Mutual/Hedge Funds

Do Morningstar’s analyst ratings predict which mutual funds will do best? In their January 2014 paper entitled “Going for Gold: An Analysis of Morningstar Analyst Ratings”, Will Armstrong, Egemen Genc and Marno Verbeek examine the performance of mutual funds after Morningstar assigns analyst ratings to them. Morningstar initiated these substantially qualitative ratings (Gold, Silver, Bronze, Neutral and Negative) in September 2011, as a supplement to star ratings, to convey expected risk-adjusted performance of funds with respect to peers over a full market cycle of at least five years. Ratings take into account past performance, fees and trading costs, quality of investment team, parent organization and investment process.  The study considers both raw returns and four-factor (market, size, book-to-market, momentum) alphas during intervals of one, three and six months after each rating initiation. It also takes into account differences in time frame, fund investment style and fund star rating. Using analyst ratings initiated during September 2011 through December 2012, associated fund characteristics and associated fund returns through June 2013, they find that:

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Do active investment managers beat the market? In their January 2014 paper entitled “Active Manager Performance: Alpha and Persistence”, Frank Benham and Edmund Walsh assess the performance of active investment managers relative to appropriate benchmarks across asset classes over long periods. They consider six basic investment classes: core bonds; high-yield bonds; domestic large capitalization stocks; domestic small capitalization stocks; foreign large capitalization stocks; and, emerging markets stocks. They focus on whether investment managers beat benchmarks in the past and whether past outperformers become future outperformers. They take steps to avoid survivorship bias, selection bias and fund classification errors. Using a sample of 5,379 live and dead funds assembled from Morningstar Direct by filtering to avoid classification errors and to eliminate redundant funds run by the same manager from benchmark inceptions (ranging from January 1979 for domestic stocks to January 1988 for emerging markets stocks) through 2012, they find that: Keep Reading

Does the expanding set of exchange-traded funds (ETF) support reliable replication (cloning) of future hedge fund returns? In their March 2014 paper entitled “In Search of Missing Risk Factors: Hedge Fund Return Replication with ETFs”, Jun Duanmu, Yongjia Li and Alexey Malakhov investigate the use of ETFs as factors in constructing hedge fund clones. They note that the number of U.S.-listed passive ETFs increases from 19 in 1997 to 1,313 in 2012, now comprising a large set of proxies for many factor/characteristic strategies. They use this set of factor proxies to clone a hedge fund via a three-step in-sample replication process based on two years of historical data. Specifically, each year they:

1. Iterate cluster analysis 100 times to identify ETFs most representative (highest correlation of monthly returns with the mean return of the cluster) of up to 100 clusters to serve as factor proxies.
2. Use an optimization tool on each of the 100 cluster analyses to combine representative ETFs into 100 clone models of pre-fee (risk factor perspective) monthly returns for each target hedge fund.
3. Apply the Bayesian information criterion (which addresses data snooping bias via a penalty for model complexity) to select the best clone model for each target hedge fund.

They then test the ability of winning clone models to match post-fee (investor perspective) monthly returns of target hedge funds for one year out-of-sample. They mitigate backfill bias in hedge fund returns (only funds with good starts begin publicizing their returns) by excluding the first 24 months of reported returns. They suppress survivorship bias by including funds that later stop reporting. Using monthly returns, fees and characteristics for 3,190 hedge funds and monthly returns and fees for 1,313 passive ETFs as available during 1997 through 2012, they find that: Keep Reading

Research on hedge fund performance derives from voluntary reports by hedge funds to commercial databases. This environment encourages: (1) backfill bias (non-reporting funds doing well are most likely to begin reporting, including historical data that arguably involves some good luck); and, (2) delisting bias (reporting funds doing poorly, arguably due in part to poor strategies, are most likely to stop reporting). Also, young databases tend to have survivorship bias because they have not accumulated much data on “dead” funds. How material is the delisting bias? In their August 2013 paper entitled “The Delisting Bias in Hedge Fund Databases”, Philippe Jorion and Christopher Schwarz compare information across three commercial hedge fund databases to estimate delisting bias. Their estimating process exploits the fact that hedge funds often do not terminate reporting to all three databases at the same time. Using matched monthly hedge fund return data across Tremont Advisory Shareholders Services, the Center for International Securities and Derivatives Markets, and Hedge Fund Research databases during 1994 through 2008 (9,970 funds), they find that: Keep Reading

Can equity funds exploit widely accepted stock return anomalies? In their July 2013 paper entitled “Academic Knowledge Dissemination in the Mutual Fund Industry: Can Mutual Funds Successfully Adopt Factor Investing Strategies?”, Eduard Van Gelderen and Joop Huij investigate whether mutual funds that materially adopt investment strategies based on published asset pricing anomalies consistently outperform the stock market. They first use monthly regressions to measure degrees of use of six factor investing strategies (low-beta, small cap, value, momentum, short-term reversal and long-term reversion) across U.S. equity mutual funds. They then calculate market-adjusted returns to determine whether funds employing the strategies outperform those that do not and the market. Using monthly returns for 6,814 U.S. equity mutual funds, and contemporaneous monthly returns for the specified factors, during 1990 through 2010, they find that: Keep Reading

How much difference does it make to calculate mutual fund alphas with exchange-traded funds (ETF) rather than ideal (frictionless) indexes/factors? In their November 2012 paper entitled “Mutual Fund’s Net Economic Alpha: Definition and Evidence” Sharon Garyn-Tal and Beni Lauterbach investigate how benchmarking mutual funds with ETFs differs from traditional benchmarking with ideal performance models based on one to five factors (market, fund style, size, book-to-market ratio and momentum). They calculate traditional alphas via regressions against a specified number of factors. They calculate net economic alphas by adding to the traditional alphas costs of implementing associated factors with one or several actual ETFs. Net economic alpha therefore represents the actual value of a fund to investors relative to mimicking ETF alternatives. While accounting for ETF expense ratios, they ignore trading frictions associated with periodic (monthly) rebalancing sets of ETFs to maintain alignment with multi-factor models. They also ignore mutual fund redemption fees and loads, hoping that ETF and mutual fund cost omissions cancel. They focus on post-2000 data because factor-implementing ETFs are not available earlier. Using returns and style designations for over 1,000 open-end, non-specialized U.S. equity funds and values for traditional performance model factors during 2001 through 2009 (segmented into three equal subperiods), they find that: Keep Reading

What are the trading behaviors of the best-performing hedge funds? In his June 2013 paper entitled “How do Hedge Fund ‘Stars’ Create Value? Evidence from Their Daily Trades”, Russell Jame uses transaction-level data to investigate the magnitude and source of hedge fund equity trading profits. His sample includes name, equity trade dates (but not non-equity trades, if any), execution prices and transaction costs for 74 hedge funds and 579 other institutions over a 12-year period. He estimates performance by constructing buy and sell portfolios from trades and computing portfolio-level returns over intervals of the next 21, 63, 126 and 252 trading days (emphasizing 252 days as closest to the average holding period of a typical hedge fund). He excludes portfolios with fewer than ten stocks as too noisy. He considers gross return, gross DGTW-adjusted return (return on a stock less the value-weighted return on a benchmark portfolio with the same size, book-to-market and momentum characteristics as the stock) and net DGTW-adjusted return. Using detailed trading data as described during January 1999 through December 2010 and associated stock prices through December 2011, he finds that: Keep Reading

What proportion of long-short equity hedge fund managers effectively time the stock market? In their January 2013 paper entitled “Hedge Fund Managers’ Market Timing Skills”, Xin Li and Hany Shawky investigate whether long-short equity hedge funds (the oldest and largest hedge fund category) exhibit market timing skill by adjusting positions with market trends. Specifically, they examine hedge fund return correlations with the Fama-French model factors (market, size and book-to-market ratio) during three major crises: the Long-Term Capital Management (LTCM) collapse in the fall of 1998; the quant crisis in August 2007; and, the financial crisis in 2008. They also examine market timing behaviors of individual hedge funds over their respective lifetimes by relating fund beta to market return via a nonlinear function accounting for risk aversion and/or market liquidity. Using monthly returns for 1,571 long-short equity hedge funds having at least 48 months of returns, and contemporaneous Fama-French factor returns, during January 1994 through January 2011, they find that: Keep Reading

Do mutual fund managers who employ technical analysis outperform those who do not? In their January 2013 paper entitled “Head and Shoulders above the Rest? The Performance of Institutional Portfolio Managers who Use Technical Analysis”, David Smith, Christophe Faugere and Ying Wang compare the aggregate investment performance of mutual funds that (self-reportedly) using technical analysis to that of funds not using technical analysis. Self-reported importance of technical analysis is on a five-level scale: “very important,” “important,” “utilized,” “not important” or “not utilized.” Using technical analysis importance levels and monthly returns for 10,452 actively managed U.S. equity, global equity, U.S. balanced and global balanced mutual funds during January 1993 through March 2012 (231 months), they find that: Keep Reading

Are managed futures programs good portfolio diversifiers? In his September 2012 paper entitled “Revisiting Kat’s Managed Futures and Hedge Funds: A Match Made in Heaven”, Thomas Rollinger updates prior research exploring the diversification effects of adding managed futures to traditional portfolios of stocks and bonds and to portfolios including stocks, bonds and hedge funds. His proxies for the four asset classes are: (1) for stocks, the S&P 500 Total Return Index; (2) for bonds, the Barclays U.S. Aggregate Bond Index; (3) for hedge funds, the HFRI Fund Weighted Composite Index; and, (4) for managed futures programs, the Barclay Systematic Traders Index (focused on systematic trend-following strategies). He assumes monthly (frictionless) portfolio rebalancing. Using monthly returns for the four asset class indexes during June 2001 through December 2011, he finds that: Keep Reading