Volume 10, No. 2, Second Quarter 2012
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Practitioner's Digest
Practitioner’s Digest • Vol. 10, 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.
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Article
Liquidity Shocks and Hedge Fund Contagion
In Boyson, Stahel, and Stulz (2010), we investigate whether hedge funds experience worst return contagion that is, correlations in extremely poor returns that are over and above those expected from economic fundamentals. We find strong evidence of contagion among hedge funds using eight separate style indices for the period from January 1990 to October 2008: the probability of a worst return in a particular index is increasing in the number of other indices that also have extremely poor returns. We then show that large adverse shocks to asset and funding liquidity strongly increase the likelihood of this contagion. In this paper, we further investigate contagion between hedge funds and main markets. We uncover strong evidence of contagion between hedge funds and small-cap, mid-cap and emerging market equity indices, high yield bonds, emerging market bonds, and the Australian Dollar. Finally, we show that this contagion between hedge funds and markets is also significantly linked to liquidity shocks, especially for small-cap domestic equities, Asian equities, high yield bonds, and the Australian Dollar.
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Article
Asset Allocation Dynamics in the Hedge Fund Industry
This paper examines asset allocation dynamics of hedge funds through conducting optimal change point test on an asset class factor model. Based on the average F-test and the Bayesian Information Criterion (BIC), we find that more dynamic hedge funds exhibit significantly better quality than less dynamic funds, signaled by lower return volatility, stricter share restrictions, and high water mark provision. In particular, a higher degree of dynamics is shown to be associated with better risk-adjusted performance at the individual fund level. We find that the degree of a fund's dynamics is closely related to share restrictions. However, the outperformance of highly dynamic funds is robust even after controlling for share restrictions. Sub-period analysis suggests that the superiority of asset allocation dynamics is mostly driven by performance during earlier time periods before the peak of the technology bubble. Fund flow analysis suggests that abnormal returns in the hedge fund industry are diminishing as capital flows in and arbitrage opportunities are not infinitely exploitable.
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Article
Hedge-Fund Performance and Liquidity Risk
This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important predictor of hedge fund performance. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6.5% annually, on average, over the period 1994 - 2009, while negative performance is observed during liquidity crises. The returns are independent of share restriction, pointing to a possible imbalance between the liquidity a fund offers its investors and the liquidity of its underlying positions. Liquidity risk seems to account for a substantial part of hedge-fund performance. The results suggest several practical implications for risk management and manager selection.
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Insight
On the Kurz Model of Asset Prices with Rational Beliefs
Mordecai Kurz has proposed an asset pricing model incorporating endogenous uncertainty. Kurz contrasts Rational Belief Equilibrium (RBE) with the more familiar theory of Rational Expectations Equilibrium (REE). In RBE, the aggregate market will generally misprice assets and stock returns can be explained by forecasting mistakes of investors. RBE suggests a strong basis for active management of risky assets, which may in fact be harmonious with passive management, rooted in REE. I conjecture that the Theory of Rational Expectations is isomorphic to the Theory of Rational Beliefs.
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Article
The Downside of High Water Marks: An Empirical Study
Using a large sample of hedge funds, I study the effects of the high water mark (HWM) on fund performance, risk, and fund closure. I find that as funds fall below the HWM, the standard deviation of future returns increases, the future expected Sharpe ratio decreases, and the incidence of fund closure increases. In addition to supporting predictions from models in the literature, these results resonate well with economic intuition: HWM contracts function as if the fund manager holds call options on the funds returns which have varying degrees of moneyness depending on how far the fund is from the HWM.
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Case Study
The Race Between the Work Force and Investment
“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.
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Book Review
Financial Risk Management - Models, History, and Institutions
“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.
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Book Review
Financial Risk Management - Models, History, and Institutions
“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.