Cristian Ioan Tiu

Do the Best Hedge Funds Hedge

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-squares with respect to systematic factors have higher Sharpe ratios, higher information ratios, charge higher fees and attract more future inflows.

Decentralized Downside Risk Management

The process of risk management for institutional investors faces two challenges. First, since most institutions are decentralized as opposed to being direct investors in assets, it is difficult to separate the risks of the assets in the portfolio from the risks generated by the investment decisions by the fund management to construct the portfolio. To address this issue, we propose a risk measurement methodology which calculates the risk contributions of individual securities and investment decisions simultaneously. This decomposition is applicable to any decentralized investor as long as its relevant risk measurement statistic can be additively decomposed. Second, statistics used to measure risk may not coincide with institution-specific investment risks, in the sense that the utility employed in asset allocation may be unrelated to the risk measure utilized. For example, an institution may do mean-variance asset allocation, but inconsistently measure the risk of the portfolio using Value at Risk. We apply this methodology to a particular type of decentralized investor, specifically, endowment funds where the relevant risk statistic is the downside risk of returns relative to actual payout levels, plus inflation. We show how downside risk can be decomposed and apply our simultaneous downside risk decomposition empirically on a sample of U.S. endowment funds. We find that an endowments asset allocation to U.S. Equity, consistent with having the largest weight in the average endowment portfolio, generates about 50% of total endowment returns but almost 100% of total portfolio downside risk. We further find that tactical allocations (or timing) have economically small contributions to both returns and risk. Finally, we find that the allocations to U.S. Fixed Income and to Hedge Funds as well as active investment decisions (except for tactical) contribute positively to returns, while reducing portfolio downside risk. The risk contributions are sensitive to changes in payout levels and an increase in the latter may offset the risk reducing power of active investing.

The Decision to Concentrate: Active Management, Manager Skill, and Portfolio Size

Several recent studies establish that more highly concentrated portfolios produce superior risk-adjusted returns. The untested premise of this literature is that it is the most skillful managers who hold the most concentrated portfolios. In this study, we formally examine the implicit assertion that the initial portfolio concentration decision is meaningfully related to a manager’s inherent investment skill. First, we present a simple theoretical model showing that the greater the manager’s skill level, the more concentrated the portfolio should be. Second, we conduct an extensive simulation analysis of the capacity to make accurate ex ante security return forecasts and show that skilled managers would select only about 3-20% of the available securities and that the portfolio concentration decision is directly proportional to investment prowess. Finally, we provide an empirical examination of the actual skill-concentration relationship for actively managed U.S. equity funds over 2002-2015, documenting that managers who demonstrated skill in the past do form portfolios with higher concentration levels. We conclude that talented asset managers should and actually do hold more concentrated portfolios and that the extent of this concentration decision is meaningfully related to forecasting skill.