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Mutual/Hedge Funds

Do investors in mutual funds and hedge funds get their fair share of returns, or are they perpetually disadvantaged by fees and underperforming fund managers? Are there ways to exploit fund behaviors? These blog entries relate to mutual funds and hedge funds.

Evaluating Hedge Fund Managers on Walk, Not Talk

Picking the right benchmark is critical when assessing the performance of a fund manager. Benchmark selection is especially difficult for hedge fund managers because of: (1) the number of style options available to them, and (2) the difficulty of assigning specific funds to styles. Should evaluators simply accept the style claims of fund managers for benchmarking purposes? In their recent paper entitled “Hedge Funds: Ability Persistence and Style Bias”, Matteo Belleri and Marco Navone do not. Instead, they calculate a benchmark for each hedge fund by fitting its actual performance over the past three years to a weighted portfolio of ten hedge fund indexes (Convertible Arbitrage, Dedicated Short Bias, Emerging Markets, Market Neutral, Event Driven, Fixed Income Arbitrage, Global Macro, Long/Short Equity, Managed Futures and Multi-Strategy). This approach essentially makes each manager accountable for modifications of fund strategy to benefit from current market conditions. Using the benchmark index data and return data for 3,627 hedge funds over the period 1994-2004, they conclude that: Keep Reading

No Fire Exit at the Overcrowded Hedge Fund Party?

Have hedge funds proliferated, grown and leveraged to the point that groups of them with similar quantitative strategies can crash as they try to exit common positions in response to some external trigger? In their September 2007 paper entitled “What Happened To The Quants In August 2007?”, Amir Khandaniy and Andrew Lo investigate the hypothesis that similar market-neutral and long/short equity hedge funds suffered a cascading fire sale liquidation (one-month losses of 5%-30%) during early August 2007. Using daily return data for a broad set of stocks to model hedge fund performance over the period 1/95-8/07, they tentatively conclude that: Keep Reading

Characteristics of Persistently Outperforming Hedge Funds

In his recent PhD thesis entitled “An Analysis of Hedge Fund Strategies”, Daniel Capocci offers an epic study of hedge fund properties, results and potential benefits. Specifically, he: (1) applies a multi-factor performance analysis model to determine the degree to which hedge funds persistently produce alpha; (2) measures the extent to which market-neutral hedge funds are really neutral; and, (3) examines the mean, volatility, skewness and kurtosis of hedge fund returns to evaluate their potential benefits to investors. Using hedge fund performance data from several sources spanning 1993-2003, he finds that: Keep Reading

The Truly Active Part of Active Fund Management

In his May 2007 paper entitled “Where Do Alphas Come From?: A New Measure of the Value of Active Investment Management”, Andrew Lo proposes a decomposition of the economic value of a fund’s management into two components, one measuring security selection (a weighted average of portfolio asset returns) and the other measuring timing (the correlation between portfolio asset weights and asset returns). When correlation between portfolio weights and returns is positive, management is moving assets toward optimization of overall portfolio returns. In other words, a manager can add value by: (1) picking the right assets; and, (2) continually growing positions with the highest future returns and shrinking positions with the lowest future returns. Using multiple examples, he argues that: Keep Reading

(Low) Volatility as an Indicator of Persistent Hedge Fund Outperformance

Market conditions vary considerably across the business cycle, presumably affecting the opportunity set for a given investing style/strategy. What are the return characteristics that predict which hedge funds can best navigate changing economic conditions? In his 2007 paper entitled “The Sustainability of Hedge Fund Performance: New Insights”, Daniel Capocci decomposes hedge fund returns to determine how investors can reliably identify funds that outperform equity and bond indexes in both bull and bear markets. Using monthly return data for the 1994-2002 business cycle from two sources (3,060 individual funds and 907 funds of funds) to investigate 14 potentially useful persistence discriminators, he concludes that: Keep Reading

Hiring and Firing Investment Managers

The sponsors of retirement/endowment plans (public and corporate pension plans, unions, foundations and endowments) retain professionals to manage their funds. Do their decisions to hire and fire such professionals pan out? In other words, do their plans outperform the market after they change managers? In their May 2006 paper entitled “The Selection and Termination of Investment Management Firms by Plan Sponsors”, Amit Goyal and Sunil Wahal examine this question. Using data for 8,204/910 hiring/firing decisions by 3,591 plan sponsors during 1994-2003, they conclude that: Keep Reading

Chumming with Sharks?

When hedge funds publicly demand that management of firms in which the funds hold large stakes take steps to improve stock prices, should other investors take notice? Do such demands distract or focus management regarding shareholder interests? In the November 2006 draft of their paper entitled “Hedge Fund Activism, Corporate Governance, and Firm Performance”, Alon Brav, Wei Jiang, Frank Partnoy and Randall Thomas investigate the relationship between hedge fund activism and stock returns. They identify instances of fund activism by (1) searching 2001-2005 news databases for stories mentioning both “activism” and “hedge fund” and (2) analyzing associated SEC Schedule 13D filings, with special attention to the reasons for the transactions as stated in the filings. Using the resulting set of 888 events involving 131 funds and 775 companies, they conclude that: Keep Reading

How Well Do Experts Time Trades of Individual Stocks?

How well do experts perform in timing individual stock trades? In their May 2007 paper entitled “Individual Security Timing Ability and Fund Manager Performance”, David Gallagher, Andrew Ross and Peter Swan define individual security timing ability as the proportion of potential returns obtained by a trader over the holding period and measure this ability for a set of active Australian equity fund managers. Using a unique database of daily trades and monthly portfolio holdings for 30 fund managers from January 1996 through December 2001, they conclude that: Keep Reading

Hedge Fund Stock Picking and Trade Timing

Are hedge fund managers the best and brightest when it comes to stock picking and market timing? In their March 2007 paper entitled “How Smart are the Smart Guys? A Unique View from Hedge Fund Stock Holdings”, John Griffin and Jin Xu investigate whether hedge fund managers are better at picking stocks and investing styles than mutual fund managers. Using the stock holdings of 306 hedge fund companies from 1980 to 2004 as reported in quarterly SEC Form 13F equity filings, they conclude that: Keep Reading

Rise of the Machines? Attack of the Clones?

Do real live hedge funds beat mechanical trading systems designed to replicate their statistical return distribution and diversification properties? In their February 2007 paper entitled “Replication-Based Evaluation of Hedge Fund Performance”, Harry Kat and Helder Palaro update their comparison of the after-fee performances of a wide range of hedge funds to the performances of mechanical replicants. In short, they attempt to isolate true hedge fund outperformance by pitting each actual fund against a replicant that mechanically trades a basket of Eurodollar, 5-year note, 10-year note, S&P 500, Russell 2000 and GSCI futures. Their replication process assumes an existing investor portfolio (to be hedged) that is 50% S&P 500 index and 50% long-term T-bonds. Using return data for 2073 individual hedge funds and 875 funds of hedge funds through November 2006, they find that: Keep Reading

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