William Fung

Performance Characteristics of Hedge Funds and Commodity Funds: Natural vs. Spurious Biases

It is well known that the pro forma performance of a sample of investment funds contains biases. These biases are documented in Brown, Goetzmann, Ibbotson, and Ross (1992) using mutual funds as subjects. The organization structure of hedge funds, as private and often offshore vehicles, makes data collection a much more onerous task, amplifying the impact of performance measurement biases. Theis paper reviews these biases in hedge funds. We also propose using funds-of-hedge funds to measure aggregate hedge fund performance, based on the idea that the investment experience of hedge fund investors can be used to estimate the performance of hedge funds.

A primer on hedge funds

Abstract In this paper, we provide a rationale for how hedge funds are organized and some insight on how hedge fund performance differs from traditional mutual funds. Statistical differences among hedge fund styles are used to supplement qualitative differences in the way hedge fund strategies are described. Risk factors associated with different trading styles are discussed. We give examples where standard linear statistical techniques are unlikely to capture the risk of hedge fund investments where the returns are primarily driven by non-linear dynamic strategies.

Hedge Fund Benchmarks: A Risk-Based Approach

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.

Measuring the market impact of hedge funds

Abstract Hedge funds often employ opportunistic trading strategies on a leveraged basis. It is natural to find their footprints in most major market events. A “small bet” by large hedge funds can be a sizeable transaction that can impact a market. This study estimates hedge fund exposures during a number of major market events. In some episodes, hedge funds had significant exposures and were in a position to exert substantial market impact. In other episodes, hedge fund exposures were insignificant, either in absolute terms or relative to other market participants. In all cases, we found no evidence of hedge funds using positive feedback trading strategies. There was also little evidence that hedge funds systematically caused market prices to deviate from economic fundamentals.

Risk in Fixed-Income Hedge Fund Styles

The authors apply principal components analysis to groups of fixed-income hedge funds to extract common sources of risk and return. These common sources of risk are related to market risk factors, such as changes in interest rate spreads and options on interest rate spreads, or asset-based style factors (ABS). The conclusion is that fixed-income hedge funds tend to be exposed to a common ABS factor, credit spreads.

Is mean-variance analysis applicable to hedge funds?

Abstract This paper shows that the mean-variance analysis of hedge funds approximately preserves the ranking of preferences in standard utility functions. This extends the results of Levy and Markowitz (1979) [Levy, H., Markowitz, H.M., 1979. Approximating expected utility by a function of mean and variance. American Economic Review 69, 308–317] and Hlawitschka (1994) [Hlawitschka, W., 1994. The empirical nature of Taylor-series approximations to expected utility. American Economic Review 84, 713–719] for individual stocks and portfolios of stocks.

Dividends and Debt under Alternative Tax Systems

The impact of corporate taxes on the leverage decision in a competitive market was analyzed in [8[, [9], and the incorporation of personal taxes into the problem structure was achieved in [4], [1] and [10]. In a more recent paper, Miller [6] suggested that the impacts of both corporate and personal taxation could be studied by simultaneously analyzing the supply of and demand for securities in an overall equilibrium framework. DeAngelo and Masulis [2], [3] formalized and extended the implications of Millers model, but found that given the U.S. tax code, an equilibrium in which positive dividends were featured was not possible over and above the relatively small dividend exclusion provision.

Leasing and Financial Intermediation: Comparative Tax Advantages

In the past two decades, leasing has developed into an important method of asset-based financing. Spurred by the tax concessions granted in the early 1980s, operating leases have become prime vehicles for financial intermediation. As a result, legal owners of assets may in fact be pure financial agents intermediating between manufacturers and operators of assets. In the past, the academic literature focused primarily on the question of valuation assuming a two party transaction namely, the lessor and the lessee. No distinction was made between the manufacturer and the pure leasing intermediary. (See, for example, [1], [2], [7], and [8].) It is, therefore, unclear if the same analysis holds for both types of lessor. Broadly speaking, the advantages of leasing as a form of financial intermediation stem from two sources reduction in taxes and lower financing costs. Many large leasing transactions have elements of both. The former arises primarily due to differences between the marginal tax rates of the lessor and the lessee. There are many aspects of the latter, but the most important one is related to the transactions cost of adjusting the debt-equity mix of a firm. In this paper, we concentrate on tax considerations. In particular, we examine the conditions under which a pure financial intermediary benefits from entering the leasi g business as a lessor. Obviously, in order to justify the creation of a leasing financial intermediary, between an equipment manufacturer and the user, base on a tax rationale, it must be demonstrated that the tax benefits of the arrangement exceed those when the manufacturer serves directly as the lessor. This may be true because the base for depreciation differs depending on whether the lessor is an intermediary or is the manufacturer of the asset. In a competitive market, it may pay a manufacturer to share the benefits of a higher depreciation base through selling the asset to an intermediary who, in turn, can act as the lessor. Note that in an otherwise identical lease contract, the manuAn earlier version of this paper was presented at the Financial Management Association meetings in Toronto, Canada, 1984. The first author acknowledges the financial support he received from Rutgers. The authors gratefully acknowledge the comments of Robert Taggart, Charles Upton, and the anonymous referees.

Growing the Asset Management Franchise: Evidence from Hedge Fund Firms

We investigate the growth strategies of hedge fund firms. We find that firms with successful first funds are able to launch follow-on funds that charge higher performance fees, set more onerous redemption terms, and attract greater inflows. Motivated by the aforementioned spillover effects, first funds outperform follow-on funds, after adjusting for risk. Consistent with the agency view, greater incentive alignment moderates the performance differential between first and follow-on funds. Moreover, multiple-product firms underperform single-product firms but harvest greater fee revenues, thereby hurting investors while benefitting firm partners. Investors respond to this growth strategy by redeeming from first funds of firms with follow-on funds that do poorly. Empirically, the multiple-product firm has become the dominant business model for the hedge fund industry.

Global Yield Curve Event Risks

DAVID A. HSIEH is professor of finance at Duke Universitys Fuqua School of Business in Durham, North Carolina. n 1994, the U.S. bond market witnessed the sharpest decline in fifty years. When the Federal Reserve raised interest rates, the three-month Treasury b d rate I rose 286 basis points, while the thirty-year Treasury bond yield rose 199 basis points. An equally dramatic shift occurred with the shape of the yield curve (bond yeld less bdl rate), whch narrowed by 171 basis points. In 1995, we saw the sharpest rally in the bond market since the October 1987 stock market crash. The first nine months of 1995 saw the three-month bill rate decline 72 basis points and the thirty-year bond yield fall 148 basis points. Once again, the spread between them moved sipficantly, widening 208 basis points. To illustrate the unpredictable nature of extreme yield curve shfts, contrast these examples with the experience in 1987. During the first ten months of 1987, the bill rate rose 189 basis points, and bond yield rose 296 basis points. The spread between them, in fact, widened by 208 basis points. After the stock market crash, the bill rate came down by 136 basis points, and bond yeld fell 145 basis points. Bond-to-bill spread narrowed 103 basis points. Such extreme non-parallel yield curve moves dramatically increase the risk of interest rate positions, particularly for fixed-income arbitrageurs who historically exploit the relations of spreads across various markets. The key question we pose in ths article is: Are extreme changes in the level of interest rates more correlated with extreme changes in yield spreads than we think? The relation between short-term rates and the slope of the yield curve is especially important from a risk management perspective. Consider a portfolio of bonds with various maturities. The portfolios value is affected by changes in the short-term interest rate and