Intelligent Hedge Fund Investing - Barry Schachter, Editor

Intelligent Hedge Fund Investing
Successfully Avoiding Pitfalls through Better Risk Evaluation

Navigate: home > table of contents > A Quantitative...

CHAPTER 11

INTRODUCTION

BIBLIOGRAPHY

ERRATA AND OTHER MATERIAL

< previous | next >

A QUANTITATIVE ANALYSIS OF HEDGE FUNDS: STYLE AND PERFORMANCE
Claus Bang Christiansen, Peter Brink Madsen and Michael Christensen

INTRODUCTION

In the asset allocation world, the hot topic of whether hedge funds were a separate asset class has given way to the hot topic of how much to allocate to hedge funds.

Christiansen, Madsen, and Christensen (“CMC”) extend one line of recent research in this area. They are trying to identify factors that explain hedge fund returns.

Key to this analysis is the recognition that the dynamic nature of hedge fund trading has some strong similarities to the return profile of options. Failure to account for the option-like characteristics of returns can result in failing to capture the essence of the returns of hedge funds. It’s important to note that it is not necessary for hedge funds to be heavy traders of options for their returns to be option-like.

The analogy can be made to the old strategy of equity portfolio insurance, through dynamic trading of equity indexes and cash in such a way as would replicate the payoff of a put option. More directly, traders who are quick to cut their positions as the market price moves against them, and who add to their positions as the market moves in their favor, are essentially dynamically replicating an option position on their underlying position. Further, it is very likely that they themselves do not think of their trading in these option terms at all.

Using Principal Components Analysis to identify the number of distinct styles (five is number they settle on), they try to explain the returns to portfolios of hedge funds corresponding to each style using various indexes for equities, fixed income and commodities, and importantly, options on those indexes.

When all is done, CMC find that option-like return dynamics do play a role in explaining return. One notable exception is ambiguous evidence for option-like dynamics in Global Macro strategies, which characteristically are trend-following, directional bet-makers, and should not be expected to evince significant option-like returns. They find only mixed evidence of a significant “alpha” to be attributed to the skill of the hedge fund managers taken as a group.

return to top

BIBLIOGRAPHY

Ackermann, C., R. McEnally and D. Ravenscraft, 1999, “The Performance of Hedge Funds: Risk, Return, and Incentives” The Journal of Finance, 54, 833-874.
Aczel, A.D, 1996, Complete Business Statistics, 3rd ed, Irwin.
view at Amazon.com
Agarwal, V. and N.Y. Naik, 2000, “Performance Evaluation of Hedge Funds with Option-based and Buy-and-Hold Strategies", WP HF-003, London Business School.
http://www.GloriaMundi.org/picsresources/rb-vann3.pdf
Amin G., and Kat H., 2003. "Hedge Fund Performance 1990-2000: Do The "Money Machines" Really Add Value?" Journal of Financial and Quantitative Analysis 38, pp. 251-274.
http://www.GloriaMundi.org/picsresources/rb-gahk.pdf
Brown, S. J., and W. Goetzmann, 2003, "Hedge Funds with Style", Journal of Portfolio Management, 29(2), pp. 101-112.
Brown, S.J., W.N. Goetzmann, and R.G. Ibbotson, 1999, "Offshore Hedge Funds: Survival and Performance 1989-95," Journal of Business 72(1), 91-117.
http://www.GloriaMundi.org/picsresources/rb-bgi.pdf
Brown, S.J., W.H. Goetzmann and J. Park, 2001, “Fees on Fees in Funds of Funds", Yale ICF Working Paper No. 02-33.
http://www.GloriaMundi.org/picsresources/rb-bgl1.pdf
Capocci, D.P.J. and G. Hubner, 2003, “An Analysis of Hedge Fund Performance", Journal of Empirical Finance, 11, pp. 55-89.
Carhart, M.M., J.N. Carpenter, A.W. Lynch and D.K. Musto, 2002, “Mutual Fund Survivorship", The Review of Financial Studies, 15, pp. 1439-1463.
Dybvig, P.H. and S.A. Ross, 1985, “Differential Information and Performance Measurement Using a Security Market Line", The Journal of Finance, 40, pp. 383-399.
Edwards, F.R. and M.O. Caglayan, 2001a, “Hedge Fund Performance and Manager Skill", The Journal of Futures Markets, 21, pp. 1003-1028.
Edwards, F.R. and M.O. Caglayan, 2001b, “Hedge Fund and Commodity Fund Investments in Bull and Bear Markets", The Journal of Portfolio Management, (Summer), pp. 97-108.
Edwards, F.R. and J. Liew, 1999, “Hedge Funds versus Managed Futures as Asset Classes", Journal of Derivatives, (Summer), pp. 45-64.
Fama, E. and K. French, 1996, “Multifactor explanations of Asset Pricing Anomalies", The Journal of Finance, 51, pp. 55-84.
Fung, W., and Hsieh D., 1997, "Empirical Characteristics of Dynamic Trading Strategies", Review of Financial Studies, 10, pp. 275-302.
http://www.GloriaMundi.org/picsresources/rb-wfdh1.pdf
Fung, W., and Hsieh D., 1999, "A Primer on Hedge Funds", Journal of Empirical Finance, 6, pp. 309-331.
Fung, W. and Hsieh, D. A., 2000, "Performance Characteristics of Hedge Funds and Commodity Funds," Journal of Financial and Quantitative Analysis, 35(3), pp. 291-307.
http://www.GloriaMundi.org/picsresources/rb-fh1.pdf
Fung, W. and Hsieh, D. A., 2002, “Risk in Fixed-Income Hedge Fund Styles. The Journal of Fixed Income, (September), 6-27
Hendry, D.F., 1997, Dynamic Econometrics, (Oxford University Press).
view at Amazon.com
Henriksson, R.D. and R.C. Merton, 1981, “On Market Timing and Investment Performance II: Statistical Procedures for Evaluating Forecasting Skills", Journal of Business, pp. 54, 513-533.
Liang, B., 1999, “On the Performance of Hedge Funds", Financial Analysts Journal, 55, pp. 72-85.
http://www.GloriaMundi.org/picsresources/rb-bl1.pdf
Liang, B., 2000, “Hedge Funds: The Living and the Dead", Journal of Financial and Quantitative Analysis, 35, pp. 309-326.
http://www.GloriaMundi.org/picsresources/rb-bl2.pdf
Liang, B., 2001, “Hedge Fund Performance: 1990-1999", Financial Analysts Journal, 57(1), pp. 11-18.
Liang, B., 2003, “On the Performance of Alternative Investments: CTAs, Hedge Funds, and Funds-of-Funds", CWRU Working Paper.
http://www.GloriaMundi.org/picsresources/rb-bl3.pdf
Malhotra, N.K, 1999, Marketing Research – An Applied Orientation, 3rd ed. (Prentice Hall International).
view at Amazon.com
Malkiel, B, 1995, “Returns from Investing in Equity Mutual Funds," The Journal of Finance, 50(2), pp. 549-572.
Merton, R.C., 1981, “On Market Timing and Investment Performance I: An Equilibrium Theory of Value for Market Forecasts", Journal of Business, 54, pp. 363-406.
Mitchell, M. and T. Pulvino, 2001, “Characteristics of Risk and Return in Risk Arbitrage", The Journal of Finance, 56, 2135-2175.
http://www.GloriaMundi.org/picsresources/rb-mmtp.pdf
Sharpe, W.F., 1992, “Asset Allocation: Management Style and Performance Measurement", The Journal of Portfolio Management (Winter), pp. 7-19.
Treynor, J.L. and K.K. Mazuy, 1966, “Can Mutual Funds Outguess the Market", Harvard Business Review, 44, pp. 131-136.
Weisman, A.B, 2001, “Dangerous Attractions: Informationless Investing and Hedge Fund Performance Measurement Bias," working paper, Nikko Securities.