Does Size Matter in the Hedge Fund Industry?
Researcher: Melvyn Teo (Singapore Management University)
We document a negative and convex relationship between hedge fund size and future risk-adjusted returns. Small hedge funds outperform large hedge funds by 2.75 percent per year after adjusting for risk. This over performance cannot be explained by fund age, leverage, serial correlation, backfill bias, or incubation bias. The capacity constraints are not confined to the smallest funds, and manifest across various investment styles and regions. In particular, they are strongest for funds managed by multiple principals that trade small, illiquid securities, suggesting that the observed diseconomies can be traced to price impact and hierarchy costs (Stein, 2002). Interestingly, these capacity constraints facing individual hedge funds do not extend to funds of hedge funds.
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Investing in Hedge Funds When Returns Are Predictable
Researchers: Doron Avramov (University of Maryland), Robert Kosowski (Imperial College), Narayan Y. Naik (London Business School) and Melvyn Teo (Singapore Management University)
This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability in managerial skills, fund risk loadings, and benchmark returns. Incorporating predictability substantially improves performance for the entire universe of hedge funds as well as for various investment styles. The outperformance is strongest during market downturns when the marginal utility of consumption is relatively high. Moreover, the major source of investment profitability is predictability in managerial skills. In particular, long-only strategies that incorporate predictability in managerial skills outperform their Fung and Hsieh (2004) benchmarks by over 17 percent per year. The economic value of predictability obtains for different rebalancing horizons and alternative benchmark models. It is also robust to adjustments for backfill bias, incubation bias, illiquidity-induced serial correlation, fund fees, and style composition.
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Dynamic Investment Opportunities and the Cross-Section of Hedge Fund Returns: Implications of Higher-Moment Risks for Performance
Researchers: Vikas Agarwal (Georgia State University), Gurdip Bakshi (University of Maryland), Joop Huij (RSM Erasmus University)
In this paper, we examine higher-moment market risks in the cross-section of hedge fund returns to make several contributions. First, we show that hedge funds are substantially exposed to the three highermoment risks - volatility, skewness, and kurtosis. In contrast, mutual funds do not display meaningful dispersions in their exposures to these risks. Further, funds of hedge funds when examined as a separate investment category do not show aggressive loading on higher-moment risks. Second, we provide evidence on economically significant premiums being embedded in hedge fund returns on account of their exposures to higher-moment risks. Third, we uncover a set of higher-moment factors that are not strongly associated with factors in benchmark models that are currently used for evaluating hedge fund performance. Finally, the addition of these higher-moment factors to benchmark models can better explain the variation in hedge fund returns. Bearing on issues of practical consequence, we find that benchmark models augmented with higher-moment factors can considerably alter the hedge funds’ alpha-based rankings.
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The Geography of Hedge Funds
Researcher: Melvyn Teo (Singapore Management University)
Forthcoming in the Review of Financial Studies
This paper analyzes the relationship between the risk-adjusted performance of hedge funds and their proximity to investments using data on Asian-focused hedge funds. We find, relative to an augmented Fung and Hsieh (2004) factor model, that hedge funds with a physical presence (head or research office) in their investment region outperform other hedge funds by 3.72 percent per year. The local information advantage is pervasive across all major geographical regions, but is strongest for Emerging Market funds and funds holding illiquid securities. These results are robust to adjustments for fund fees, serial correlation, backfill bias, and incubation bias. We show also that distant funds, especially those based in the U.S. and the U.K., are able to raise more capital, charge higher fees, and set longer redemption periods, despite their underperformance relative to nearby funds. It appears that distant funds trade investment performance for better access to capital.
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Do Hedge Funds Deliver Alpha? A Bayesian and Bootstrap Analysis
Researchers: Robert Kosowski (Imperial College), Narayan Naik (London Business School) and Melvyn Teo (Singapore Management University)
Published in the Journal of Financial Economics
Using a robust bootstrap procedure, we find that top hedge fund performance cannot be explained by luck, and that hedge fund performance persists at annual horizons. Moreover, we show that Bayesian measures, which help overcome the short-sample problem inherent in hedge fund returns, lead to superior performance predictability. Relative to sorting on OLS alphas, sorting on Bayesian alphas yields a 5.5 percent per year increase in the alpha of the spread between the top and bottom hedge fund deciles. Our results are robust, and relevant to investors, as they are neither confined to small funds, nor driven by incubation bias, backfill bias or serial correlation.
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Statistical Digest
July 2008 Issue - Hedge Funds in a Volatile Market
We show that relative to the first half of 2007, the volatility of hedge fund returns has doubled during the September 2007 to April 2008 period. At the same time, aggregate hedge fund returns have declined while exit rates have tripled. Commodity, macro, and, to a lesser extent, arbitrage funds outperformed during this period, while bottom-up funds underperformed. In Asia, funds engaging in less traditional strategies like arbitrage, event driven, fixed income, and distressed debt have emerged relatively unscathed. Our results also suggest that around the world, funds with headquarters near their investment markets, fewer assets under management, and higher performance fees have weathered the storm better than other funds.
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Nov 2007 Issue - Lessons from the Sub-Prime Crisis
We show that there is significant variation in performance across hedge funds during the subprime crisis. Hedge funds that (i) invested in Asia , (ii) had equity exposure, (iii) adopted directional strategies, or (iv) allowed for frequent redemptions, underperformed other funds. Moreover, leveraged funds did not fare significantly worse than their non-leveraged counterparts. Our results suggest that credit market illiquidity was not directly responsible for the bloodshed amongst hedge funds. Rather, funds were hurt by a global increase in risk aversion and by fire sales conducted in anticipation of redemptions.
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Jul 2007 Issue - Asian Hedge Funds: A Tale of Three Cities
In this issue of the statistical digest, we use a fairly unique lens to view hedge funds: manager location. We uncover differences in size, investment strategies, and investment geography between funds managed from Hong Kong , Singapore , and Sydney . Funds managed from Hong Kong tend to be Equity Long/Short funds between US$100m to US$500m in size. Funds in Singapore tend to be smaller while funds in Sydney demonstrate significant variation in assets under management. Sydney attracts a disproportionate number of CTA funds while Singapore attracts a disproportionate number of Macro and Japan focused funds.
We also show that there are systematic differences in risk exposures between funds managed from the three centres. Asia ex Japan and Asia incl Japan Equity Long/Short funds managed from Sydney tend to have lower market exposures relative to other Asian funds. Similarly, Japan focused Equity Long/Short funds managed from Singapore tend to have a lower exposure to the Nikkei 225 index relative to other Japan focused funds.
Finally, our performance analysis reveals that funds managed from Asia outperform funds managed from the US and the UK . A local informational advantage manifests in Asia and this translates to differences in risk-adjusted returns between nearby and distant fund portfolios of around 2 and 4% per year. While Asian Equity Long/Short funds managed from Hong Kong outperform those managed from Singapore and Sydney , we hypothesize that some of the over performance may be driven by Hong Kong 's geographical proximity to China . These results are relevant to hedge fund investors considering an allocation to Asia .
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