Narayan Y. Naik

Liquidity and stock returns: An alternative test

Abstract This paper provides an alternative test of Amihud and Mendelsons (1986, Journal of Financial Economics, 8, 31–35) model using the turnover rate (number of shares traded as a fraction of the number of shares outstanding) as a proxy for liquidity. The evidence suggests that liquidity plays a significant role in explaining the cross-sectional variation in stock returns. This effect persists after controlling for the well known determinants of stock returns like the firm-size, book-to-market ratio and the firm beta. Unlike Eleswarapu and Reinganum (1993, Journal of Financial Economics, 34, 373–386), this paper finds that the liquidity effect is not restricted to the month of January alone and is prevalent throughout the year. The evidence supports Amihud and Mendelsons (1986) notion of liquidity premium and establishes its role in the overall cross section of stock returns.

Multi-Period Performance Persistence Analysis of Hedge Funds

Since hedge funds specify significant lock-up periods, we investigate persistence in the performance of hedge funds using a multi-period framework in which the likelihood of observing persistence by chance is lower than in the traditional two-period framework. Under the null hypothesis of no manager skill (no persistence), the theoretical distribution of observing wins or losses follows a binormial distribution. We test this hypothesis using the traditional two-period framework and compare the findings with the results obtained using our multi-period framework. We examine whether persistence is sensitive to the length of return measurement intervals by using quarterly, half-yearly and yearly returns. We find maximum persistence at the quarterly horizon indicating that presistence among hedge fund managers is short term in nature.

On Taking the "Alternative" Route: The Risks, Rewards, and Performance Persistence of Hedge Funds

The risk–return characteristics, risk exposures, and performance persistence of various hedge fund strategies remains an area of interest to alternative asset investors. Using a database on hedge fund indices and individual hedge fund managers in a mean–variance framework, results show that a combination of alternative investments and passive indexing provides a significantly better risk–return tradeoff than passively investing in the different asset classes. Moreover, using parametric and non–parametric methods, a reasonable degree of persistence is found for hedge fund managers. This seems to be attributable more to the losers continuing to be losers instead of winners continuing to be winners and highlights the importance of manager selection in case of hedge funds.

Capacity Constraints and Hedge Fund Strategy Returns

Hedge funds have generated significant absolute returns (alpha) in the decade between 1995 and 2004. However, the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period. Our results provide support for the Berk and Green (2004) rational model of active portfolio management.

Habit Formation and Intertemporal Substitution in Individual Food Consumption

Individual food consumption data are used to examine three issues. First, is food consumption linked intertemporally at the individual level? Second, does the association between current and past consumption reflect habit or heterogeneity? Third, what do the estimates imply about the intertemporal elasticity of substitution? The authors find that habit matters, that controlling for heterogeneity reduces estimated habit effects, and that the product of the estimated intertemporal elasticity of substitution and the risk aversion parameter is less than one. These results all lead to rejection of time separable specifications of intertemporal consumption behavior. Copyright 1996 by MIT Press.

Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds

Recently, there has been rapid growth in the assets managed by “hedged mutual funds”—mutual funds mimicking hedge fund strategies. We examine the performance of these funds relative to hedge funds and traditional mutual funds. Despite using similar trading strategies, hedged mutual funds underperform hedge funds. We attribute this finding to hedge funds’ lighter regulation and better incentives. Conversely, hedged mutual funds outperform traditional mutual funds. Notably, this superior performance is driven by managers with experience implementing hedge fund strategies. Our findings have implications for investors seeking hedge-fund-like payoffs at a lower cost and within the comfort of a regulated environment.

Do Dealer Firms Manage Inventory on a Stock-by-Stock or a Portfolio Basis?

This paper investigates whether dealer firms’ trading and pricing decisions are governed by their equivalent inventories, based on total returns as in Ho and Stoll (1983) or on unhedgeable returns as in Froot and Stein (1998), or by their ordinary inventories, as would be the case in a decentralized market-making organisational structure. It finds that ordinary inventories, and not equivalent inventories best explain dealer firms’ quote placement strategy, which dealer firm executes trades and the qua lity of execution offered to the trades. This finding is consistent with decentralized market making where, due to information sharing difficulties or the nature of compensation contracts, individual dealers care only about risk of stocks managed by them, and not the positions of other dealers within the firm.

On aggregation of information in competitive markets: The dynamic case

Abstract This article examines, in the spirit of Hellwig (1980), how a dynamic competitive security market aggregates and communicates information between various market participants at every instant. It employs a continuous time economy consisting of a large number of heterogeneous agents who are endowed with noisy private signals about the risky asset payoff of differing precision. It yields a stationary rational expectations equilibrium in which at every instant the agents use information contained in the market prices without rendering their private information redundant. It shows that the market price reflects only that part of private information which is common to many signals and, thus, extends Hellwigs single-period results to a multi-period model.

Volatility of Aggregate Volatility and Hedge Fund Returns

This paper investigates empirically whether uncertainty about volatility of the market portfolio can explain the performance of hedge funds both in the cross-section and over time. We measure uncertainty about volatility of the market portfolio via volatility of aggregate volatility (VOV) and construct an investable version of this measure by computing monthly returns on lookback straddles on the VIX index. We find that VOV exposure is a significant determinant of hedge fund returns at the overall index level, at different strategy levels, and at an individual fund level. After controlling for a large set of fund characteristics, we document a robust and significant negative risk premium for VOV exposure in the cross-section of hedge fund returns. We further show that strategies with less negative VOV betas outperform their counterparts during the financial crisis period when uncertainty was at its highest. On the contrary, strategies with more negative VOV betas generate superior returns when uncertainty in the market is less. Finally, we demonstrate that VOV exposure-return relationship of hedge funds is distinct from that of mutual funds and is consistent with the dynamic trading of hedge funds and risk-taking incentives arising from performance-based compensation of hedge funds.

Multi-period information markets

Abstract This article examines the single-shot decision problem of a monopolistic information seller selling a flow of information in a dynamic framework. In a generalized version of Wangs (1993) economy, it shows that the profit maximizing strategy of the seller is to sell his information as is but only to a fraction of traders. It argues that this strategy of selling information is different from that in a static model mainly due to the very different nature of constraints faced by the information seller in a dynamic framework.