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Hedge Funds (-->Wiki)

Post by Barry Barnitz » Mon Jul 02, 2007 12:24 pm

An expanded version of this page can be found on The Bogleheads Wiki.


[contributions welcome]

Definitions

Hedge Fund

Hedge Fund Indexes

Tremont Hedge Index
MSCI Investable Hedge Fund Index


One of the leading academics studying Hedge Funds is Harry Kat. Given the large number of papers on both Hedge Funds and Synthetic Hedge Funds composed by Mr. Kat, we will provide a link to the SSRN author's paper page for convenient access.

SSRN Author Page for Harry M. Kat

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Last edited by Barry Barnitz on Sat Aug 16, 2008 3:06 am, edited 4 times in total.
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Papers:

Post by Barry Barnitz » Mon Jul 02, 2007 1:01 pm

1. Understanding Alternative Investments: A Primer on Hedge Fund Evaluation by Christopher B. Philips, Vanguard Investment Counseling & Research (2006)
Sparked by the 2000–2002 equity bear market and fueled by general expectations of lower future returns for stocks and bonds, popular opinion has embraced the idea that hedge funds can deliver positive returns regardless of the direction and magnitude of stock and bond market returns. As a result, hedge funds have garnered considerable attention as a viable alternative investment. But is such enthusiasm justified? What have been the risk-adjusted returns of hedge funds? And what are the risks of hedge fund investing? This report examines the characteristics and historical performance of a common set of hedge fund strategies available to investors. While we find that most hedge funds operate in a risk-controlled framework, we caution that investing in hedge funds may not be as simple or safe as often portrayed. Indeed, this report concludes that:

• Reported hedge fund returns contain significant biases that skew conventional mean-variance and regression analysis.
• Distinct and enduring differences exist between opportunistic and non-directional strategies.
• Because of serious data limitations, quantitative analysis of hedge funds should be supplemented by qualitative judgment.


2. The A,B,Cs of Hedge Funds by Robert C. Ibbotsen and Peng Chen (September, 2006)
In this paper, we focus on two issues. First, we analyze the potential biases in reported hedge fund returns, in particular survivorship bias and backfill bias, and attempt to create an unbiased return sample. Second, we decompose these returns into their three A,B,C components: the value added by hedge funds (alphas), the systematic market exposures (betas), and the hedge fund fees (costs). We analyze the performance of a universe of about 3,500 hedge funds from the TASS database from January 1995 through April 2006. Our results indicate that both survivorship and backfill biases are potentially serious problems. The equally weighted performance of the funds that existed at the end of the sample period had a compound annual return of 16.45% net of fees. Including dead funds reduced this return to 13.62%. Excluding backfill further reduced the return to 8.98%, net of fees. In this last sample, we estimate a pre-fee return of 12.72%, which we split into a fee (3.74%), an alpha (3.04%), and a beta return (5.94%). Overall, even after correcting for data biases, we find that the alphas are significantly positive and are approximately equal to the fees, meaning that excess returns were shared roughly equally between hedge fund managers and their investors.


3. A Reality Check on Hedge Funds Returns by Posthuma, Nolke and van der Sluis, Pieter Jelle, (July 8, 2003)
In this article we examine the backfill bias or instant history bias for hedge funds using additional information from the Tass database. This is information about the exact date a hedge fund starts reporting to Tass. Using this information we are able to reveal the length of the instant histories. We find these to be just over 3 years on average. This number is far greater than previously documented. More than half of the recorded returns in the database are backfilled. The magnitude of the overall backfill bias is about 4 percent per annum on average. Again this number exceeds all previous estimates of the backfill bias we are aware of. We elaborate further across different time periods styles. Next, we eliminate backfilled returns and use survivorship free data to create a universe in which we could invest in real time. We introduce an investor who invests an equal amount in each fund that is in the universe. Conditional on this investment strategy our results indicate that the backfill bias is underestimated, and has a substantial downward effect on the returns across most hedge fund styles and is consistent over time for the whole sample. We have no reason to believe that our conclusions are limited to the Tass database.


4.) The Life Cycle of Hedge Funds: Fund Flows, Size and Performance by Mila Getmansky (January 2006)
Since the 1980s we have seen a 25% yearly increase in the number of hedge funds, and an annual attrition rate of 7.10% due to liquidation. This paper analyzes the life cycles of hedge funds. Using the TASS database provided by the Tremont Company, it studies industry and fund specific factors that affect the survival probability of hedge funds. The findings show that in general, investors chasing individual fund performance decrease probabilities of hedge funds liquidating. However, if investors follow a category of hedge funds that has performed well, then the probability of hedge funds liquidating in this category increases. We interpret this finding as a result of competition among hedge funds in a category. As competition increases, marginal funds are more likely to be liquidated than funds that deliver superior risk-adjusted returns. We also find that there is a concave relationship between performance and assets under management. The implication of this study is that an optimal asset size can be obtained by balancing out the effects of past returns, fund flows, market impact, competition and favorable category positioning that are modeled in the paper. Hedge funds in illiquid categories are subject to high market impact, have limited investment opportunities, and are more likely to exhibit an optimal size behavior compared to those in more liquid hedge fund categories.


5.) Do Hedge Funds Hedge? by Asness, Clifford S., Krail, Robert and Liew, John M.,(May 2001)
In addition to attractive returns, many hedge funds claim to provide significant diversification for traditional portfolios. This paper empirically examines the return and diversification benefits of hedge fund investing using the CSFB/Tremont hedge fund indices from 1994-2000. We, like many others, find that simple regressions of monthly hedge fund excess returns on monthly S&P 500 excess returns seem to support the claims. The regressions show only modest market exposure and positive added value. However, this type of analysis can produce misleading results. Many hedge funds hold, to various degrees and combinations, illiquid exchange-traded securities or difficult-to-price over-the-counter securities. For the purposes of monthly reporting, hedge funds often price these securities using either last available traded prices or estimates of current market prices. These practices can lead to reported monthly hedge fund returns that are not perfectly synchronous with monthly S&P 500 returns due to the presence of either stale or "managed" prices. Non-synchronous return data can lead to understated estimates of actual market exposure. We employ standard techniques that account for this problem and find that hedge funds in the aggregate contain significantly more market exposure than simple estimates indicate. Furthermore, after accounting for this increased market exposure, we find that taken as a whole the broad universe of hedge funds does not add value over this period. With the stock market still near all-time high valuations, investors who view their hedge funds as protection from a market correction should consider this a potentially serious issue.


6.) Hedge Funds: Performance, Risk and Capital Formation by William Fung; David Hsieh; Narayan Naik; Tarun Ramadorai (March 2006)
We use a comprehensive dataset of Funds-of-Hedge-Funds (FoFs) to investigate performance, risk and capital formation in the hedge fund industry over the past ten years. We confirm the finding of high systematic risk exposures in FoF returns. We divide up the past ten years into three distinct subperiods and demonstrate that the average FoF has only delivered alpha in the short second period from October 1998 to March 2000. In the cross-section of FoFs, however, we are able to identify FoFs capable of delivering persistent alpha. We find that these more successful FoFs experience far greater (and steadier) capital inflows than their less fortunate counterparts. Berk and Green’s (2004) rational model of active portfolio management implies that diminishing returns to scale combined with the inflow of new capital leads to the erosion of superior performance over time. In keeping with this implication, we provide evidence that even successful FoFs have experienced a recent, dramatic decline in risk-adjusted performance.


7.) A Portrait of Hedge Fund Investors: Flows, Performance and Smart Money by Baquero, G. and Verbeek, Marno, (February 28, 2006)
We explore the flow-performance interrelation for hedge funds by explicitly separating the investment and divestment decisions of hedge fund investors. This separation has been overlooked in previous studies in mutual funds and hedge funds and it has several major implications. First, if money inflows and outflows are not modeled as two distinct regimes, the impact of past performance and several control variables like size, age and style upon money flows is improperly estimated. Using a regime switching model with endogenous switching reveals a number of important asymmetries between both regimes of money flows. Second, this separation allows us to identify a different response time of inflows and outflows to past performance, which implies a different shape of the flow-performance relation across evaluation horizons. While money inflows chase the winners at annual horizons, outflows are highly responsive to the losers at quarterly horizons. This immediate and sustained response of investors to poor performance over the following two or three quarters remained hidden in previous studies over annual horizons. Several economic implications follow. On the one hand, fast outflows pose a credible threat of termination that mitigates the incentives of hedge fund managers to increase volatility to meet their high watermark. On the other hand, inflows are not fast enough to exploit and compete away the quarterly performance persistence among the winners. On average, investors direct their money towards funds that subsequently underperform the style index by 1% per quarter or more. Our results do not support the existence of smart money and raise concerns about an inefficient allocation of capital across hedge funds.


8.)
Systemic Risk and Hedge Funds
by Chan, Nicholas T., Getmansky, Mila, Haas, Shane M. and Lo, Andrew; (February 22, 2005). MIT Sloan Research Paper No. 4535-05
Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions - typically banks - that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise


9.) Time-varying exposures and leverage in hedge funds by Patrick McGuire; Eli Remolona;Kostas Tsatsaronis
Style analysis shows that as market conditions change so do the investment strategies of hedge funds. It also provides a simple indicator of hedge fund leverage that varies over time. The indicator suggests that leverage tended to be high in 1997–98 but lower more recently.


10.) Hedge Funds: Past, Present and Future by Stulz, René M., Fisher College of Business Working Paper No. 2007-03-003
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. This 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.
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Hedge Funds and Synthetic Funds

Post by Barry Barnitz » Wed Jul 04, 2007 10:17 pm

Papers

1.) FundCreator-Based Evaluation of Hedge Fund Performance by Kat, Harry M. and Palaro, Helder P., (February 22, 2007).
In this paper we use the FundCreator hedge fund return replication technique recently introduced in Kat and Palaro (2005) to evaluate the net-of-fee performance of 875 funds of hedge funds and 2073 individual hedge funds, up to an including November 2006. Comparing fund returns with the returns on FundCreator-based dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 18.6% of the funds of funds and 22.5% of the individual hedge funds in our sample convincingly beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading a diversified basket of liquid futures contracts. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time. This supports the hypothesis that increased assets under management tend to endanger future performance.


2.) Hedge Fund Indexation the FundCreator Way: Efficient Hedge Fund Indexation Without Hedge Funds by Kat, Harry M. and Palaro, Helder P., (December 7, 2006). Alternative Investment Research Centre Working Paper No. 38
Disappointing performance is leading hedge fund investors to look for cheaper alternatives. Hedge fund indexation has been suggested as a possible solution. Unfortunately, investable hedge fund indices are nothing more than funds of funds in disguise, with performance similar or even worse than real funds of funds. The core problem of hedge fund indexation is that as long as one still invests in hedge funds, the cost factor that indexation is meant to eliminate will still be there. In this paper we use our FundCreator technology to generate returns with statistical properties very similar to those of hedge fund indices, but without actually investing in hedge funds. The proposed strategies only trade liquid futures contracts and therefore not only offer investors an accurate replica, but at the same time solve many other problems typically surrounding hedge fund investments, such as illiquidity, lack of transparency, limited capacity, etc.


3.) Alternative Routes to Hedge Fund Return Replication: Extended Version by Kat, Harry M., (April 30, 2007). Cass Business School Research Paper No. 0037
With average hedge fund performance steadily deteriorating and equity markets picking up again, interest in hedge fund return replication as a cheaper means of obtaining hedge fund-like returns is growing steadily. Currently, there are various products on offer. Compared to real hedge funds (of funds), all of them offer improved liquidity, transparency, capacity, etc. and thereby solve a range of problems surrounding hedge fund investment. There are, however, substantial differences in terms of their attraction as portfolio diversifiers. The multi-strategy replication products offered by Merrill Lynch (Factor Index), Goldman Sachs (ART Index), and Partners Group (ABS fund) exhibit a strong correlation with the stock market. This severely limits these products' attraction as portfolio diversifiers. FundCreator does not necessarily replicate any specific fund or index, but allows investors to design their own diversifier from scratch. This gives investors a unique opportunity to create new tailor-made diversifiers with characteristics that are optimal given their existing portfolios. Clearly, this makes FundCreator-based synthetic funds much more attractive than the various multi-strategy hedge fund replication and alternative beta products currently on offer.


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