Volume 5, No. 2, Second Quarter 2007

Rivalry at Appleton-Pearson

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

Practitioner’s Digest • Vol. 5, No. 2

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

Can Hedge-Fund Returns Be Replicated?: The Linear Case

by: Jasmina Hasanhodzic and Andrew W. Lo

In contrast to traditional investments such as stocks and bonds, hedge-fund returns have more complex risk exposures that yield additional and complementary sources of risk premia. This raises the possibility of creating passive replicating portfolios or clones" using liquid exchange-traded instruments that provide similar risk exposures at lower cost and with greater transparency. Using monthly returns data for 1,610 hedge funds in the TASS database from 1986 to 2005, we estimate linear factor models for individual hedge funds using six common factors, and measure the proportion of the funds' expected returns and volatility that are attributable to such factors. For certain hedge-fund style categories, we and that a significant fraction of both can be captured by common factors corresponding to liquid exchange-traded instruments. While the performance of linear clones is often inferior to their hedge-fund counterparts, they perform well enough to warrant serious consideration as passive, transparent, scalable, and lower-cost alternatives to hedge funds.

How Hedge Funds Beat the Market

by: Craig French and Damian Ko

This paper investigates the determinants of hedge fund portfolio performance -- whether hedge funds exhibit security selection skill and market-timing skill. We examine a sample of 157 long-short equity hedge funds over the 10-year period from January, 1996 through December, 2005. To account for nonlinearities we employ the Treynor and Mazuy (1966) quadratic model. To account for illiquidity we incorporate the Scholes and Williams (1977) nonsynchronous data model. Before and after adjusting for illiquidity, we find strong evidence of security selection skill and limited evidence of market-timing skill.

Will Hedge Funds Regress towards Index-like Products?

by: William Fung and David A. Hsieh

Hedge funds have grown substantially in the past few years even as hedge fund performance has declined with the rapid increase of capital. History tells us that over-priced, active managers will be replaced by low-cost, passive, index-like alternatives. Could the same process be taking place in the hedge fund industry? Much of the innovative technology central to the creation of rule-based passive (or “synthetic”) hedge funds can be traced to the past decade’s research, which endeavored to address the fundamental question in hedge fund investing: do hedge funds add value? The key to answering this question lies with the separation of hedge fund returns into “alternative beta” and “alternative alpha,” terms that were coined by Fung and Hsieh (2003) to distinguish the problem from the familiar alpha–beta separation in measuring performance of traditional asset managers. In this paper, we extend the concept of alpha–beta separation for analyzing mutual fund performance to hedge funds. In particular, we argue that at the portfolio level, separation of alternative alpha from alternative beta involves the additional complexity of identifying alpha created by successful timing across strategies as opposed to security selection within strategies. Using historical hedge fund returns, we provide examples to illustrate the additional technology needed to successfully mimic this dynamic asset allocation process. Finally, the existence of index-like hedge fund products also act as a catalyst to improve the price-discovery process in the hedge fund industry—more efficient fee structure with equitable risk-return sharing between investors and managers. Ultimately, whether hedge funds will become index-like products will depend on the answer to the fundamental question that precipitated this process, but with this qualification, namely do hedge funds add value (have alpha) that cannot be replicated at a lower cost?

Timing Ability in the Focus Market of Hedge Funds

by: Yong Chen

This paper examines the timing ability of hedge funds covering various investment categories. We extend the Treynor-Mazuy (1966) and Henriksson-Merton (1981) market timing models to a multiple market framework and propose the concept of a focus market in which a fund trades most actively. Concentrating on the focus market enables us to parsimoniously apply conditional multifactor models. With a large sample of hedge funds during 1994-2002, we show evidence of significant timing ability in the focus markets including bond, currency, and equity markets at both the category and the fund levels. Tests of performance persistence present some supportive evidence over a short horizon.

Hedge Fund Mergers

by: Nusret Cakici and Sris Chatterjee

This paper examines the characteristics of merged hedge-funds. The data indicate that merged hedge-funds are larger funds that have underperformed over a two-year period prior to merger and have suffered from significantly lower money-flow prior to merger. Merged hedge-funds are also older funds. The fee structure of merged funds is similar to other hedge-funds. The paper compares these findings with recent research findings on mutual fund mergers.

Financial Modeling of the Equity Market: From CAPM to Cointegration

by: Frank J. Fabozzi, Sergio M. Facardi and Peter N. Kolm • reviewed by: Cel Kulasekaran

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Financial Modeling of the Equity Market: From CAPM to Cointegration

by: Frank J. Fabozzi, Sergio M. Facardi and Peter N. Kolm • reviewed by: Cel Kulasekaran

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.