Public hedge funds

Hedge funds managed by listed firms significantly under-perform funds managed by unlisted firms. The under-performance is more severe for funds with low manager deltas, poor governance, and no manager co-investment, or those managed by firms whose prices are sensitive to earnings news. Notwithstanding the under-performance, listed asset management firms raise more capital, by growing existing funds and launching new funds post listing, and harvest greater fee revenues than do comparable unlisted firms. The results are consistent with the view that, for asset management firms, going public weakens the alignment between ownership, control, and investment capital, thereby engendering conflicts of interest.     

Information spillovers and performance persistence for hedge funds

We present a simple model that rationalizes performance persistence in hedge fund limited partnerships. In contrast to the model for mutual funds of Berk and Green (2004), the learning in our model pertains to profitability associated with an innovative trading strategy or emerging sector, rather than ability specific to the fund manager. As a result of potential information spillovers, which would increase competition if informed investors were to partner with non-incumbent managers, incumbent managers will let informed investors benefit from increases in estimated profitability following high returns realized with the trading strategy or in the sector.     

Highwaymen or heroes: Should hedge funds be regulated?: A survey

There are increasing calls for the regulation of hedge funds, both for consumer protection and systemic reasons. We argue that the consumer protection arguments for direct regulation are not convincing, but find that the systemic concerns are sufficiently serious to warrant some forms of regulation. Existing regulatory methods, disclosure and activity restrictions, are unsuitable for hedge funds. Any future regulation must reduce the likelihood and potential costs of the failure of systemically important hedge funds while at the same time preserving the wider market benefits of hedge funds’ ongoing activities.     

Performance measurement of hedge funds using data envelopment analysis

Data envelopment analysis (DEA) is a nonparametric method from the area of operations research that measures the relationship of produced outputs to assigned inputs and determines an efficiency score. This efficiency score can be interpreted as a performance measure in investment analysis. Recent literature contains intensive discussion of using DEA to measure the performance of hedge funds, as this approach yields some advantages compared to classic performance measures. This paper extends the current discussion in three aspects. First, we present different DEA models and analyze their suitability for hedge fund performance measurement. Second, we systematize possible inputs and outputs for DEA and again examine their suitability for hedge fund performance measurement. Third, two rules are developed to select inputs and outputs in DEA of hedge funds. Using this framework, we find a completely new ranking of hedge funds compared to classic performance measures and compared to previously proposed DEA applications. Thus, we propose that classic performance measures should be supplemented with DEA based on the suggested rules to fully capture hedge fund risk and return characteristics.      

Generalized runs tests to detect randomness in hedge funds returns

The major contribution of this paper is to make use of generalized runs tests (Cho and White, 2011) to analyze the randomness, i.e. the lack of persistence, in both absolute and relative returns of hedge funds. We find that about 42% of the HFR universe exhibit iid absolute returns over the period spanning 2000 to 2012. These funds are mainly found in proportions within the Macro and Equity Hedge strategies. A similar result holds for relative returns. We also find that funds having non-iid returns often exhibit ARCH effects and structural breaks, with largest breaks located within financial crises. Also, only a small percentage displays persistence in their relative performance, 8.2% to 16.7% of the universe, mainly found in proportions within the Relative Value and Event-Driven strategies. The robustness of results is challenged by implementing the tests on a crisis-free period. We find similar results for absolute returns. For relative ones, differences appear across strategies and benchmarks, but still both ARCH and breaks are present. Our work contributes to the hedge fund literature in terms of methodology, portfolio allocation, and performance measurement.     

Optimal hedge fund portfolios under liquidation risk

We use an expected utility framework to integrate the liquidation risk of hedge funds into portfolio allocation problems. The introduction of realistic investment constraints complicates the determination of the optimal solution, which is solved using a genetic algorithm that mimics the mechanism of natural evolution. We analyse the impact of the liquidation risk, of the investment constraints and of the agent's degree of risk aversion on the optimal allocation and on the optimal certainty equivalent of hedge fund portfolios. We observe, in particular, that the portfolio weights and their performance are significantly affected by liquidation risk. Finally, tight portfolio constraints can only provide limited protection against liquidation risk. This approach is of special interest to fund of hedge fund managers who wish to include the hedge fund liquidation risk in their portfolio optimization scheme.     

Structural holes and hedge fund return comovement: evidence from network-connected stock hedge funds in China

Using data from a new hedge fund database, we examine the impact of social networks on the return comovement of stock hedge funds in China. We use structural holes in the college alumni networks of managers to measure the managers’ social network positions. We perform an empirical analysis on a sample of 3,012 hedge fund products in China from 2010 to 2017. We find that greater structural holes are associated with higher return comovement. The positive impact of the structural holes on return comovement is not affected by market cycles, a manager's major in college, or his or her abilities.     

Performance hypothesis testing with the Sharpe ratio: The case of hedge funds

As recent research highlights that the Sharpe ratio has a decision theoretic foundation even in the case of asymmetric or fat-tailed excess returns and thus is adequate even for the evaluation of hedge funds, this note provides the first Sharpe ratio based performance analysis of the hedge fund market. Furthermore, it addresses the important practical question whether the choice of hypothesis test used to statistically compare Sharpe ratios can influence an investor’s hedge fund selection process. Our key findings are as follows: (i) Only a small fraction of hedge funds in our large dataset can significantly outperform passive investments in corresponding hedge fund indices. (ii) Especially in the presence of autocorrelated or skewed excess returns, the traditional test of Jobson and Korkie, 1981, Memmel, 2003 tends to overstate the number of significant outperformers and thus provides potentially misleading information for investors. Decision makers are advised to use the bootstrap test of Ledoit and Wolf (2008) allowing robust and more reliable inference.     

Commonality in hedge fund returns: Driving factors and implications

We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.     

Leveraged investor disclosures and concentrations of risk

We analyze a model where investors (e.g., hedge funds) need to borrow from lenders with heterogeneous risk-exposures and risk-management motives. Investors may obtain advantageous terms of borrowing by disclosing their investment strategy, thereby revealing its correlation to the lender's existing risk exposure. Investors risk being “front-run” by their lender if they disclose, however. We show that in the presence of front-running, the “unraveling” result of full disclosure may not hold. In addition, disclosure regulation results in a loss of welfare since investors compelled to disclose will mitigate front-running by choosing a lender with sufficiently high correlation, thus exacerbating concentrations of risk.     

Rehabilitating the role of active management for pension funds

Pension fund returns can be decomposed into different sources, including market movements, asset allocation policy, and active portfolio management. We use a unique database covering the asset allocations of US defined-benefit pension funds for the period 1990–2008, and we test the role of each factor in explaining their returns. Our results shed new light on pension funds’ sources of performance. While the previous literature emphasized that policy allocation accounts for the bulk of returns, leaving little room for active management, we show that taking explicit account of market movement can change the results significantly. Although active management plays a minor role in global asset allocation, its role is predominant in explaining returns to individual asset classes, whether traditional or alternative. This paper rehabilitates the contribution of active management as a source of performance for pension funds, at least at the asset class level.     

Performance implications of active management of institutional mutual funds

We use information on institutional US mutual funds to examine the performance implications of the decisions they make when actively implementing their investment processes. Our findings show that the success of active fund managers' stock selection decisions is influenced both by the aggressiveness with which they implement their processes and also the style tilts incorporated into their active positions. Our findings provide useful insights into both where one might best look when choosing an active manager and also suggest possible profitable investment strategies.     

中国开放式基金投资管理效率研究

本文利用数据包络分析法(DEA)对我国开放式基金2003～2008年的投资管理效率进行总体分析,发现我国开放式基金投资效率很低,基金风格、基金管理公司、规模大小、分红等都会影响其综合技术效率、纯技术效率与规模效率。进一步利用Malmquist生产率指数对其动态效率进行分析表明,开放式基金整体效率存在改善,主要来自于技术进步。     

Information asymmetry,mutual funds and earnings management: Evidence from China

This paper investigates how information asymmetry and mutual fund ownership affect listed companies’ earnings management. We show that (1) reducing information asymmetry improves firms’ earnings management behavior; (2) relative to short-term mutual funds, long-term mutual funds promote earnings quality by adopting a monitoring role; and (3) by dividing firms into high/low information asymmetry groups, we find that the information environment significantly increases the effect of long-term mutual funds on firms’ earnings management. In this paper, we provide new evidence for the role that institutional investors play in a typical emerging capital market. Our results have clear policy implications: to increase earnings quality, it is essential to improve information transparency and develop long-term institutional investors.     

Market structure and diversification of mutual funds

This study characterizes a systematic relationship between the diversification incentives and the market structure of the mutual funds industry with investors differentiated by their attitude towards risk. With sufficiently low competition the subgame perfect portfolio equilibrium exhibits maximal risk differentiation. With intensified competition intermediate funds, i.e., those attracting investors with intermediate attitudes towards risk, select diversified portfolios. Finally, we offer a general characterization of how imperfect competition between risk-differentiated funds will generate an equilibrium relationship between risk and expected returns.     

A return-based approach to identify home bias of European equity funds

This paper introduces a return-based approach to studying a possible home bias of European equity funds by estimating their exposures to their domestic markets. We first confirm the robustness of our approach using simulated portfolios with different proportions of domestic and foreign stocks. The empirical analysis examines equity funds domiciled in 15 European countries that invest in European stocks. We examine individual funds as well as portfolios comprising funds that are all domiciled in a particular country. Our findings reveal that the portfolios of four domiciles show a significant home bias. Moreover, we observe that in seven domiciles more than a quarter of the individual funds are home-biased. These results are robust when controlling for fund-specific benchmarks or for the average country exposures of all funds in our final sample. Finally, a home bias of individual funds is not related to superior performance, but actually results in higher investment risk consistent with underdiversification.     

The minimum variance hedge and the bankruptcy risk of the firm

In this paper, we analyze the influence of hedging with forward contracts on the firm's probability of bankruptcy (POB). The minimization of this probability can serve as a substitute for the maximization of shareholders' wealth. It is shown that the popular minimum variance hedge is generally neither necessary nor sufficient for the minimization of the firm's POB. Moreover, our model suggests a correction of the widespread view that a reduction in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution, we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a “natural” hedge.     

Risk management committees and readability of risk management disclosure

This paper examines whether the presence of risk management committees is associated with the readability of risk management disclosure. Specifically, we consider the presence and the effectiveness of risk management committees. We measure the readability of risk management disclosure using six different readability indices, namely: Bog index; Flesch Reading Ease score; Coleman–Liau index; Flesch–Kincaid Grade level; Simple Measure of Gobbledygook; and Automated Reading index. We find that the presence and the effectiveness of risk management committees are associated with the higher readability of risk management disclosure. We adopt various methods, including an instrumental variable approach, the entropy balancing method and the dynamic generalised method of moments, to address endogeneity concerns. Taken together, our results highlight the important role of the risk management committee in communicating risk management information.     

Liquidity risk and the cross-section of hedge-fund returns

This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important determinant in the cross-section of hedge-fund returns. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually, on average, over the period 1994–2008, while negative performance is observed during liquidity crises. The returns are independent of the liquidity a fund provides to its investors as measured by lockup and redemption notice periods, and they are also robust to commonly used hedge-fund factors, none of which carries a significant premium during the sample period. These findings highlight the importance of understanding systematic liquidity variations in the evaluation of hedge-fund performance.     

Corporate governance and risk management: The role of risk management and compensation committees

This paper examines the role of compensation and risk committees in managing and monitoring the risk behaviour of Australian financial firms in the period leading up to the global financial crisis (2006–2008). This empirical study of 711 observations of financial sector firms demonstrates how the coordination of risk management and compensation committees reduces information asymmetry. The study shows that the composition of the risk and compensation committees is positively associated with risk, which, in turn, is associated with firm performance. More importantly, information asymmetry is reduced when a director is a member of both the risk and compensation committees which moderate the negative association between risk and firm performance for firms with high risk.