Hedge Funds With Style

The popular perception is that hedge funds follow a reasonably well defined market-neutral investment style. While this long-short investment strategy may have characterized the first hedge funds, today hedge funds are a reasonably heterogeneous group. They are better defined in terms of their freedom from the constraints imposed by the Investment Company Act of 1940, than they are by the particular style of investment. We study the monthly return history of hedge funds over the period 1989 through to January 2000 and find that there are in fact a number of distinct styles of management. We find that differences in investment style contribute about 20 per cent of the cross sectional variability in hedge fund performance. This result is consistent across the years of our sample and is robust to the way in which we determine investment style. We conclude that appropriate style analysis and style management are crucial to success for investors looking to invest in this market.

Fees on Fees in Funds of Funds

Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class, the high degree of fund specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manaager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors access to the most sought-after managers. However, the diversification, oversight and access comes at the cost of a multiplication of fees paid by the investor. One would expect that the information advantage of funds of funds would more than compensate investors for these fees. Unfortunately, individual hedge funds dominate fund of funds on an after-fee return or Sharpe ratio basis. In this paper we argue that the disappointing after-fee performance of some fund of funds may be explained by the nature of this fee arrangement. Fund of funds providers pass on individual hedge fund incentive fees in the form of after-fee returns, although they are in a better position to hedge these fees than are their investors. We examine a new fee arrangement emerging in the industry that may provide better incentives at a lower cost to investors in these funds.

Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows

We find evidence that is consistent with the hypothesis that daily mutual fund flows may be instruments for investor sentiment about the stock market. We use this finding to construct a new index of investor sentiment, and validate this index using data from both the United States and Japan. In both markets exposure to this factor is priced, and in the Japanese case, we document evidence of negative correlations between Bull' and Bear' domestic funds. The flows to bear foreign funds in Japan display some evidence of negative correlation to domestic and foreign equity funds, suggesting that there is a foreign vs. domestic sentiment factor in Japan that does not appear in the contemporaneous U.S. data. By contrast, U.S. mutual fund investors appear to regard domestic and foreign equity mutual funds as economic substitutes.

Conditions for Survival: changing risk and the performance of hedge fund managers and CTAs

Investors in hedge funds and commodity trading advisors [CTA] are naturally concerned with risk as well as return. In this paper, we investigate whether hedge fund and CTA return variance depends upon whether the manager is doing well or poorly. Our results are consistent with the Brown, Harlow and Starks (1996) findings for mutual fund managers. We find that good performers in the first half of the year reduce the volatility of their portfolios, and poor performers increase volatility. These “variance strategies" depend upon the fund’s ranking relative to other funds. Interestingly enough, despite theoretical predictions, changes in risk are not conditional upon distance from the high water mark threshold, i.e. a ratcheting absolute manager benchmark. This result may be explained by the relative importance of fund termination. We analyze factors contributing to fund disappearance. Survival depends on both absolute and relative performance. Excess volatility can also lead to termination. Finally, other things equal, the younger a fund, the more likely it is to fail. Therefore our results strongly confirm an hypothesis of Fung and Hsieh (1997b) that reputation costs have a mitigating effect on the gambling incentives implied by the manager contract. Particularly for young funds, a volatility strategy that increases the value of a performance fee option may lead to the premature death of that option through termination of the fund. The finding that hedge fund and CTA volatility is conditional upon past performance has implications for investors, lenders and regulators

Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

Investors in hedge funds and commodity trading advisors [CTA’s] are naturally concerned with risk as well as return. In this paper, we investigate risk of hedge funds and CTA’s in light of managerial career concerns. We find an association between past performance and risk levels consistent with Brown, Harlow and Starks (1996) findings for mutual fund managers. Good performers in the first half of the year reduce the volatility of their portfolios, and poor performers increase volatility. These “variance strategies" depend upon the fund’s ranking relative to other funds. The importance of relative rankings as opposed to the absolute ranking suggested by analysis of hedge fund and CTA manager contracts points to the importance of reputation costs. These costs are best thought of in the context of the career concerns of managers and the relative importance of fund termination. We analyze factors contributing to fund disappearance. Survival depends on both absolute and relative performance. Excess volatility can also lead to termination. Finally, other things equal, the younger a fund, the more likely it is to disappear from the sample. Therefore our results strongly confirm an hypothesis of Fung and Hsieh (1997b) that reputation costs have a mitigating effect on the gambling incentives implied by the manager contract. Particularly for young funds, a volatility strategy that increases the value of a performance fee option may lead to the premature death of that option through termination of the fund. The finding that hedge fund and CTA volatility is conditional upon past performance has implications for investors, lenders and regulators. An important result of our finding is that variance strategy depends upon relative rather than absolute performance evaluation

Fees on Fees in Funds of Funds

Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class, the high degree of fund specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors access to the most sought-after managers. However, the diversification, oversight and access comes at the cost of a multiplication of the fees paid by the investor. It is not generally understood that the incentive fee component of the fee on fee arrangement may under certain circumstances exceed the realized return on the fund. In this paper we argue that the disappointing after fee performance of some fund of funds may be explained by the nature of this fee arrangement. We examine an alternative fee arrangement that may provide better incentives at a lower cost to investors in these funds

Fees on Fees in Funds of Funds

Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class, the high degree of fund specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors access to the most sought-after managers. However, the diversification, oversight and access comes at the cost of a multiplication of the fees paid by the investor. One would expect that the information advantage of funds of funds would more than compensate investors for these fees. Unfortunately, individual hedge funds dominate fund of funds on an after-fee return or Sharpe ratio basis. In this paper we argue that the disappointing after-fee performance of some fund of funds might be explained by the nature of this fee arrangement, and that fund of funds providers may actually benefit from considering other possible fee arrangements. These alternative arrangements will improve reported performance and may make funds of funds more attractive to a growing institutional clientele