Article

Hedge Fund Liquidity and Performance: Evidence from the Financial Crisis

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Abstract

In this paper, we investigate how share restrictions affect hedge fund performance in crisis and non-crisis periods. Consistent with prior research, we find that more illiquid funds produce both higher returns and alphas in the pre-crisis period. Hence, funds generate a share illiquidity premium for investors as a compensation for limited liquidity. In contrast, in the crisis period, this share illiquidity premium turns into an illiquidity discount. Hedge funds with more stringent share restrictions invest more heavily in illiquid assets. While share restrictions enable funds to manage these illiquid assets effectively in the pre-crisis period, they do not seem to be sufficient to ensure effective management of illiquid portfolios in a crisis. In a crisis period, funds holding illiquid portfolios experience lower returns and alphas, also when share restrictions are controlled for. Funds with an asset-liability mismatch, i.e., funds holding illiquid asset portfolios combined with weak share restrictions, perform particularly poorly and experience the strongest outflows in a crisis. However, share restrictions are not only a proxy for asset portfolio liquidity but also for incentives. Funds with stronger share restrictions and greater managerial discretion have fewer incentives to perform better because investors cannot immediately withdraw their money after poor performance. We show that hedge funds with stricter share restrictions and higher incentive fees do not experience a share illiquidity discount in the crisis period.

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... Standards Committee (IVSC 2014) defines liquidity as 'a measure of the ease with which an asset may be converted into cash' which is a significant influence on price (Bernado and Welch 2004;Amihud and Mendelson 1986;Yiu et al. 2006;Schaub and Schmid 2013;Lin et al. 2014)). Changing the ownership structures of an asset allows for the parts to trade in an optimal price range as the reduced capital outlay introduces the market participation from smaller investors (Angel 1997;Maloney and Mulherin 1992). ...
... The Barclay-Holderness method implies that premia increase incrementally with increasing levels of ownership. However, there are significant differences between publicly traded securities and the tightly held ownership structures that may apply to mineral assets (Bernado and Welch 2004;Amihud and Mendelson 1986;Yiu et al. 2006;Schaub and Schmid 2013). ...
... Alternatively, the vendor may place a premium on ceding control as it may place them at the mercy of the incoming party, while the acquirer may view the willingness to maintain an interest in the deposit as a sign of good faith and confidence in the asset. Regardless of the motivation and circumstances in any particular transaction, the consistent and substantial premiums observed confirm that the market attributes option value to joint ventures (Lukas 2013), and that increased liquidity (as represented by the deposit size) positively affects price (Bernado and Welch 2004;Amihud and Mendelson 1986;Yiu et al. 2006;Schaub and Schmid 2013). ...
Thesis
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This thesis addresses “how the characteristics of gold deposit transactions affect their price” through investigation of four hypotheses related to risks that often affect price: ownership, commodity price, certainty and country-risk. An empirical approach based on geostatistical methods is used to determine the behaviour of gold deposit prices in response to the risks. The results identify differences between security and asset price behaviour, as well as challenge the validity of accepted pricing methods and assumptions.
... A typical fund charges a management fee of 1-2% and a performance fee amounting to 20% of earned profits (Agarwal et al., 2015). Hedge funds investors are subject to significant restrictions related to their investment decisions (Aragon, 2007, andSchaub andSchmid, 2013). For example, lockups, limited redemption periods, and the redemption notice period make hedge fund investments highly illiquid. ...
... A typical fund charges a management fee of 1-2% and a performance fee amounting to 20% of earned profits (Agarwal et al., 2015). Hedge funds investors are subject to significant restrictions related to their investment decisions (Aragon, 2007, andSchaub andSchmid, 2013). For example, lockups, limited redemption periods, and the redemption notice period make hedge fund investments highly illiquid. ...
... Hedge funds with their redemption restrictions are also able to take positions in illiquid assets to earn liquidity premium (Schaub and Schmid, 2013). Getmansky et al. (2004) show that hedge funds' exposures in illiquid securities are even reflected in their observed returns due to thin trading related return smoothing. ...
Article
This paper reviews recent trends in alternative investments and their implications as the background for the Special Issue of the Journal of Empirical Finance on Alternative Investments. The historically low bond yields have brought new challenges to many investors in their search for yield, and led many of them to look outside traditional asset classes. The increased flows to alternative assets are motivated by their good performance and diversification benefits. Dynamic trading strategies used by hedge funds, and their increased presence in the financial markets are likely to have profound effects to financial market dynamics. Similarly, the large flows to commodities markets are likely to intensify the financialization of commodities market and its effects. Full text available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3066673
... Brown et al. (2001) observed that hedge funds tend to decrease volatility, following good performance in the first half of the year and increase volatility, following bad performance. Liang and Kat (2001), Capocci and Hübner (2004), Strömqvist (2009), Schaub andSchmid (2013), had a closer look at hedge funds, during crises periods and financial distress. Liang and Kat (2001) showed that hedge funds were strongly affected by the economic crises in 1998 but concluded that this does not necessarily mean that hedge funds did not contribute as a trigger to the crisis. ...
... In case of the financial crisis in 2008, Strömqvist (2009) was unable to find any evidence of hedge funds having a greater impact on the crisis than other investors. Schaub and Schmid (2013) indicated that liquidity plays a crucial role in hedge fund performance, during crises periods. Their study showed that hedge funds with illiquid portfolios had lower returns and alphas, compared to hedge funds with more liquid portfolios, during crisis periods. ...
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The performance of hedge funds is of interest to investors looking for ways of generating value over passive strategies, particularly in bad times. This study used the Hedge Index database with over 9500 hedge funds to analyse, in depth, the performance of ten major strategies, during and after the financial crisis (June 2007–January 2017). To the best of our knowledge, such a study covering the last ten years has not been published. Performance of the various strategies was analysed, using correlations, the Carhart’s four factor model, persistence of performance, and reward-risk ratios. The findings are that some hedge fund strategies which have persistent performances are also able to outperform the benchmark in some periods. In the crisis period, value-wise, all strategies did better than the S&P500, thereby, conserving value for investors, better than passive investment in the S&P500. Over the entire period of the research (June 2007–January 2017), seven strategies performed better than the S&P500: Global Macro, Multi Strategy, Emerging Markets, Long/Short Equity, Event Driven, Convertible Arbitrage, and Fixed Income Arbitrage. As hedge funds typically have skewed return distributions, performance was analysed in different periods, within conventional and downside risk frameworks. This research contributes to the advancement of knowledge on the outcomes of hedge fund strategies in different market conditions and the reliability of alternative risk frameworks in their evaluation. Apart from the theoretical implications, this research provides practical knowledge to managers and investors on which strategies hold better value and in what circumstances.
... We model fund presence as dependent variable and regress it against crisis interaction terms to disentangle crisis effect from the entire sample period. Following Maier et al. (2011);Ben-David et al. (2012), I define crisis by means of a dummy which equals one if fund files 13D between July 2007 and December 2013. "Delta Leverage_Y1," is net change in leverage after one year of activism, and denoted by a dummy which takes value one if change is positive. ...
... The dependent variable fund presence is regressed against crisis interaction terms, and firm characteristics. Following Maier et al. (2011);Ben-David et al. (2012), crisis is a dummy which equals one if fund files 13D between July 2007 and December 2013. "Delta Leverage_Y1," is net change in leverage after one year of activism, and equals one if change is positive. ...
Article
Hedge fund targets have experienced an unprecedented upsurge in leverage following the recent financial crisis. This study examines whether an increase in firm's leverage affects an activist decision of holding a stake in the target. We investigate the link between different components of a firm capital structure and their subsequent effects on fund strategy of retaining the target. Using a hand-collected data on 543 US listed firms over the period of 2000 to 2013, we show that leverage explains the cross-sectional variation in fund decision of holding the target. The significance of leverage pronounces in the first year and becomes marginal in the second year when we control for the crisis effect. Activists prefer to restructure the debts prior to their exit after the first year of activism. We also find a positive relation between the increase in leverage and firm investment and payout.
... However, as some researchers have noted, the ongoing financial market crisis has impacted hedge funds in a somewhat negative way (Healy and Lo, 2009;Hartmann and Kaiser, 2011;Ben-David et al, 2012;Maier et al, 2012). In particular, hedge funds seem to have lost some of their pre-eminence since 2008, when they were unable to generate the promised absolute returns. ...
... As we allocate across different hedge fund styles, our analysis is restricted to market illiquidity. In addition, there is a growing literature that analyses the liquidity of hedge funds (as measured by various forms of share restrictions) and the relationship to returns (Aragon, 2007;Liang and Park, 2007;Khandani and Lo, 2011;Teo, 2011 andMaier et al, 2012). 7. Cao et al (2012) document that about 20 per cent of their sample hedge funds have significant liquidity-timing ability. ...
Article
The hedge fund literature has predominantly focused on the return and risk characteristics as well as the portfolio properties of different hedge fund styles. However, relatively little is known about how hedge fund investors should allocate their capital across various hedge fund styles. The aim of this study is to develop a rules-based framework that can be used by investors to optimize their hedge fund style allocation. We construct four hedge fund style indices using a sample of 6088 hedge funds from the Lipper TASS Hedge Fund Database over the January 1995–September 2010 time period. We also develop technical and fundamental indicators on the basis of the style return drivers from earlier hedge fund studies. We use these indicators to generate trading recommendations through a style allocation model that systematically over- and underweights the four major hedge fund styles. The empirical results indicate that our hedge fund style allocation model delivers an outperformance of up to 1 per cent per year over an equally weighted portfolio.
... Liang and Kat [48] show that hedge funds were strongly affected by economic crises, while their role as triggers of crises remains uncertain. Schaub and Schmid [49] highlighted the challenges faced by hedge funds with illiquid portfolios, resulting in lower returns and alphas. Capocci and Hübner [50] and Stoforos et al. [51] show that hedge funds suffered from losses and struggled to achieve higher absolute returns during crises. ...
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This paper introduces a new trading strategy in investment: including the asset (Asset A) with the highest mean, the asset (Asset B) that stochastically dominates many other assets, and the asset (Asset C) with the smallest standard deviation in their portfolio to form portfolios in the efficient frontier for emerging and developed markets that could get higher expected utility and/or expected arbitrage opportunities. To test whether our proposed new trading strategy performs better, we set a few conjectures including the conjectures that investors should include any one, two, or three of Assets A, B, and C from emerging and developed markets. We test whether the conjectures hold by employing both mean-variance and stochastic dominance (SD) approaches to examine the performance of the portfolio formed by using hedge funds from emerging and developed markets with and without Assets A, B, and C, the naïve 1/N portfolio, and all other assets studied in our paper. We find that most of the portfolios with assets A, B, and C++ stochastically dominate the corresponding portfolio without any one, two, or all three of the A, B, and C strategies and dominate most, if not all, of the individual assets and the naïve 1/N portfolio in the emerging and developed markets, implying the existence of expected arbitrage opportunities in either emerging or developed markets and the market is inefficient. In addition, in this paper, we set a conjecture that combinations of portfolios with no arbitrage opportunity could generate portfolios that could have expected arbitrage opportunity. Our findings conclude that the conjecture holds and we claim that this phenomenon is a new anomaly in the financial market and our paper discovers a new anomaly in the financial market that expected arbitrage opportunity could be generated. We also conduct an out-of-sample analysis to check whether our proposed approach will work well in the out-of-sample period. Our findings also confirm our proposed new trading strategy to include Assets A, B, and C in the portfolio is the best strategy among all the other strategies used in our paper and gets the highest expected wealth and the highest expected utility for the emerging and developed markets. Our findings contribute to the literature on the emerging and developed markets of hedge funds and the reliability of alternative risk frameworks in the evaluation. Our findings also provide practical experience to academics, fund managers, and investors on how to choose assets in their portfolio to get significantly higher expected utility in emerging and developed markets.
... Indeed, recently, a greater number of studies have considered other characteristics as potential determinants of funds' performance. Some of these attributes explaining mutual funds portfolios' performance include past returns (Ippolito 1989); size (Grinblatt and Titman 1989;Yan 2008); liquidity (Amihud et al. 2005;Chen et al. 2004;Schaub and Schmid 2013); age (Pástor et al. 2015); fees or global costs (Wermers 2000); incentive fees (Edwards and Caglayan 2001); Standard deviation or gross returns (Gouveia et al. 2018;Kenchington et al. 2019;Henriques et al. 2022); among others. ...
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This paper aims to analyze the efficiency of the funds in technological, healthcare, and consumer cyclical sectors based on the U.S. News & World Report rankings. We employed a Principal Component Analysis to select the indicators to explain efficiency. Then, we have used an alternative approach that combines Data Envelopment Analysis (DEA) with Multiple Criteria Decision Aiding, the Value-Based DEA, to assess the efficiency of funds for 1 year (2020), 3 years (2018–2020), and 5 years (2016–2020). The results highlight that in 2020 the number of efficient funds is much smaller than in previous periods and this can be justified by the effect of the COVID-19 pandemic crisis. The sectors with the most efficient funds are technology and healthcare. The factors that determine the efficiency of funds in the health sector and the technology sector are quite different, although they have not undergone major changes in the three periods considered. For managers, health funds are seen as low risk and hardly consider the return factors in all analyzed periods, which is often considered as benchmarks for inefficient funds. In the technology sector, Beta and Alpha are generally the indicators with the greatest weight in fund efficiency, showing that these funds beat the market in terms of returns and are less risky than the benchmark. This study seeks to complete the scarce existing literature on the subject, namely in the sectors under analysis, seeking to identify the indicators that fund managers ponder most to consider a fund as efficient. As far as we know, the joint efficiency analysis of these sectors and the impact they suffered from the COVID-19 pandemic are new in the literature.
... The majority of them choose to invest in emerging markets and small stocks. Schaub and Schmid (2013) analyzed hedge fund performance during the global financial crisis and the results showed that hedge funds were not capable of effectively managing illiquid portfolios. In the same direction Stoforos et al. (2016) argued that hedge funds could not achieve superior returns over passive investments in the period of crisis. ...
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This study aimed at comparing the performances of distinct hedge fund strategies and assessing the diversification opportunities using hedge funds. This paper analyses the overall performance of distinct hedge fund strategies (as indices) for the period of 2001-2020. Hedge fund performances are compared using alternative risk adjusted performance metrics; first, alpha based on four asset-pricing models (CAPM, Fama-French 3 factor, Carhart and Fama-French 5 factor models); then, the Sharpe ratio. The findings of the study revealed that almost all hedge fund strategies outperform the benchmark return (MSCI World Index) and are superior in terms of risk/return measures. The alternative risk metrics used in the calculation of risk-adjusted performances did not cause a dramatic change in the rank ordering of the hedge fund strategies.
... A potential explanation based on the Adaptive Market Hypothesis by Lo (2004) is that systematic managed futures are less exposed to behavioral biases (like herd behavior and disposition effect) during times of market distress when efficiency is reduced (Greyserman and Kaminski (2014)). Differences in performance are often linked with liquidity (Schaub & Schmid, 2013). Since CTAs invest in highly liquid markets, this can explain a potential crisis alpha. ...
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We examine whether commodity trading advisors (CTAs), or managed futures, provide investors with diversification benefits in times of crises, along with looking into the source of such a “crisis alpha”. We developed a systematic crisis identification methodology that takes into account both, the magnitude and the speed of price deterioration and apply it to a unique dataset, that includes realized returns and sector positions of CTAs on a daily basis. We find CTAs do acquire positive gains in most sectors during crises, which originate from two sources: Firstly, their diversification across multiple futures markets, i.e. positive yields in gaining markets can counterbalance low performance in the crisis market. Secondly, the fast reduction in CTAs' exposure to crisis markets (in less than 15 days for composite indices) allows them to stabilize their performance. Both factors together, quickly cutting losses in crisis sectors while staying profitable in the other ones, allow CTAs to generate crisis alpha.
... The finance literature gives account of numerous studies focused on the impact that financial equilibrium has on financial performance (Batrancea 2020;Borges Junior and Fernandes Malaquias 2019;Li et al. 2020;Schaub and Schmid 2013;Yang et al. 2017). Yet, little or no ground is given to the impact of financial performance on financial equilibrium, which is the perspective of the present study. ...
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Financial performance and financial equilibrium are two key aspects that should be monitored by any business manager interested in passing the test of time and overcoming unpredictable events such as economic crises. The organic link between financial performance and financial equilibrium has rarely been studied in the long run for companies listed on the stock market. The present article fills this gap in the literature by examining the degree to which financial performance influenced long-term financial equilibrium using data from 34 major companies publicly traded on the New York Stock Exchange and operating around the world in a wide variety of industries and sectors. The period of analysis spread over a decade (2007Q1–2020Q3) in order to cover two major crises that have marked the dawn of the third millennium and occurred relatively close to one another: the 2008 financial meltdown and the COVID-19 pandemic crisis. By means of panel data modelling, the study showed that the short-term and long-term financial equilibria of these public companies measured by current ratio, quick ratio and debt to equity ratio were significantly impacted by different financial performance indicators. The study addresses various implications of the empirical results and lays out avenues for future research.
... [ Table 8 around here] 6.3. Financial crisis Schaub & Schmid (2013) find that hedge funds with more stringent share restrictions hold more illiquid assets and earn an illiquidity premium in the period before the financial crisis. However, during the financial crisis, these funds experience lower returns and lower alphas. ...
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Analyzing trading of hedge funds facing substantial outflows, we find that hedge funds that "trade against the flow" display significant stock picking skills. Stocks purchased by hedge funds facing large outflows deliver positive ex-post abnormal returns, which are larger than those of stocks purchased upon inflows. Such "revealed under pressure" stock-picking skills are associated with hedge funds that are more dependent on management fee income and more prone to sudden outflows due to less stringent share restrictions.
... [ Table 8 around here] 6.3. Financial crisis Schaub & Schmid (2013) find that hedge funds with more stringent share restrictions hold more illiquid assets and earn an illiquidity premium in the period before the financial crisis. However, during the financial crisis, these funds experience lower returns and lower alphas. ...
Preprint
Full-text available
Analyzing trading of hedge funds facing substantial outflows, we find that hedge funds that "trade-against-the-flow" display significant stock picking skills. Stocks purchased by hedge funds facing large outflows deliver positive ex-post abnormal returns, which are larger than those of stocks purchased upon inflows. Such "revealed under pressure" stock-picking skills are associated with hedge funds that are more dependent on management fee income and more prone to sudden outflows due to less stringent share restrictions.
... The employed data showed that, on average, hedge funds provided higher Sharpe ratios compared with mutual funds between 1992 and 1996, although their returns had higher volatility. According to Schaub and Schmid [27], greater incentive fees help to defeat the illiquidity discount noticed in crisis phases. ...
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This paper explores the sensitivity of Romanian collective investment undertakings’ returns to changes in equity, fixed income and foreign exchange market returns. We use a sample of 80 open-end investment funds and pension funds with daily returns between 2016 and 2018. Our methodology consists of measuring changes in the daily conditional volatility for the fund returns (EGARCH) and changes in their conditional correlation with selected market risk factors (DCC MV-GARCH) throughout different volatility regimes identified using a Markov Regime Switching model. We argue that, on average, the level of conditional correlations between funds and market risk factors remained stable and unconcerned by the volatility regimes. In addition, for only less than half of the funds in the sample, their volatility regimes were synchronized with those of the selected market risk factors. We found that, on average, fund returns are more correlated with equity returns and less correlated with changes in local bond yields, while not being significantly influenced by changes in foreign bond yields or changes in foreign exchange. During the period investigated equity returns were the most volatile while the funds returns volatility were, on average, much more reduced. Overall, our results show the resilience of the Romanian collective investment sector to the selected market risk factors, during the investigated period.
... Este estudo contribui para a literatura sobre o tema ao fornecer evidências do efeito que as restrições de liquidez, impostas pelos fundos, exercem nas opções de investimento e no seu desempenho. Apesar de já existirem estudos internacionais que forneceram elementos consistentes de que essas restrições proporcionam melhor desempenho aos fundos de investimento, como os trabalhos de Liang (1999), Bali, Gokcan e Liang (2007), Aragon (2007), Agarwal et al. (2009) e Schaub e Schmid (2013), entre outros, as justificativas para a procedência dessa performance superior, como o prêmio de liquidez proveniente do investimento em ativos ilíquidos operacionalizado a partir das restrições de ...
Article
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RESUMO Este trabalho analisou a relação entre restrições de resgate e liquidez dos ativos sob gestão de fundos de ações brasileiros, bem como seu efeito no desempenho. A amostra contou com 2.706 fundos de ações brasileiros com investimentos em ações listadas na BM&FBovespa ou em cotas de outros fundos de ações no período entre 2009 e 2016. Os dados foram analisados a partir de estatísticas descritivas e aplicação de modelos de regressão linear com dados em painel. Os resultados indicaram que as restrições de resgate impactam positivamente o desempenho dos fundos de ações. Além disso, os resultados sugeriram que as restrições de resgate possibilitam aos fundos explorar investimentos menos líquidos em ações e em cotas de outros fundos. Por outro lado, o investimento em ativos de baixa liquidez por parte dos fundos de ações não necessariamente está relacionado à melhores indicadores de performance.
... The fact that hedge funds suffered from substantial losses during the great recession of 2007/08 has been documented in many papers. The total volume of all hedge funds decreased by 31% in 2008 [9] as hedge fund managers were not able to manage their illiquid portfolios [10]. [11] recently wrote a comment about the weakness of the performance of hedge funds. ...
Article
The golden times of the hedge fund industry ended with the beginning of the financial crisis of 2007/08. Since then hedgefunds have underperformed against the S&P 500. This study shows that the Dodd Frank Act regulation was responsible for a completely changing environment for hedge funds. We have developed a model where equity indices and the CRB index are explanatory variables for hedge fund performance. Concerning methodology, data of two different phases are considered, namely the time period from 1990 to July 2010 (implementation of Dodd Frank Act) and the time period from August 2010 to April 2015. Surveys for the second time period showed that regulation was a major issue for the hedge fund industry. Especially small hedge funds find it problematic to get leverage from prime brokers and capital from investors. Another trend shown with the surveys is a general increase in the long only strategy (especially of small hedge funds). Our hypothesis assumes that the explanatory character of the MSCI Emerging Market (MSCI EM), the S&P 500, and the CRB index for hedge fund performance is increasing in the second period. The hypothesis is found to be correct.
... Since the observations for one specif ic fund for different years may not be independent (within correlation), following Adams, Mansi, and Nishikawa [2010]; Christoffersen and Sarkissian [2009]; Cremers and Petajisto [2009]; Aiken et al. [2013]; Aragon and Strahan [2012]; and Schaub and Schmid [2013], we used clustered-robust standard errors and treated each fund as a cluster. For comparative purposes, we also conducted our analysis with heteroscedasticity-robust standard errors. ...
Article
The use of commodities to hedge inflation risk and diversify portfolios is generally thought to be an important consideration for portfolio management. Direct investment in commodities or commodity derivatives requires that investors have significant assets and/or expertise in these commodities or their respective derivatives markets. As an alternative to direct investment, investors in recent years have increasingly resorted to the use of commoditybased mutual funds. In this article we evaluate the performance, persistence, market timing, and selectivity of four categories of mutual funds whose returns are based on commodity prices. Our period of analysis begins with each fund's inception and ends in December of 2012. Our results indicate that these funds have not been able to create positive alphas for their investors, have negative or insignificant performance persistence, and have no market timing ability. Some of the categories of funds, however, do exhibit some selectivity. We did find that when these commoditybased funds' performance was evaluated during specific time periods of market downturns (e.g., the 2000 stock market downturn and the financial crisis that began in late 2007), their performance was significantly positive, which indicates that these funds provide a good hedge during bear markets/financial crises.
... On a subset of hedge funds that have minimal redemption restrictions, those funds that expose themselves to more liquidity risk significantly outperform those funds who invest more conservatively. Schaub and Schmid (2013) tackle similar questions; however, they treat the periods before and after the recent global financial crisis separately. Their results indicate that the illiquidity premium documented in the aforementioned studies is specific to the precrisis period, and hedge funds were not able to manage their illiquid portfolios effectively in the postcrisis period, resulting in lower abnormal returns for less liquid funds. ...
Book
This book will present a comprehensive view of the risk characteristics, risk-adjusted performances, and risk exposures of various hedge fund indices. It will distinguish itself from other books and journal articles by focusing solely on hedge fund indices and emphasizing tail risk as a predictor of hedge fund index returns. The three chapters in this short book have not been previously published.
... Finally, we examine how the risk profile of top and mediocre performing funds change through time by running rolling quantile regressions throughout our sample period from This area of research complements the recent literature that seeks to understand the factors that influence hedge fund performance and performance persistence. Specifically, Li, Zhang and Zhao (2011) examine the effects of managerial characteristics, Sun, Wang and Zheng (2012) examine strategy distinctiveness, Cumming et al. (2012) examine the influence of regulation, Chincarini (2014) compares the effect of quantitative and qualitative investment styles and Schaub and Schmid (2013) study the effects of liquidity restrictions on hedge fund performance and performance persistence. Our contribution is to examine whether top performing funds are in some sense " different " from the run of the mill hedge funds and whether this difference can be attributed to a distinctive risk profile that mediocre hedge funds are unable or unwilling to emulate. ...
Research
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We seek evidence that top performing hedge funds follow a different strategy than mediocre performing hedge funds by examining the structure of significant risk factors that explain the out of sample excess net returns. Consequently, we examine the out of sample returns of hedge funds to determine, first, if hedge funds have outperformed the market in recent years, second, whether top funds actually outperform mediocre performing hedge funds and thirdly, whether top funds have a different risk profile than mediocre hedge funds and therefore appear to follow a different strategy. We find that the risk profile of top quintile performing funds is distinctly different than mediocre quintile funds by having fewer risk factors that appear to anticipate the troubling economic conditions that prevailed after 2006.
... Finally, we examine how the risk profile of top and mediocre performing funds change through time by running rolling quantile regressions throughout our sample period from This area of research complements the recent literature that seeks to understand the factors that influence hedge fund performance and performance persistence. Specifically, Li, Zhang and Zhao (2011) examine the effects of managerial characteristics, Sun, Wang and Zheng (2012) examine strategy distinctiveness, Cumming et al. (2012) examine the influence of regulation, Chincarini (2014) compares the effect of quantitative and qualitative investment styles and Schaub and Schmid (2013) study the effects of liquidity restrictions on hedge fund performance and performance persistence. Our contribution is to examine whether top performing funds are in some sense " different " from the run of the mill hedge funds and whether this difference can be attributed to a distinctive risk profile that mediocre hedge funds are unable or unwilling to emulate. ...
... In order to reliably evaluate hedge fund performance, this study constructs, specifies and statistically tests a dynamic risk factor model, 'the hedge fund multifactor model' (HFMM). This model adapts and expands on well established asset pricing models, but incorporates, additionally, a number of 'location factors', that is proxies for different buy-and-hold strategies on equity, bond and commodity markets as well as 'option-based factors' to control for nonlinear risk exposures of hedge fund investments (Agarwal & Naik, 2004;Bali, Brown, & Caglayan, 2011;Schaub & Schmid, 2013). As mentioned earlier, the performance of the proposed HFM model is critically compared with and contrasted against two benchmark risk-adjusted factor-based asset pricing models, that is, the FF three-factor model and the Carhart four-factor model. ...
... On a subset of hedge funds that have minimal redemption restrictions, those funds that expose themselves to more liquidity risk significantly outperform those funds who invest more conservatively. Schaub and Schmid (2013) focus on the global financial crisis of 2008 and find that hedge funds were not able to manage their illiquid portfolios effectively in the post-crisis period resulting in lower abnormal returns for less liquid funds. ...
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This paper investigates the performance of various strategy-specific and composite hedge fund indices. Given the flexible and nonlinear investment mandates of hedge funds, various risk metrics that take factors such as extreme events and losses with respect to previous peaks are considered. Our analysis compares the risk-adjusted performances of hedge fund indices among themselves, with respect to the overall equity market and over time. Special attention is given to the distinction between investable and non-investable hedge fund indices. We find that the risk-adjusted performances of most hedge fund indices deteriorate over time. Although many hedge fund indices outperform a broad equity index in the full sample period, most hedge fund indices have highly negative returns during market downturns which sheds suspicion over the diversification benefits of investing hedge funds. We also find that non-investable indices are superior performers with respect to their investable counterparts. Finally, the comparison of performance among various indices has little dependence on which particular risk metric is used.
... Thus, hedge funds are not immunized from financial crises and the subprime crisis obviously impacted, substantially, their performance. These results seem to differ from those obtained by some recent empirical studies on the performance of hedge funds during the subprime crisis (Joenväärä et al., 2012;Schaub and Schmid, 2013). Turning to the impact of the explanatory variables, we note that the market risk premium is actually the main driver of hedge fund returns. ...
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We revisit the factors incorporated in asset pricing models following the recent developments in financial markets – i.e., the rise of shadow banking and the change in the transmission channel of monetary policy. We propose two versions of the Fung and Hsieh (2004) hedge fund return model, especially an augmented market model which accounts for the new dynamics of financial markets and the procyclicality of hedge fund returns. We run these models with an innovative Hausman procedure, tackling the measurement errors embedded in the models factor loadings. Our empirical method also allows for confronting the drawbacks of the instruments used to estimate hedge fund asset pricing models.
Chapter
This chapter analyses the role played by hedge funds in institutional investment portfolios. The operational and functional features of these investment vehicles are investigated, with a focus on the adoption of manager remuneration schemes based on their participation in the performance achieved using the high-water mark mechanism. The option-like structure of this contractual formula may involve a potential conflict of interest between managers and investors and an inequitable allocation of incentive fees among the subscribers of the hedge fund. Despite these issues, hedge funds have become widespread in the recent past, especially with institutional investors who are attracted by the managers’ ability to control the risk and to be uncorrelated from the market trends, significantly improving the return/risk profile of the overall asset allocation. This chapter analyses, therefore, the main strategies of the hedge funds, which can be distinguished between directional and non-directional, taking into account the fact that performance measurement of the hedge fund strategies cannot ignore the inherent biases of the available databases.
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In the setting of a dynamic panel data framework, we investigate the international five‐factor Fama–French (2017) model augmented with traditional illiquidity factors (Amihud, Journal of Financial Markets, 2002, 5, 31–56; Amihud, Critical Finance Review, 2019, 8, 203–221; Pástor and Stambaugh, Journal of Political Economy, 2003, 111, 642–685; Pástor and Stambaugh, Critical Finance Review, 2019, 8, 277–299) to determine if any of these factors are priced. Since illiquidity measures are endogenous, we propose an algorithm that generates robust instruments which are combined with a GMM estimator to cope with both the endogeneity issues surrounding illiquidity and other eventual specification errors. In this dynamic framework, we generally find that the most significant factors correspond to market and size but illiquidity may matter depending on the level of the beta. We find that illiquidity has more impact on returns in expansion than in recession. However, the bid‐ask spread seems to behave differently from the other illiquidity measures.
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This paper is the first to empirically examine the incidence, determinants, and consequences of the stop-loss early termination clauses (SLCs) in the hedge fund industry. The SLCs force hedge funds to be terminated when their cumulative losses breach certain thresholds. We find 14% of hedge funds in China have SLCs. Fund management companies with higher previous performance and risks are more likely to establish funds with SLCs. And funds with SLCs generate higher future performance. Further, funds become more risk-averse when they approach to the termination thresholds, especially for large funds. We attribute the better performance of funds with SLCs to prompt terminations of bad performing funds.
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Bank capital requirements reduce the probability of bank failure and help mitigate taxpayers’ sharing in the losses that result from bank failures. Under Basel III, direct capital requirements are supplemented with liquidity requirements. Our results suggest that liquidity provisions of banks are connected to bank capital and that changes in liquidity indirectly affect the capital structure of financial institutions. Liquidity appears to be another instrument for adjusting bank capital structure beyond just capital requirements. Consistent with Diamond and Rajan (2005), we find that liquidity and capital should be considered jointly for promoting financial stability.
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Our study provides a new research perspective on firms’ recovery during the COVID-19 pandemic, i.e., can similar events experienced by firms in the past have an imprinting effect on the improvement of firm’s recovery? We focus on firms’ Severe Acute Respiratory Syndromes (SARS) imprints. Based on four quarters of panel data of Chinese A-share listed companies in 2020, our study finds that SARS imprints are positively related to firms’ recovery ability during the COVID-19 pandemic. Meanwhile, if the more severe the SARS pandemic experienced by a firm, the more significant the effect of SARS imprint on the firm’s recovery ability during the COVID-19 pandemic. In addition, the higher the level of digitization of firms during the COVID-19 pandemic, the more it contributed to the enhancing effect of the SARS seal on firm recovery. Our study makes an important theoretical contribution to the recovery literature as well as to imprinting theory, while providing practical guidance for improving the recovery of firms during the COVID-19 pandemic.
Thesis
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The purpose of this paper is to provide readers with a thorough understanding of the main general and strategic features of hedge funds, with a focus on the main tactics employed by their managers from inception in the early 90s up until the recent market developments. The method used aims to analyze the hedge fund performance by grouping most of the live hedge funds into the strategy groupings defined by the Hedge Fund Research Index (HFRI) constituents; each of the considered strategies will then be carefully scrutinized on a risk adjusted basis independently and with respect to the overall market. The models employed necessarily need to account for the non-linear option-like payoffs derived from investing in hedge funds and as such, non-basic risk-adjusted measures and evaluation methods more sophisticated than the Capital Asset Pricing Model (CAPM) will be used throughout this paper.
Article
While the performance of hedge funds has grabbed much attention from researchers, a few studies have been conducted on the drivers of hedge fund liquidity and performance (Shaub & Schmid, 2013). This study proposes new approaches to investigate the effect of share restrictions on European hedge fund performance and liquidity. We run different regressions of 1) returns, 2) flows, and 3) exposure to market liquidity risk on share restrictions, managerial incentives, and a set of control variables as independent variables. Using a sample of 1423 European hedge funds, our results suggest that restrictions imposed by European hedge funds add economic value to investors. Furthermore, we find that European hedge funds with strong share restrictions take on lower liquidity risk. There is a weak difference in liquidity risk exposure across directional European hedge funds with and without share restrictions. In addition, European hedge funds’ experience, large outflows during a crisis, and all share restrictions do not seem to be significantly related to funding flows in the crisis period, as well as in times of non-crisis. Finally, only the groups of young funds are associated with significant funds exposure to market liquidity risk
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We analyse the drivers of hedge fund performance, focusing simultaneously on fund size, age, lockup period, fund strategies, business cycles and different market conditions, dealing with the omitted variable bias. We use exogenous break points and a switching Markov model to endogenously determine different market conditions. We find that HFs deliver positive alpha only during “good” times, irrespective of their fundamentals. During “bad” times, they minimise their systematic risk. Small and young funds, and those with redemption restrictions deliver higher alpha compared to their peers during “good” times. Finally, specific strategies deliver significantly negative alpha during “bad” times.
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We examine whether connected hedge funds (i.e. those that are prime-brokerage clients of bailout banks) benefited from bailout programs initiated in seven countries during the 2007–2009 financial crisis. We find that being connected to a bailout bank is generally beneficial for hedge funds in that it lowers the rate of fund failure. However, this benefit becomes smaller during the post bailout period, for example, due to the greater risk-taking and higher leverage of such funds subsequent to bailouts. As such, our findings provide support for the moral hazard hypothesis.
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We examine the dynamic effect of aggregate stock market sentiment on the performance of various hedge fund styles. We find that hedge funds typically perform better during periods of optimistic sentiment and that for different hedge fund styles there is a differential response of hedge fund returns to positive and negative sentiment shocks. We also find that changes in aggregate investor sentiment have a larger effect on hedge fund performance during periods of high conditional volatility. Our results suggest there is a strong asymmetry in the relationship between hedge fund performance and investor sentiment.
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Open fund managers face situations of excess liquidity due to higher inflows, such as liquidity shortages when redemptions occur, which could affect the fund’s performance. This study aimed to evaluate the impact of the volume of inflows, redemptions and liquidity levels on the Adjusted Sharpe Ratio based on the analysis of 634 Brazilian hedge funds directed to retail investors, from October 2009 to December 2015. We estimate the model using quantile regression. The results showed up a no significant influence of the liquidity level on the fund’s performance. On the other hand, there was a significant evidence that the volume of redemptions negatively influence the fund’s performance for specific quantiles. The results confirm the evidence found by Rakowski (2010) for the US market. Considering the inflows, the analyses showed that, with the exception of the worst performance funds, the ones that suffer the entrance of a current largest amount of money presented better performance, however, this major inflow hurts the fund’s future return.
Chapter
This chapter analyses the role played by hedge funds in institutional investment portfolios. The operational and functional features of these investment vehicles are investigated, with a focus on the adoption of manager remuneration schemes based on their participation in the performance achieved using the high watermark mechanism. The option-like structure of this contractual formula may involve a potential conflict of interest between managers and investors and an inequitable allocation of incentive fees among the subscribers of the hedge fund. Despite these issues, hedge funds have become widespread in the recent past, especially with institutional investors who are attracted by the managers' ability to control the risk and to be uncorrelated from the market trends, significantly improving the return/risk profile of the overall asset allocation. This chapter analyses, therefore, the main strategies of the hedge funds, which can be distinguished between directional and non-directional, taking into account the fact that performance measurement of the hedge fund strategies cannot ignore the inherent biases of the available databases.
Article
This paper examines the ability of global hedge funds to time a particularly volatile asset class – emerging market equities. In particular, we study whether or not these funds can either time emerging markets as a whole, or time their exposures to different regions. Using both pooled and calendar-time approaches, we generally find no evidence of overall timing ability. However, we do find some evidence of period-specific timing ability during the financial crisis and subsequent recovery.
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Using a clean sample of private equity placements over the period of 1999 to 2012, we examine the effects of trading restrictions on the discounts on private placements. Classifying various determinants into three categories, namely risk, illiquidity, and marketability, we show that risk and marketability are significant determinants of the discount on private placements over the entire sample period. However, we identify a structural break in the relation between the discount on private placements with illiquidity and, to a lesser degree, marketability. Specifically, we find that liquidity is a more important determinant during the pre-2003 period, but marketability becomes a more important determinant during the post-2003 period. We attribute the structural break to substantial changes in market microstructure during our sample period. Lower transaction costs make illiquidity less of a concern for investors, whereas more active trading by investors calls for a higher discount for the lack of marketability.
Article
We measure the commonality in hedge fund returns, identify its main driving factor and analyze its implications for financial stability. We find that hedge funds’ commonality increased significantly from 2003 until 2006. We attribute this rise mainly to the increase in hedge funds’ exposure to emerging market equities, which we identify as a common factor in hedge fund returns over this period. Our results show that funds with a high commonality were affected disproportionately by illiquidity and exhibited negative returns during the subsequent financial crisis, thereby providing little diversification benefits to the financial system and to investors.
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This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.
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This paper examines liquidity premium focusing on the difference between offshore and onshore hedge funds. Due to tax provisions and regulatory concerns, offshore and onshore hedge funds have different legal structures, which lead to differences in share restrictions such as a lockup provision. We find that offshore investors collect higher illiquidity premium when their investment has the same level of share illiquidity as the investment of onshore investors. Introducing a lockup provision increases the abnormal return by 4.4% per year for offshore funds compared with only 2.7% for onshore funds during the period of 1994-2005. We argue that the difference is explained by the stronger relationship between share illiquidity and asset illiquidity in offshore hedge funds. We also find that the benefit of offshore investors is maximized when they invest in offshore hedge funds that are not affected by onshore funds through a master-feeder structure.
Article
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We review the theories on how liquidity affects the required returns of capital assets and the empirical studies that test these theories. The theory predicts that both the level of liquidity and liquidity risk are priced, and empirical studies find the effects of liquidity on asset prices to be statistically significant and economically important, controlling for traditional risk measures and asset characteristics. Liquidity-based asset pricing empirically helps explain (1) the cross-section of stock returns, (2) how a reduction in stock liquidity result in a reduction in stock prices and an increase in expected stock returns, (3) the yield differential between on- and off-the-run Treasuries, (4) the yield spreads on corporate bonds, (5) the returns on hedge funds, (6) the valuation of closed-end funds, and (7) the low price of certain hard-to-trade securities relative to more liquid counterparts with identical cash flows, such as restricted stocks or illiquid derivatives. Liquidity can thus play a role in resolving a number of asset pricing puzzles such as the small-firm effect, the equity premium puzzle, and the risk-free rate puzzle.
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We explore a new dimension of fund managers’ timing ability by examining whether they can time market liquidity through adjusting their portfolios’ market exposure as aggregate liquidity conditions change. Using a large sample of hedge funds, we find strong evidence of liquidity timing. A bootstrap analysis suggests that top-ranked liquidity timers cannot be attributed to pure luck. In out-of-sample tests, top liquidity timers outperform bottom timers by 4.0%–5.5% annually on a risk-adjusted basis. We also find that it is important to distinguish liquidity timing from liquidity reaction which primarily relies on public information. Our results are robust to alternative explanations, hedge fund data biases, and the use of alternative timing models, risk factors, and liquidity measures. The findings highlight the importance of understanding and incorporating market liquidity conditions in investment decision-making.
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Hedge funds significantly reduced their equity holdings during the recent financial crisis. In 2008:Q3----Q4, hedge funds sold about 29% of their aggregate portfolio. Redemptions and margin calls were the primary drivers of selloffs. Consistent with forced deleveraging, the selloffs took place in volatile and liquid stocks. In comparison, redemptions and stock sales for mutual funds were not as severe. We show that hedge fund investors withdraw capital three times as intensely as mutual fund investors do in response to poor returns. We relate this stronger sensitivity to losses to share liquidity restrictions and institutional ownership in hedge funds. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
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This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability based on macroeconomic variables. Incorporating predictability substantially improves out-of-sample performance for the entire universe of hedge funds as well as for various investment styles. While we also allow for predictability in fund risk loadings and benchmark returns, 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% 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, fund termination, and style composition.
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We use a comprehensive data set of funds-of-funds to investigate performance, risk, and capital formation in the hedge fund industry from 1995 to 2004. While the average fund-of-funds delivers alpha only in the period between October 1998 and March 2000, a subset of funds-of-funds consistently delivers alpha. The alpha-producing funds are not as likely to liquidate as those that do not deliver alpha, and experience far greater and steadier capital inflows than their less fortunate counterparts. These capital inflows attenuate the ability of the alpha producers to continue to deliver alpha in the future. Copyright (c) 2008 The American Finance Association.
Article
This paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bidirectional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to- quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.
Article
This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.
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Following a review of the data and methodological difficulties in applying conventional models used for traditional asset class indexes to hedge funds, this article argues against the conventional approach. Instead, in an extension of previous work on asset-based style (ABS) factors, the article proposes a model of hedge fund returns that is similar to models based on arbitrage pricing theory, with dynamic risk-factor coefficients. For diversified hedge fund portfolios (as proxied by indexes of hedge funds and funds of hedge funds), the seven ABS factors can explain up to 80 percent of monthly return variations. Because ABS factors are directly observable from market prices, this model provides a standardized framework for identifying differences among major hedge fund indexes that is free of the biases inherent in hedge fund databases.
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This paper studies the effect of share restrictions on the flow-performance relation of individual hedge funds. As such, we reconcile previous research that shows conflicting results for this relation without explicitly considering restrictions. Specifically, we find that hedge funds exhibit a convex flow-performance relation in the absence of share restrictions (similar to mutual funds), but exhibit a concave relation in the presence of restrictions - our evidence is consistent with both a direct effect of the binding restrictions and an indirect effect that is due to investors endogenizing expected future binding restrictions when investing their money. Further, we find that live funds exhibit a concave flow-performance relation due to stricter flow restrictions than defunct funds, which display a convex relation. Finally, we find that money is “smart,” that is, fund flows predict future hedge fund performance; however, this “smart money” effect is eliminated among funds with greater share restrictions.
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We establish a link between illiquidity and positive autocorrelation in asset returns among a sample of hedge funds, mutual funds, and various equity portfolios. For hedge funds, this link can be confirmed by comparing the return autocorrelations of funds with shorter vs. longer redemption-notice periods. We also document significant positive return-autocorrelation in portfolios of securities that are generally considered less liquid, e.g., small-cap stocks, corporate bonds, mortgage-backed securities, and emerging-market investments. Using a sample of 2,927 hedge funds, 15,654 mutual funds, and 100 size- and book-to-market-sorted portfolios of U.S. common stocks, we construct autocorrelation-sorted long/short portfolios and conclude that illiquidity premia are generally positive and significant, ranging from 2.74% to 9.91% per year among the various hedge funds and fixed-income mutual funds. We do not find evidence for this premium among equity and asset-allocation mutual funds, or among the 100 U.S. equity portfolios. The time variation in our aggregated illiquidity premium shows that while 1998 was a difficult year for most funds with large illiquidity exposure, the following four years yielded significantly higher illiquidity premia that led to greater competition in credit markets, contributing to much lower illiquidity premia in the years leading up to the Financial Crisis of 2007-2008.
Article
This paper investigates hedge fund performance and risk. The empirical evidence indicates that hedge funds differ substantially from traditional investment vehicles such as mutual funds. The funds with watermarks significantly outperform the funds without watermarks. The average hedge fund returns are related positively to incentive fees, the size of the fund, and the lockup period. Hedge funds follow dynamic trading strategies and have low systematic risk. There are low correlations among different strategies. Compared with mutual funds, hedge funds offer better risk-return trade-offs: they have higher Sharpe ratios, lower market risks, and higher abnormal returns. In the period of January 1994 to December 1996, hedge funds provide positive abnormal returns. Overall, hedge fund strategies dominate mutual fund strategies, hence hedge funds provide a more efficient investment opportunity set for investors.
Article
We examine how commonality in liquidity varies across countries and over time in ways related to supply determinants (funding liquidity of financial intermediaries) and demand determinants (correlated trading behavior of international and institutional investors, incentives to trade individual securities, and investor sentiment) of liquidity. Commonality in liquidity is greater in countries with and during times of high market volatility (especially, large market declines), greater presence of international investors, and more correlated trading activity. Our evidence is more reliably consistent with demand-side explanations and challenges the ability of the funding liquidity hypothesis to help us understand important aspects of financial market liquidity around the world, even during the recent financial crisis.
Article
We investigate the extent to which hedge fund managers smooth self-reported returns. In contrast to prior research on the "anomalous" properties of hedge fund returns, we observe the mechanisms used to price the fund's investment positions and report the fund's performance to investors, thereby allowing us to differentiate between asset illiquidity and misreporting-based explanations. We find that funds using less verifiable pricing sources and funds that provide managers with greater discretion in pricing investment positions are more likely to have returns consistent with intentional smoothing. Traditional controls, however, such as removing the manager from the setting and reporting of the fund's net asset value and the use of reputable auditors and administrators, are not associated with lower levels of smoothing. With respect to asset illiquidity versus misreporting, investment style and portfolio characteristics explain 14.0--24.3% of the variation in our smoothing measures, and pricing controls explain an additional 4.1--8.8%, suggesting that asset illiquidity is the major factor driving the anomalous properties of self-reported hedge fund returns. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.
Article
This paper establishes liquidity linkage between stock and Treasury bond markets. There is a lead-lag relationship between illiquidity of the two markets and bi-directional Granger causality. The effect of stock illiquidity on bond illiquidity is consistent with flight-to-quality or flight-to-liquidity episodes. Monetary policy impacts illiquidity. The evidence indicates that bond illiquidity acts as a channel through which monetary policy shocks are transferred into the stock market. These effects are observed across illiquidity of bonds of different maturities and are especially pronounced for illiquidity of short-term maturities. The paper provides evidence of illiquidity integration between stock and bond markets.
Article
We provide a simple argument that suggests that better-informed hedge funds choose to have less exposure to factor risk. Consistent with this argument, we find that hedge funds that exhibit lower R-squareds with respect to systematic factors have higher Sharpe ratios, higher information ratios, and higher alphas. They also exhibit higher manipulation-proof performance measures and charge higher fees. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
Article
We provide a model that links an asset's market liquidity (i.e., the ease with which it is traded) and traders' funding liquidity (i.e., the ease with which they can obtain funding). Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and margin requirements, depends on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality," and (v) co-moves with the market. The model provides new testable predictions, including that speculators' capital is a driver of market liquidity and risk premiums. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
Article
This article identifies a common latent liquidity factor, which is the driver of observable and commonly used liquidity proxies across asset classes. We use two methodologies to identify the latent liquidity factor: state space modeling (SSM) and principal component analysis (PCA). We find that the returns of hedge funds respond to an increase in illiquidity with statistically significant negative returns. The relative size of the liquidity factor loadings of the different hedge fund indices is generally consistent with the liquidity sensitivities of the underlying strategies. The results hold up in a range of robustness tests. Finally, we find a surprisingly strong link between global risk factors and hedge fund returns, questioning the industry’s claim to deliver pure manager alpha.
Article
This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important determinant in the cross-section of hedge-fund returns. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually, on average, over the period 1994–2008, while negative performance is observed during liquidity crises. The returns are independent of the liquidity a fund provides to its investors as measured by lockup and redemption notice periods, and they are also robust to commonly used hedge-fund factors, none of which carries a significant premium during the sample period. These findings highlight the importance of understanding systematic liquidity variations in the evaluation of hedge-fund performance.
Article
We investigate whether bank performance during the recent credit crisis is related to chief executive officer (CEO) incentives before the crisis. We find some evidence that banks with CEOs whose incentives were better aligned with the interests of shareholders performed worse and no evidence that they performed better. Banks with higher option compensation and a larger fraction of compensation in cash bonuses for their CEOs did not perform worse during the crisis. Bank CEOs did not reduce their holdings of shares in anticipation of the crisis or during the crisis. Consequently, they suffered extremely large wealth losses in the wake of the crisis.
Article
Using two large hedge fund databases, this paper empirically tests the presence and significance of a cross-sectional relation between hedge fund returns and value at risk (VaR). The univariate and bivariate portfolio-level analyses as well as the fund-level regression results indicate a significantly positive relation between VaR and the cross-section of expected returns on live funds. During the period of January 1995 to December 2003, the live funds with high VaR outperform those with low VaR by an annual return difference of 9%. This risk-return tradeoff holds even after controlling for age, size, and liquidity factors. Furthermore, the risk profile of defunct funds is found to be different from that of live funds. The relation between downside risk and expected return is found to be negative for defunct funds because taking high risk by these funds can wipe out fund capital, and hence they become defunct. Meanwhile, voluntary closure makes some well performed funds with large assets and low risk fall into the defunct category. Hence, the risk-return relation for defunct funds is more complicated than what implies by survival. We demonstrate how to distinguish live funds from defunct funds on an ex ante basis. A trading rule based on buying the expected to live funds and selling the expected to disappear funds provides an annual profit of 8–10% depending on the investment horizons.
Article
The returns to hedge funds and other alternative investments are often highly serially correlated. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure and smoothed returns. We propose an econometric model of return smoothing and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.
Article
This paper examines institutional price pressure in equity markets by studying mutual fund transactions caused by capital flows from 1980 to 2004. Funds experiencing large outflows tend to decrease existing positions, which creates price pressure in the securities held in common by distressed funds. Similarly, the tendency among funds experiencing large inflows to expand existing positions creates positive price pressure in overlapping holdings. Investors who trade against constrained mutual funds earn significant returns for providing liquidity. In addition, future flow-driven transactions are predictable, creating an incentive to front-run the anticipated forced trades by funds experiencing extreme capital flows.
Article
This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79% per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the Treasury-Eurodollar spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).
Article
This paper identifies five common risk factors in the returns on stocks and bonds. There are three stock-market factors: an overall market factor and factors related to firm size and book-to-market equity. There are two bond-market factors, related to maturity and default risks. Stock returns have shared variation due to the stock-market factors, and they are linked to bond returns through shared variation in the bond-market factors. Except for low-grade corporates, the bond-market factors capture the common variation in bond returns. Most important, the five factors seem to explain average returns on stocks and bonds.
Article
This paper presents evidence on the relation between hedge fund returns and restrictions imposed by funds that limit the liquidity of fund investors. The excess returns of funds with lockup restrictions are approximately 4–7% per year higher than those of nonlockup funds. The average alpha of all funds is negative or insignificant after controlling for lockups and other share restrictions. Also, a negative relation is found between share restrictions and the liquidity of the fund's portfolio. This suggests that share restrictions allow funds to efficiently manage illiquid assets, and these benefits are captured by investors as a share illiquidity premium.
Article
This paper presents a parameter covariance matrix estimator which is consistent even when the disturbances of a linear regression model are heteroskedastic. This estimator does not depend on a formal model of the structure of the heteroskedasticity. By comparing the elements of the new estimator to those of the usual covariance estimator, one obtains a direct test for heteroskedasticity, since in the absence of heteroskedasticity, the two estimators will be approximately equal, but will generally diverge otherwise. The test has an appealing least squares interpretation.
Article
In this paper, we investigate the performance persistence of hedge funds over time horizons between 6 and 36 months based on a merged sample from the Lipper/TASS and CISDM databases for the time period from 1994 to 2008. Unlike previous literature, we use a panel probit regression approach to identify fund characteristics that are significantly related to performance persistence. We then investigate the performance of two-way sorted portfolios where sorting is based on past performance and one of the additional fund characteristics identified as persistence-enhancing in the probit analysis. We find statistically and economically significant performance persistence for time horizons of up to 36 months. Although we identify several fund characteristics that are strongly correlated with the probability of observing performance persistence, we find only one fund characteristic, a strategy distinctiveness index that attempts to measure manager skills and the uniqueness of the hedge fund's trading strategies, to have the ability to systematically improve performance persistence up to a time horizon of 24 months. The economic magnitude of this improvement amounts to a sizeable increase in alpha by approximately 4.0% and 2.3% p.a. for annual and biennial rebalancing, respectively. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1650232&
Article
This paper investigates the returns on British collectible postage stamps over the very long run, based on stamp catalogue prices. Between 1900 and 2008, we find an annualized return on stamps of 6.7% in nominal terms, which is equivalent to an average real return of 2.7% per annum. Prices have increased much faster in the second half of the 1960s, the late 1970s, and the current decade. However, we also record prolonged periods of real depreciation, for example in the 1980s. As a financial investment, stamps have outperformed bonds, but underperformed stocks. After unsmoothing the returns on stamps, we find that the volatility of stamp prices approaches that of equities. There is mixed evidence that stamps are a good hedge against inflation. Once the problem of non-synchronous trading is taken into account, stamp returns seem impacted by movements in the equity market.
Article
Using a comprehensive hedge fund database, we examine the role of managerial incentives and discretion in hedge fund performance. Hedge funds with greater managerial incentives, proxied by the delta of the option-like incentive fee contracts, higher levels of managerial ownership, and the inclusion of high-water mark provisions in the incentive contracts, are associated with superior performance. The incentive fee percentage rate by itself does not explain performance. We also find that funds with a higher degree of managerial discretion, proxied by longer lockup, notice, and redemption periods, deliver superior performance. These results are robust to using alternative performance measures and controlling for different data-related biases. Copyright (c) 2009 the American Finance Association.
Article
This article analyzes the relationship between the risk-adjusted performance of hedge funds and their proximity to investments using data on Asia-focused hedge funds. I 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% 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. I show also that distant funds, especially those based in the United States and the United Kingdom, 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. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.
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Though overall bank performance from July 2007 to December 2008 was the worst since the Great Depression, there is significant variation in the cross-section of stock returns of large banks across the world during that period. We use this variation to evaluate the importance of factors that have been put forth as having contributed to the poor performance of banks during the credit crisis. Our evidence is inconsistent with the argument that poor governance of banks made the crisis worse, but it is supportive of theories that emphasize the fragility of banks financed with short-run capital market funding. Strikingly, differences in banking regulations across countries are generally uncorrelated with the performance of banks during the crisis, except that banks in countries with more restrictions on banking activities performed better, and are uncorrelated with observable risk measures of banks before the crisis. The better-performing banks had less leverage and lower returns in 2006 than the worst-performing banks.
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Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor’s decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.
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Using data on the monthly returns of hedge funds during the period January 1990 to August 1998, we estimate six-factor Jensen alphas for individual hedge funds, employing eight different investment styles. We find that about 25% of the hedge funds earn positive excess returns and that the frequency and magnitude of funds’ excess returns differ markedly with investment style. Using six-factor alphas as a measure of performance, we also analyze performance persistence over 1-year and 2-year horizons and find evidence of significant persistence among both winners and losers. These findings, together with our finding that hedge funds that pay managers higher incentive fees also have higher excess returns, are consistent with the view that fund manager skill may be a partial explanation for the positive excess returns earned by hedge funds.
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This paper investigates the alpha generation of the hedge fund industry based on a recent sample compiled from the Lipper/TASS database covering the time period from January 1994 to September 2008. We find a positive average hedge fund alpha in the cross-section for the majority of strategies and a positive and significant alpha for roughly half of all funds. Moreover, the alpha of three-quarter of the strategy indices is positive and significant in the time series. A comparison of a factor model in which the risk factors are selected based on a stepwise regression approach and the widely used factor model proposed by Fung and Hsieh (2004) reveals that the estimated alpha is robust with respect to the choice of the factor model. In contrast to prior research, we find no evidence of a decreasing hedge fund alpha over time. Moreover, based on our sample, we cannot confirm prior evidence pointing to capacity constraints in the hedge fund industry. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1532742
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The authors present a simple overlapping generations model of an asset market in which irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders' beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than rational investors do. The model sheds light on a number of financial anomalies. Copyright 1990 by University of Chicago Press.
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This study investigates whether marketwide liquidity is a state variable important for asset pricing. We find that expected stock returns are related cross-sectionally to the sensitivities of returns to fluctuations in aggregate liquidity. Our monthly liquidity measure, an average of individual-stock measures estimated with daily data, relies on the principle that order flow induces greater return reversals when liquidity is lower. From 1966 through 1999, the average return on stocks with high sensitivities to liquidity exceeds that for stocks with low sensitivities by 7.5 percent annually, adjusted for exposures to the market return as well as size, value, and momentum factors. Furthermore, a liquidity risk factor accounts for half of the profits to a momentum strategy over the same 34-year period.
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This article characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. Our results show that a large number of equity-oriented hedge fund strategies exhibit payoffs resembling a short position in a put option on the market index and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional value-at-risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance.
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Hedge fund strategies typically generate option-like returns. Linear-factor models using benchmark asset indices have difficulty explaining them. Following the suggestions in Glosten and Jagannathan (1994), this article shows how to model hedge fund returns by focusing on the popular “trend-following” strategy. We use lookback straddles to model trend-following strategies, and show that they can explain trend-following funds’ returns better than standard asset indices. Though standard straddles lead to similar empirical results, lookback straddles are theoretically closer to the concept of trend following. Our model should be useful in the design of performance benchmarks for trend-following funds.
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This article explores cross-market liquidity dynamics by estimating a vector autoregressive model for liquidity (bid-ask spread and depth, returns, volatility, and order flow in the stock and Treasury bond markets). Innovations to stock and bond market liquidity and volatility are significantly correlated, implying that common factors drive liquidity and volatility in these markets. Volatility shocks are informative in predicting shifts in liquidity. During crisis periods, monetary expansions are associated with increased liquidity. Moreover, money flows to government bond funds forecast bond market liquidity. The results establish a link between “macro” liquidity, or money flows, and “micro” or transactions liquidity.
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This paper uses commercial aircraft transactions to determine whether capital constraints cause firms to liquidate assets at discounts to fundamental values. Results indicate that financially constrained airlines receive lower prices than their unconstrained rivals when selling used narrow-body aircraft. Capital constrained airlines are also more likely to sell used aircraft to industry outsiders, especially during market downturns. Further evidence that capital constraints affect liquidation prices is provided by airlines' asset acquisition activity. Unconstrained airlines significantly increase buying activity when aircraft prices are depressed; this pattern is not observed for financially constrained airlines. Copyright The American Finance Association 1998.
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The 2008/9 financial crisis highlighted the importance of evaluating vulnerabilities owing to interconnectedness, or Too-Connected-to-Fail risk, among financial institutions for country monitoring, financial surveillance, investment analysis and risk management purposes. This paper illustrates the use of balance sheet-based network analysis to evaluate interconnectedness risk, under extreme adverse scenarios, in banking systems in mature and emerging market countries, and between individual banks in Chile, an advanced emerging market economy.
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In this paper we present a number of results which describe the behavior of the maximum likelihood estimator of the parameters of a dynamic model which is incorrectly or incompletely specified. We provide conditions which ensure the existence of the Quasi-Maximum Likelihood Estimator (QMLE) and its consistency for the parameters of an approximation to the unknown true probability density which has optimal information theoretic properties. The ability of the QMLE to consistently estimate certain parameters of interest despite misspecification is investigated. We give conditions ensuring the asymptotic normality of the QMLE together with conditions under which its asymptotic covariance matrix may be consistently estimated. Two model specification tests are briefly discussed.
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Matching university places to students is not as clear cut or as straightforward as it ought to be. By investigating the matching algorithm used by the German central clearinghouse for university admissions in medicine and related subjects, we show that a procedure designed to give an advantage to students with excellent school grades actually harms them. The reason is that the three-step process employed by the clearinghouse is a complicated mechanism in which many students fail to grasp the strategic aspects involved. The mechanism is based on quotas and consists of three procedures that are administered sequentially, one for each quota. Using the complete data set of the central clearinghouse, we show that the matching can be improved for around 20% of the excellent students while making a relatively small percentage of all other students worse off.
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Using a sample free of survivor bias, the author demonstrates that common factors in stock returns and investment expenses almost completely explain persistence in equity mutual funds' mean and risk-adjusted returns. Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser's (1993) 'hot hands' result is mostly driven by the one-year momentum effect of Narasimham Jegadeesh and Sheridan Titman (1993), but individual funds do not earn higher returns from following the momentum strategy in stocks. The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers. Copyright 1997 by American Finance Association.
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Hedge funds display several interesting characteristics that may influence performance, including: flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. Using a large sample of hedge fund data from 1988-1995, we find that hedge funds consistently outperform mutual funds, but not standard market indices. Hedge funds, however, are more volatile than both mutual funds and market indices. Incentive fees explain some of the higher performance, but not the increased total risk. The impact of six data-conditioning biases is explored. We find evidence that positive and negative survival-related biases offset each other. Copyright The American Finance Association 1999.