A unique view of hedge fund derivatives usage: Safeguard or speculation?

We study the common equity and equity option positions of hedge fund investment advisors over the 1999–2006 period. We find that hedge funds' stock positions predict future returns and that option positions predict both volatility and returns on the underlying stock. A quarterly tracking portfolio of stocks based on publicly observable hedge fund option holdings earns abnormal returns of 1.55% through the end of the quarter. Net of fees, hedge funds using options deliver higher benchmark-adjusted portfolio returns and lower risk than nonusers. The results suggest that hedge fund positions reflect significant timing and selectivity skill.     

Dissecting hedge funds' strategies

This paper dissects the dynamics of the hedge fund industry with four financial markets, including the equity market, commodities, currencies, and debt market by employing a large number of assets from these markets. We employ four main representative hedge fund strategy indices, and a cap-weighted global index to estimate an asymmetric dynamic conditional correlation (ADCC) GJR-GARCH model using daily data from April 2003 to May 2021. We break down the performance, riskiness, investing style, volatility, dynamic correlations, and shock transmissions of each hedge fund strategy thoroughly. Further, the impact of commodity futures basis on hedge funds' return is analyzed. Comparing the dynamic correlations during the 2008 global financial crisis (GFC) with COVID-19 pandemic reveals changing patterns in hedge funds' investing styles. There are strong and pervasive shock spillovers from hedge fund industry to other financial markets, especially to futures commodities. An increase in the futures basis of several commodities drives up hedge funds' performance. While hedge fund industry underperforms compared to equity market and commodities, the risk-reward measures show that hedge funds are superior to other markets, and safer than the bond market.     

Who benefits in a crisis? Evidence from hedge fund stock and option holdings

We use a unique data set of hedge fund long equity and equity option positions to investigate a significant lockup-related premium earned during the tech bubble (1999–2001) and financial crisis (2007–2009). Net fund flows are significantly greater among lockup funds during crisis and noncrisis periods. Managers of hedge funds with locked-up capital trade opportunistically against flow-motivated trades of non-lockup managers, consistent with a hypothesis of rent extraction in providing crisis era liquidity. The success of this opportunistic trading is concentrated during periods of high borrowing costs, in less liquid stock markets, and is enhanced by hedging in the equity option market.     

Do hedge funds trade on private information? Evidence from syndicated lending and short-selling

This paper investigates an important contemporary issue relating to the involvement of hedge funds in the syndicated loan market. In particular, we investigate the potential conflicts of interest that arise when hedge funds make syndicated loans and take short positions in the equity of borrowing firms. We find evidence consistent with the short-selling of the equity of the hedge fund borrowers prior to public announcements of both loan originations and loan amendments. We also find that hedge funds are more likely to lend to highly leveraged, lower credit quality firms, where access to private information is potentially the most valuable and where trading on such information could lead to enhanced profits. Overall, our results have important implications for the current debate regarding regulating the hedge fund industry.     

Conditional Properties of Hedge Funds: Evidence from Daily Returns*

Using daily returns on a set of hedge fund indices, we study (i) the properties of the indices' conditional density functions and (ii) the presence of asymmetries in conditional correlations between hedge fund indices and other investments and between hedge fund indices themselves. We use the SNP approach to obtain estimates of conditional densities of hedge fund returns and then proceed to examine their properties. In general, a nonparametric GARCH(1,1) model appears to provide the best fit for all strategies. We find that the conditional third and fourth moments are significantly affected by changes in the current volatility of returns on hedge fund indices. We examine changes in the conditional probability of tail events and report significant changes in the probability of extreme events when the conditioning information changes. These results have important implications for models of hedge fund risk that rely on probability of tail events. We formally test for the presence of asymmetries in conditional correlations to determine if there is contagion between hedge funds and other investments and between various hedge fund indices in extreme down markets versus extreme up markets. We generally do not find strong evidence in support of asymmetric correlations.     

Investor structure and the informational efficiency of commodity futures prices

This article investigates the impact of the trading positions of hedgers (i.e., producers, merchants, processors, or users of a commodity), speculators (i.e., commodity pool operators, trading advisors, or hedge funds), and swap dealers on the price formation process in the agricultural, metal, and energy futures markets. The hedgers' relative positions exert negative impacts on price efficiency in commodity futures markets. Hedgers are less likely to be information motivated, so their trading delays the price formation process. However, speculators' positions have positive impacts on price efficiency because speculators correct pricing errors. This study also offers evidence that the role of swap dealers, similar to speculators in futures markets, is to provide liquidity and cross-market arbitrage. These findings highlight the role of producers, hedge funds, and swap dealers in price formation processes in commodity futures—information that is beneficial to academics, practitioners, and regulators.     

The Italian hedge funds industry: An empirical analysis of performance and persistence

This study analyses Italian hedge funds performance and persistence. The peculiarity of the Italian hedge fund industry is that 95% of the hedge funds are funds of hedge funds (FoHF), whereas only 5% of them employ other investment styles. Using monthly data on FoHF provided by MondoHedge, we examine the impact of both market variables and funds’ own characteristics on funds performance using panel data. We find that the European, the Japanese and the emerging markets equity markets, and the commodity market have a positive impact on Italian FoHF performances, while the US Bond Market negatively affects them. Moreover, we find performance fees and notice days to have a negative impact on funds performances. Finally, we test the presence of performance persistence. Employing two different nonparametric methods, we find that funds performances are persistent on a monthly and quarterly basis, while the regression-based parametric method provides evidence of persistence only on a monthly basis.     

Liquidity commonality in commodities

We examine liquidity commonality in commodity futures markets. Using data from 16 agricultural, energy, industrial metal, precious metal, and livestock commodities, we show there is a strong systematic liquidity factor in commodities. Liquidity commonality was present in 1997–2003 when commodity prices were relatively stable and during the recent boom. There is some support for both “supply-side” and “demand-side” explanations for this commonality. We find no evidence of a consistent link between stock and commodity liquidity in general. Energy commodities appear to provide a better hedge against equity market liquidity risk than the other commodity families.     

Scale economies in pension fund investments: A dissection of investment costs across asset classes

Using a unique dataset of 225 Dutch occupational pension funds with a total of 928 billion euro of assets under management, we provide a comprehensive cross-sectional analysis of the relation between investment costs and pension fund size. Our dataset is free from self-reporting biases and decomposes investment costs for 6 asset classes in management costs and performance fees. We find that a pension fund that has 10 times more assets under management on average reports 7.67 basis points lower annual investment costs. Economies of scale differ per asset class. We find significant economies of scale in fixed income, equity and commodity portfolios, but not in real estate investments, private equity and hedge funds. We also find that large pension funds pay significantly higher performance fees for equity, private equity and hedge fund investments.     

The performance and diversification benefits of funds of hedge funds

We examine the performance and diversification potential of 332 funds of hedge funds (FOHFs) for the period from January 1990 to May 2003. Consistent with prior studies, we find that FOHFs appear to underperform the hedge fund index on a risk-adjusted basis. However, FOHFs have characteristics that offset their apparent underperformance. Their returns do not suffer from negative skewness that is a feature of many hedge fund strategies. Relative to the hedge fund index, we find that FOHFs have lower correlations with stock indices in both bull and bear markets, making them a better diversification tool in equity portfolios. For bond portfolios, however, FOHFs have no diversification advantage over hedge fund indexing.     

Style analysis and Value-at-Risk of Asia-focused hedge funds

In this paper we identify risk factors for Asia-focused hedge funds through a modified style analysis technique. Using an Asian hedge fund index, we find that Asian hedge funds show significant positive exposures to emerging equity markets. For both a static and rolling period style analysis, our model provides a high explanatory power for returns of the considered hedge fund index. We further conduct a Value-at-Risk analysis using the results of a rolling window style analysis as inputs. Our findings suggest that the considered parametric models outperform a simple historical simulation that is purely based on past return observations.     

The risk in hedge fund strategies: Theory and evidence from long/short equity hedge funds

Theory suggests that long/short equity hedge funds' returns come from directional as well as spread bets on the stock market. Empirical analysis finds persistent net exposures to the spread between small vs large cap stocks in addition to the overall market. Together, these factors account for more than 80% of return variation. Additional factors are price momentum and market activity. Combining two major branches of hedge fund research, our model is the first that explicitly incorporates the effect of funding (stock loan) on alpha. Using a comprehensive dataset compiled from three major database sources, we find that among the three thousand plus hedge funds with similar style classification, less than 20% of long/short equity hedge funds delivered significant, persistent, stable positive non-factor related returns. Consistent with the predictions of the Berk and Green (2004) model we find alpha producing funds decays to “beta-only” over time. However, we do not find evidence of a negative effect of fund size on managers' ability to deliver alpha. Finally, we show that non-factor related returns, or alpha, are positively correlated to market activity and negatively correlated to aggregate short interest. In contrast, equity mutual funds and long-bias equity hedge funds have no significant, persistent, non-factor related return. Expressed differently, L/S equity hedge funds, as the name suggests, do benefit from shorting. Besides differences in risk taking behavior, this is a key feature distinguishing L/S funds from long-bias funds.     

Changing investment styles: style creep and style gaming in the hedge fund industry

Notwithstanding their common features, hedge funds remain an extremely diverse asset class. Information on fund styles is important for numerous purposes, such as portfolio construction, performance attribution and risk management. With fund self‐declaration being prone to (strategic) misclassification, return‐based taxonomies grouping funds along similarities in realized returns provide a useful alternative. We provide a consistent classification system of homogeneous groups of hedge funds based on self‐organizing maps. Whereas some fund categories such as managed futures are largely consistent in their self‐declared strategies, others, especially so‐called ‘equity hedge’ funds, display no or very limited return similarities. Furthermore, we also find evidence of fund managers performing undisclosed changes of their trading style over time. Those funds that misclassified themselves once are particularly likely to change their trading style again. Although style self‐declaration can, therefore, be quite misleading, our results indicate that hedge funds do not misdeclare their style strategically to improve their relative performance. Copyright © 2006 John Wiley & Sons, Ltd.     

Liquidity shocks,size and the relative performance of hedge fund strategies

We examine whether the increase in the flow of capital to hedge funds over the period 1994–2005 had a negative impact on performance. More specifically, we study the relative performance of small versus large funds for each of the hedge fund strategies. Our results indicate that on an absolute return basis, small funds outperform large funds. On a risk-adjusted return basis, however, we find that large funds outperform small funds, and that large funds are also shown to hold less liquid assets and take on less systematic and idiosyncratic risk than small funds. Further, funds that experience positive liquidity shocks generally outperform those that experience negative liquidity shocks. We also find evidence that hedge fund managers that are aggressive in dealing with liquidity shocks perform better than hedge fund managers that are conservative in dealing with liquidity shocks.     

Hedge Fund Regulation and Misreported Returns

This paper introduces a cross‐country law and finance analysis of the misreporting behaviour in the hedge fund industry in terms of smoothing returns so that a fund consistently generates positive returns. We find strong evidence that international differences in hedge fund regulation are significantly associated with the propensity of fund managers to misreport monthly returns. We find a positive association between wrappers and misreporting, particularly for funds that do not have a lockup provision. Also, we find some evidence that misreporting is less common among funds in jurisdictions with minimum capitalisation requirements and restrictions on the location of key service providers. We assess the robustness of our finds to a number of specifications, including, different specifications of misreporting bin widths, subsets of the data by fund type, as well as specifications controlling for collinearity and selection effects and other robustness checks. We show misreporting significantly affects capital allocation, and calculate the wealth transfer effects of misreporting and relate this wealth transfer to differences in hedge fund regulation.     

Should investors invest in hedge fund-like mutual funds? Evidence from the 2007 financial crisis

This study empirically examines the value added for investors during the 2007–2009 financial crisis from hedge fund-like equity mutual funds, including 130/30, market neutral, and long/short equity funds. We find that based on the information ratio, all market neutral funds, top 90% of long/short funds, and top 25% of 130/30 funds outperform a long-only passive index fund over the crisis period. However, we find little evidence of abnormal performance by the average and median funds in our sample, based on either unconditional or conditional four-factor alphas. The reason for the overall under-performance in the crisis period is that while short positions taken by these funds do generate alpha, the gain from their short positions is not sufficiently large to offset the loss from their long positions. Finally, the abnormal performance of short positions is found to be attributable to managers’ characteristic-adjusted and industry-adjusted stock selection skills. One implication of this study is that even though market neutral and long/short funds on average may not generate alpha, investors can benefit from holding these funds, especially the former, that can provide a hedge against down markets due to their low betas and that can be useful for asset allocation.     

Footprints in the market: Hedge funds and the carry trade

This paper uses a new database provided by the Commodity and Futures Trading Commissions to examine the price impact of hedge fund carry trades in “hot” and “cold” markets. We find that hedge funds significantly increase their carry trade positions during hot markets (periods with very high currency returns). Consistent with currency overpricing, positions in hot markets are followed by exchange rate reversals. Optimism in the stock market seems to have a spillover effect on hedge fund speculation in the currency market: controlling for the variance risk premium fully accounts for the reversal effect. Overall, our results add to a growing body of empirical evidence that institutional demand can move asset prices.     

Hedge Fund Indices: Reconciling Investability and Representativity

Following a growing concern among investors about the quality of hedge fund index return data, this paper addresses the question of whether designing hedge fund indices that fulfil the usual requirements (in particular representative and investable) is or not a feasible task, given a variety of features that are specific to that industry. To test whether or not investability should necessarily come at the cost of representativity, we use a well‐known methodology in the asset pricing literature based on the concept of factor replicating portfolios. Our results suggest that it is actually possible to construct representative indices based on a limited number of funds that are open to new investments, except perhaps in the case of equity market neutral strategies, provided that: i) these funds are suitably selected and ii) a portfolio is constructed with the objective of replicating the common trend in hedge fund returns for a given strategy. A range of robustness tests are performed that show that high correlation of the factor replicating portfolios with the common factor of returns for each strategy is remarkably stable with respect to modifying the number of funds in the replicating portfolio or changing the frequency of rebalancing.     

The Performance of Hedge Fund Strategies and the Asymmetry of Return Distributions

We present hedge fund performance estimates that adjust for stale prices, Fama‐French risk factors and skewness. We contrast these new performance estimates with traditional performance measures. Using three‐factor models to adjust for staleness in prices and to incorporate Fama‐French factors along with the Harvey‐Siddique (2000) two‐factor model that incorporates skewness, we find that for the period 1990–2003, all hedge fund categories achieve above average performance when measured against an aggregate market index. More significantly, however, when we estimate performance at the individual hedge fund level, we discover that only 40 to 47% of the funds are shown to achieve an above average performance over that time period depending on the model used. These results have important implications for investors, endowments and pensions when they choose hedge fund managers.     

Hedge fund performance attribution under various market conditions

We investigate US hedge funds' performance. Our proposed model contains exogenous and endogenous break points, based on business cycles and on a regime switching process conditional on different states of the market. During difficult market conditions most hedge fund strategies do not provide significant alphas. At such times hedge funds reduce both the number of their exposures to different asset classes and their portfolio allocations, while 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.