Trend-following hedge funds and multi-period asset allocation

Abstract

Selected hedge funds employ trend-following strategies in an attempt to achieve superior risk-adjusted returns. We employ a lookback straddle approach for evaluating the return characteristics of a trend-following strategy. The strategies can improve investor performance in the context of a multi-period dynamic portfolio model. The gains are achieved by taking advantage of the funds' high level of volatility. A set of empirical results confirms the advantages of the lookback straddle for investors at the top end of the multi-period efficient frontier.     

INVESTORS' DIFFERENTIAL RESPONSE TO MANAGED FUND PERFORMANCE

Several studies measuring the flow of monies into and out of U.S. mutual funds note a convexity in the performance‐flow relation and offer several explanations for the apparent investor insensitivity to poor performance. In this study investor response to past performance is measured in a different setting: the Australian wholesale funds market. The results confirm that, like the U.S. mutual fund investor, institutional investors in Australia react to recent performance. However, a similar response asymmetry is not detected in most tests. Evidence that small, young funds are potential drivers of the asymmetric response effect is also provided. JEL classification: G10, G14     

Optimal design of derivatives in illiquid markets*

Abstract

The aim of this paper is to determine the optimal structure of derivatives written on an illiquid asset, such as a catastrophic or a weather event. This transaction involves two agents: a bank which wants to hedge its initial exposure towards this illiquid asset and an investor which may buy the contract. Both agents also have the opportunity to invest their residual wealth on a financial market.

Based on a utility maximization point of view, we determine an optimal profile (and its value) such that it maximizes the bank's utility given that the investor decides to make the deal only if it increases its utility. In the case of exponential utility, we show that the pricing rule is a non-linear function of the structure and that the bank always transfers the same proportion of its initial exposure. In the general case, an additional term appears, depending only on the relative log-likelihood of the two agents' views of the distribution of the illiquid asset.     

Analysing the performance of managed funds using the wavelet multiscaling method

We propose a new approach for investigating the performance of managed funds using wavelet analysis and apply it to an Australian dataset. This method, applied to a multihorizon Sharpe ratio, shows that the wavelet variance at the short scale is higher than that of the longer scale, implying that an investor with a short investment horizon has to respond to every fluctuation in the realized returns, while for an investor with a much longer horizon, the long-run risk associated with unknown expected returns is not as important as the short-run risk. Using multihorizon Sharpe ratios of six groups of managed funds, we find that none of the fund groups are dominant over all time scales.

Capacity constraints,investor information,and hedge fund returns

To identify capacity constraints in hedge funds and simultaneously gauge how well-informed hedge fund investors are, we need measures of investor demand that do not affect deployed hedge fund assets. Using new data on investor interest from a secondary market for hedge funds, this paper verifies the existence of capacity constraints in hedge funds. There is more mixed evidence on the information available to hedge fund investors. Buy and sell indications arrive following fund outperformance. While buy indications have little incremental power to predict hedge fund performance over and above well-known forecasting variables, sell indications do somewhat better.     

Investor attention,ETF returns,and country-specific factors

Using the data of 47 single-country exchange-traded funds (ETFs) traded in the U.S. from 36 countries during 2004–2017, this research examines the impact of investor attention proxied by Google Search Volume Index and home country-specific factors on different quantile of their returns. Evidence first shows that compared with U.S. investor attention, home country investor attention largely correlates with low to medium ETF returns, supporting the attention-induced price pressure hypothesis. Second, home country-specific factors significantly affect ETF returns at different conditional quantiles. We also find that investors prefer investing in a country with strong similarity to that of the U.S., supporting the cross-country information asymmetry hypothesis. Third, an intervening effect of home country-specific factors exists on the relationship between U.S. investor attention and ETF returns. These findings should help government authorities find appropriate strategies to attract foreign investment and upgrade the value of their capital market as well as provide a reference on efficiency for equity investors.     

Locked Up by a Lockup: Valuing Liquidity as a Real Option

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with constant relative risk aversion utility and risk aversion of three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.     

Information,sophistication, and foreign versus domestic investors’ performance

Using an intraday transaction dataset with trader identity, we study foreign and domestic investors’ trading activities and investment performance ahead of open-ending events of Taiwanese closed-end funds. Simply buying the funds at a discount and holding until open-ending generates large abnormal returns. All information required to execute this strategy is made public, so the events set up natural experiments to examine how investors trade, holding constant access to information. Foreign investors are net buyers ahead of the open-endings, more than doubling their positions and earning large abnormal returns. Domestic investors are net sellers while the discounts are still large, and forego large abnormal returns. The results suggest that investor sophistication in interpreting the same information is potentially an important determinant of investment performance differences across foreign and domestic investors.     

The effect of investor service costs on mutual fund performance

We examine the effect of investor service costs on mutual fund performance. Benchmarking passive funds against ETFs managed by the same fund company with the same investment objectives, we show that passive funds on average underperform ETFs by 42 bps in annualized net returns, of which about 90% can be attributed to investor service costs. Further benchmarking active funds against passive funds, we show that active funds on average outperform passive funds by 31 bps in annualized gross returns. However, the higher expense ratios charged by active funds lead to about 28 bps of underperformance in annualized net fund returns.     

Kidnapped mutual funds: Irrational preference of naive investors and fund incentive distortion

This study documents that mutual fund investors in Chinese stock markets confuse factor-related returns (FRR) with active alpha. This revealed preference “kidnaps” mutual funds to chase FRR instead of alpha. The observed distorted incentive is intensified among less sophisticated groups as evidenced by investor type and fund-rating heterogeneity. Investors' biased skill assessment is irrational, even if FRR is a vital part of investors' utility function, as there is performance reversal for funds assessed as top performers. We further showed that a distorted incentive to chase FRR undermines mutual funds' willingness to generate alpha by combating fundamental mispricing. Mutual funds cater to investors' preferences by creating more speculative short-term factor timing and holding more lottery-like stocks. Our findings question the widely held belief of the sophisticated Bayesian-agent paradigm in household financial decision-making and cast doubt on institutions' willingness to address mispricing, as suggested by the efficient market hypothesis.     

International equity funds,performance, and investor flows: Australian evidence

This is the first paper in the Australian literature to examine the investment performance of actively managed international equity funds (domiciled in Australia). Both institutional and retail international equity funds are assessed together with the impacts of investor fund flows on portfolio returns. Performance is also evaluated using conditional measures that account for public information in the global economy, however, despite an improvement in the measurement of risk-adjusted returns, performance remains consistent with an efficient global market. These findings support prior research, which concludes that active management does not provide investors with superior returns to passive indices. When consideration is given to the liquidity service provided by active managers, fund flows are shown to negatively impact on performance.     

COGNITIVE DISSONANCE AND MUTUAL FUND INVESTORS

We present evidence from questionnaire responses of mutual fund investors about recollections of past fund performance. We find that investor memories exhibit a positive bias, consistent with current psychological models. We find that the degree of bias is conditional upon previous investor choice, a phenomenon related to the well-known theory of cognitive dissonance. Psychological and economic frictions in the mutual fund industry are examined via a cross-sectional study of equity mutual funds. We find an unusually high frequency of poorly performing funds, consistent with investor “inertia.” We also examine the differential responses of investment dollars to past performance, controlling for survivorship. These show that the effect is confined to the top quartile. We find little evidence that the response to poor performance is unusual.     

Multiperiod Optimal Investment-Consumption Strategies with Mortality Risk and Environment Uncertainty

Abstract

In this article we investigate three related investment-consumption problems for a risk-averse investor: (1) an investment-only problem that involves utility from only terminal wealth, (2) an investment-consumption problem that involves utility from only consumption, and (3) an extended investment-consumption problem that involves utility from both consumption and terminal wealth. Although these problems have been studied quite extensively in continuous-time frameworks, we focus on discrete time. Our contributions are (1) to model these investmentconsumption problems using a discrete model that incorporates the environment risk and mortality risk, in addition to the market risk that is typically considered, and (2) to derive explicit expressions of the optimal investment-consumption strategies to these modeled problems. Furthermore, economic implications of our results are presented. It is reassuring that many of our findings are consistent with the well-known results from the continuous-time models, even though our models have the additional features of modeling the environment uncertainty and the uncertain exit time.     

Optimal Portfolio Selection with Transaction Costs

Abstract

This paper examines the lifetime portfolio-selection problem in the presence of transaction costs. Using a discrete time approach, we develop analytical expressions for the investor's indirect utility function and also for the boundaries of the no-transactions region. The economy consists of a single risky asset and a riskless asset. Transactions in the risky asset incur proportional transaction costs. The investor has a power utility function and is assumed to maximize expected utility of end-of-period wealth. We illustrate the solution procedure in the case in which the returns on the risky asset follow a multiplicative binomial process. Our paper both complements and extends the recent work by Gennotte and Jung (1994), which used numerical approximations to tackle this problem.     

Dynamic preferences for popular investment strategies in pension funds

In this paper, we characterize dynamic investment strategies that are consistent with the expected utility setting and more generally with the forward utility setting. Two popular dynamic strategies in the pension funds industry are used to illustrate our results: a constant proportion portfolio insurance (CPPI) strategy and a life-cycle strategy. For the CPPI strategy, we are able to infer preferences of the pension fund’s manager from her investment strategy, and to exhibit the specific expected utility maximization that makes this strategy optimal at any given time horizon. In the Black–Scholes market with deterministic parameters, we are able to show that traditional life-cycle funds are not optimal to any expected utility maximizers. We also prove that a CPPI strategy is optimal for a fund manager with HARA utility function, while an investor with a SAHARA utility function will choose a time-decreasing allocation to risky assets in the same spirit as the life-cycle funds strategy. Finally, we suggest how to modify these strategies if the financial market follows a more general diffusion process than in the Black–Scholes market.     

The performance of enhanced-return index funds: evidence from bootstrap analysis

We apply the bootstrap technique proposed by Kosowski et al. [J. Finance, 2006, 61, 2551–2595] in conjunction with Carhart's [J. Finance, 1997, 52, 57–82] unconditional and Ferson and Schadt's [J. Finance, 1996, 51, 425–461] conditional four-factor models of performance to examine whether the performances of enhanced-return index funds over the 1996 to 2007 period are based on luck or superior ‘enhancing’ skills. The advantages of using the bootstrap to rank fund performance are many. It eliminates the need to specify the exact shape of the distribution from which returns are drawn and does not require estimating correlations between portfolio returns. It also eliminates the need to explicitly control for potential ‘data snooping’ biases that arise from an ex-post sort. Our results show evidence of enhanced-return index funds with positive and significant alphas after controlling for luck and sampling variability. The results are robust to both stock-only and derivative-enhanced index funds, although the spread of cross-sectional alphas for derivative-enhanced funds is slightly more pronounced. The study also examines various sub-periods within the sample horizon.     

Impact investing

We show that investors derive nonpecuniary utility from investing in dual-objective Venture Capital (VC) funds, thus sacrificing returns. Impact funds earn 4.7 percentage points (ppts) lower internal rates of return (IRRs) ex-post than traditional VC funds. In random utility/willingness-to-pay (WTP) models investors accept 2.5–3.7 ppts lower IRRs ex ante for impact funds. The positive WTP result is robust to fund access rationing and investor heterogeneity in fund expected returns. Development organizations, foundations, financial institutions, public pensions, Europeans, and United Nations Principles of Responsible Investment signatories have high WTP. Investors with mission objectives and/or facing political pressure exhibit high WTP; those subject to legal restrictions (e.g., Employee Retirement Income Security Act) exhibit low WTP.     

Conditionally fitted Sharpe performance with an application to hedge fund rating

We define a battery of Sharpe performance measures, which differ by the information taken into account in their computation, but also by the potential use of the fund by the investor. Four advantages of Sharpe performance based rating are especially important for the investor. First, the performance measures correspond to the standard measures used for mutual funds and known by retail investors. Second, we can compare the numerical results, even if they are obtained with different assumptions. Third, the rankings are based on regression analysis and easy to compute. Fourth, we can easily use these performance measures in the design of an optimal basket of hedge funds. Finally, we can use the performance measures to partition the set of funds into homogenous segments.     

Stocks,bonds and the investment horizon: a test of time diversification on the French market

Abstract

In this paper, we investigate the relative performance of stocks and bonds for various investment horizons on the French market. We use a new matched block bootstrap approach to take account of estimation risk. Furthermore, in the light of non-normality of returns, we use two different risk approaches as inputs in portfolio optimization: the traditional variance, and a downside risk measure, the semi-variance. Our results suggest that an investor should avoid bonds in the long run due to the time diversification effect.     

Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation

This paper analyzes mutual-fund performance from an investor's perspective. We study the portfolio-choice problem for a mean-variance investor choosing among a risk-free asset, index funds, and actively managed mutual funds. To solve this problem, we employ a Bayesian method of performance evaluation; a key innovation in our approach is the development of a flexible set of prior beliefs about managerial skill. We then apply our methodology to a sample of 1,437 mutual funds. We find that some extremely skeptical prior beliefs nevertheless lead to economically significant allocations to active managers.