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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.

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

Hedge Funds Versus Mutual Funds

How are hedge funds like, and not like, mutual funds? How is the hedge fund industry likely to evolve? In his February 2007 paper entitled “Hedge Funds: Past, Present and Future”, Rene Stulz compares the performance and risks of hedge funds to those of mutual funds and examines the likelihood that hedge funds will become more like mutual funds in the future. Based on a review of relevant research, he concludes that: Keep Reading

The Rareness and Elusiveness of Mutual Fund Outperformance

What are an investor’s chances of reaping abnormal returns from mutual funds? Is it possible to identify the funds that will outperform? In their December 2006 paper entitled “Mutual Fund Performance”, Keith Cuthbertson, Dirk Nitzsche and Niall O’Sullivan address these questions via review of past academic research on US and UK managed mutual funds, with focus on studies done within the last 20 years. They conclude that: Keep Reading

Follow the Leaders to Capture Short-term Abnormal Returns

Do investors/traders taking cues from the trades of top performers produce the momentum effect? In his December 2006 paper entitled “Follow the Leader: Peer Effects in Mutual Fund Portfolio Decisions”, Lukasz Pomorski investigates whether actively managed equity mutual funds tend to follow the stock trading leads of outperforming peers as the picks become known via the media and quarterly filings. He defines outperforming (leader) funds in two ways: (1) funds with alphas in the top 5% over the past two years, and (2) funds on the Forbes Honor Roll (high media exposure). He calculates overall leader activity in a stock based only on trades by leader funds with a position in the stock. Using mutual fund holdings and performance data for 1980-2003 (96 quarters), he finds that: Keep Reading

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