present the investor with any benefits that would be valuable in a hedge fund portfolio. There is weak evidence of persistence in risk-adjusted returns at the fund-level. However, good performance is not rewarded with capital inflows. This reduces incentives for managers to exert effort and may even deter skillful managers from entering the strategy. Consistent with these results, investors have reallocated their money to other hedge fund strategies.

Although emerging market hedge funds have performed poorly in the past, an important finding is the upward trend over time in performance. Given that other hedge fund strategies have a declining trend in alpha, perhaps emerging market funds are where future alphas can be found.

Detail: Should You Invest in Emerging Market Hedge Funds?

* Banks' role

During systematic liquidity shocks, hedge funds are able to borrow from banks and thus are not limited by capital constraints. Government-protected bank deposits receive inflows during systematic liquidity shocks. These inflows provide low cost funding and help estimate the magnitude of a shock, reducing the information asymmetry that constrains hedge funds.

The unique combination of low funding cost and sophisticated information gives banks an advantage in lending to hedge funds. While banks do not participate in the upside risk that they finance, they compete away their effective government subsidy to the benefit of their hedge fund clients.

Detail: Liquidity Risk and Limited Arbitrage: Are Banks Helping Hedge Funds Get Rich?

* Past, Present and Future

Assets managed by hedge funds have grown faster over the last ten years than assets managed by mutual funds. Hedge funds and mutual funds perform the same economic function, but hedge funds are largely unregulated while mutual funds are tightly regulated.

The following paper compares the organization, performance, and risks of hedge funds and mutual funds. It then examines whether one can expect increasing convergence between these two investment vehicles and concludes that the performance gap between hedge funds and mutual funds will narrow, that regulatory developments will limit the flexibility of hedge funds, and that hedge funds will become more institutionalized.

Detail: Hedge Funds: Past, Present and Future

* Last resort?

Hedge funds have become important investors in public companies raising equity privately. Hedge funds tend to finance companies that have poor fundamentals and pronounced informational asymmetries. To compensate for these shortcomings, hedge funds protect themselves by requiring substantial discounts, negotiating repricing rights, and entering into short positions of the underlying stocks.

Researchers find that companies that obtain financing from hedge funds significantly underperform companies that obtain financing from other investors during the following two years. They argue that hedge funds are investors of last resort and provide funding for companies that are otherwise constrained from raising equity capital.

Detail: Hedge Funds as Investors of Last Resort?

* Implications for Financial Stability

The following paper provides an overview of the hedge fund industry, mainly from a financial stability and European angle. It is primarily based on an extensive analysis of information from the TASS database. On the positive side of the financial stability assessment, hedge funds have a role as providers of diversification and liquidity, and they contribute to the integration and completeness of financial markets. Possible negative effects occur through their impact on financial markets (e.g. via crowded trades) and financial institutions (e.g. via prime brokerage).

Several initiatives have been launched to address these concerns and most of them follow indirect regulation via banks. If any direct regulation were to be considered, it would probably have to be implemented in a coordinated manner at the international level. At the EU level there is currently no common regulatory regime, although some Member States have adopted national legislation.

Detail: Hedge Funds and their Implications for Financial Stability

* Multi-factor approach

In contrast to long-only fund management, where investment strategies are often tethered to benchmarks and usually employ linear trading strategies, hedge funds can invest in a vast range of opportunity sets through a wide array of instruments, often employing complex non-linear or levered trading strategies, or potentially illiquid positions. Furthermore, these investment themes and niche opportunities are often turned over on a much more frequent basis, and hence the historic return profile will inevitably lag the changing dynamics of the investment basis.

Accounting for all of the above, it is evident that, relative to long-only strategies, the presence of these additional degrees of freedom in alternative strategies invariably means that traditional, return-analysis based, risk. Compounding matters, this discrepancy is widely understood to be of greatest significance in the extreme downside tail of the prevailing risk profile.

Detail: Hedge fund risk drivers from a fund of funds perspective

* Hedge Fund unique?

By dynamically trading futures in very much the same way as investment banks hedge their OTC option positions it is possible to generate returns that are statistically very similar to the returns generated by hedge funds but without any of the usual drawbacks surrounding alternative investments, i.e. without liquidity, capacity, transparency or style drift problems and without paying over-the-top management fees.

Hedge fund returns may be different, but they are certainly not unique.


Detail: Hedge Fund Returns: You Can Make Them Yourself!

* Cardboard collateral

“Cardboard collateral” refers to illiquid securities and investments that are deposited as collateral by hedge funds with prime brokers and, in the first instance, not given a “haircut” commensurate with the nature of the instrument and the inability to gain a price or to sell it.

In the opening phases of the sub-prime/credit crisis, prime brokers were forced to revalue downwards the value of illiquid instruments they held, resulting in margin calls and drops in hedge fund AUMs.

* Due diligence

Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly - or fail - due to operational risk concerns.

However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that researchers document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.

Detail: Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy

* Categorise gatekeepers

A gatekeeper can be defined as anyone who is responsible for selecting, screening and eventually allocating capital on behalf of others. Many gatekeepers exhibit similar qualities in the way they view and evaluate hedge fund investments and this has led to categorise gatekeepers as follows:

1. The Good
– forward thinking, sophisticated and independent thinkers.

2. The Bad
– unsophisticated, alarmists and having a tendency to generalise.

3. The Ugly
– sophisticated, crowd followers and often victims of their large size.

* Taking Advantage

This following paper explores the question of whether hedge funds engage in front-running strategies that exploit the predictable trades of others. One potential opportunity for front-running arises when distressed mutual funds - those suffering large outflows of assets under management - are forced to sell stocks they own.

The researchers document two pieces of evidence that are consistent with hedge funds taking advantage of this opportunity. First, in the time series, the average returns of long/short equity hedge funds are significantly higher in those months when a larger fraction of the mutual-fund sector is in distress. Second, at the individual stock level, short interest rises in advance of sales by distressed mutual funds.

Detail: Do Hedge Funds Profit from Mutual-Fund Distress?

* Misreport Returns?

Some researchers find a significant discontinuity in the pooled distribution of reported hedge fund returns: the number of small gains far exceeds the number of small losses.

The discontinuity is present in live funds, defunct funds, and funds of all ages, suggesting that it is not caused by database biases. The discontinuity is absent in the three months culminating in an audit, funds that invest in liquid assets, and hedge fund risk factors, suggesting that it is generated neither by the skill of managers to avoid losses nor by nonlinearities in hedge fund asset returns. A remaining explanation is that hedge fund managers avoid reporting losses to attract and retain investors.

Detail: Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled Distribution

* Convergence & Divergence

Hedge Funds and Private Equity Funds have long been treated as two distinct alternative invesment categories. However, these two styles of investing may be converging, some hedge fund advisers are taking a more active role in their investments and directing fund assets to areas that were traditionall occupied by private equity advisers. At the same time, the securities regulation framework under which these two types of funds operate has recently begun to diverge.

Detail: Convergence and Divergence: Blurring the Lines Between Hedge Funds and Private Equity Funds

* Relative performance matters

Some research papers that are related to the relative performance: (it will be updated regularly)

1. Compensation Option, Managerial Incentives and Risk-Shifting in Hedge Funds
They find that compared to absolute performance, relative performance has a stronger influence on the risk-taking behavior of hedge fund managers. This result is not uniform over all strategies.

* Selection Criteria

Institutions’ Hedge Fund Selection Criteria - What are the Most Critical Factors in Selecting a Hedge Fund and/or Fund of Hedge Fund?

^{Source: Bank of New York and Casey, Quirke and Associates.
Institutional Demand For Hedge Funds 2
October 2006}

^Details:

Communication has never been so important

* Hedge Fund Regulation

This paper "Capital Flows and Hedge Fund Regulation" introduces a cross-country law and finance analysis of the flow-performance relationship for hedge funds. The data indicate that distribution channels in the form of private placements and wrappers mitigate the impact of performance on fund flows. Distribution channels via investment managers and fund distribution companies enhance the impact of performance on fund flows.

Funds registered in countries which have larger minimum capitalization requirements for funds have higher levels of capital flows. Funds registered in countries which restrict the location of key service providers have lower levels of capital flows. Further, offshore fund flows and calendar effects evidenced in the data are consistent with tax factors influencing fund flows. Our findings are robust to Heckman-selection effects for offshore registrants, among other robustness checks.

Details: Capital Flows and Hedge Fund Regulation

* Benefits of Bond ETFs

Recent market difficulties have drawn attention to the risk management practices of institutional investors. particularly significant was the fact that negative equity market returns were eroding plan assets at the same time as declining interest rates were increasing benefit obligations. these events have spotlighted the weakness of current funding standards for corporate defined benefit pension plans. They have also emphasized the weakness of investment practices.

There are readily available tools that can allow institutional investors in general, and pension funds in particular, to implement a more structured investment and risk management process. More specifically, it can be shown the benefits that institutional investors can gain from the implementation of active and passive asset allocation decisions cast in the context of core-satellite portfolio management and implemented by dynamic trading in bond Exchange Traded Funds. (ETFs)

Details: Benefits of bond ETFs for institutional investors, The Natural Vehicle for a core-satellite approach