NYU Stern

Hedge Funds

Do Hedge Funds’ Exposures to Risk Factors Predict Their Future Returns?

sbrownThis paper investigates hedge funds’ exposures to various financial and macroeconomic risk factors through alternative measures of factor betas and examines their performance in predicting the cross-sectional variation in hedge fund returns. Both parametric and nonparametric tests indicate a significantly positive (negative) link between default premium beta (inflation beta) and future hedge fund returns.
The results are robust across different subsample periods and states of the economy, and after controlling for market, size, book-to-market, and momentum factors as well as the trend-following factors in stocks, short-term interest rates, currencies, bonds, and commodities. The paper also provides macro and micro level explanations of our findings. (Read the paper here)

Papers

"The Pricing and Hedging of Deferred Commission Asset Backed Securities," Jacob Boudoukh, Robert F. Whitelaw, Stern School of Business, 2000.

ABSTRACT (Click Here To Open)

Due to a timing mismatch between fee receipts and commission payments, there is a newand growing market for securities backed by fees from back-end load and level load mutualfunds. This paper develops a contingent claims methodology for the valuation of thesesecurities. The resulting security value depends primarily on the current value of fund assets and the fee schedule. The valuation formula also provides an analytical expression for the appropriate strategy for hedging fluctuations in asset value. As a case study, we investigate the hedging performance of an institution that holds a portfolio of these securities.

"Do Hedge Funds Exposures to Risk Factors Predict Their Future Returns?," Stephen J. Brown, Turan Bali, Mustafa Caglayan, Journal of Financial Economics, 2011.

ABSTRACT (Click Here To Open)

This paper investigates hedge funds' exposures to various financial and macroeconomic risk factors through alternative measures of factor betas and examines their performance in predicting the cross-sectional variation in hedge fund returns. Both parametric and nonparametric tests indicate a significantly positive (negative) link between default premium beta (inflation beta) and future hedge fund returns. The results are robust across different subsample periods and states of the economy, and after controlling for market, size, book-to-market, and momentum factors as well as the trend-following factors in stocks, short-term interest rates, currencies, bonds, and commodities. The paper also provides macro and micro level explanations of our findings.

"Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry," Stephen J. Brown, William Goetzmann, James Park, Journal of Finance, 1997.

ABSTRACT (Click Here To Open)

We investigate whether hedge fund and commodity trading advisor [CTA] return variance is conditional upon performance in the first half of the year. Our results are consistent with the Brown, Harlow and Starks (1994) findings for mutual fund managers. We find that good performers in the first half of the year reduce the volatility of their portfolios, but not vice-versa. The result that manager "variance strategies" depend upon relative ranking not distance from the high water mark threshold is unexpected, because CTA manager compensation is based on this absolute benchmark, rather than relative to other funds or indices. We conjecture that the threat of disappearance is a significant one for hedge fund managers and CTAs. An analysis of performance preceding departure from the database shows an association between disappearance and underperformance. An analysis of the annual hazard rates shows that performers in the lowest decile face a serious threat of closure. We find evidence to support the fact that survivorship and backfilling are both serious concerns in the use of hedge fund and CTA data.

"The Economics of Asset Management" Robert Whitelaw, Jacob Boudoukh, Matthew Richardson, and Richard Stanton, Working Paper

ABSTRACT (Click Here To Open)

The paper develops a contingent claims approach to valuing the fee flow generated by mutual funds. The method incorporates the key empirical characteristic of mutual funds, namely the relation between fund performance and fund inflows. Using this approach, we address a number of central issues in asset management such as the risk-taking incentives of mutual funds, the value of active management, and the optimal fund contract.

"Precautionary Hoarding of Liquidity and Inter-Bank Markets: Evidence from the Sub-prime Crisis," Viral Acharya, Ouarda Merrouche, 2009

ABSTRACT (Click here to read)

Using data on the behavior of large settlement banks in the UK and the Sterling Money Markets before and during the sub-prime crisis of 2007-08, we provide evidence of precautionary hoarding of liquidity and its effect on inter-bank borrowing rates. Our evidence consists of three pieces. First, we document that liquidity holdings of the large settlement banks in the UK experienced on average a 30% increase in the period immediately following 9th August, 2007, the widely accepted date of money-market \freeze" during the sub-prime crisis. Second, we show that following this structural break, bank liquidity had a precautionary nature in that it rose on calendar days predicted to have a large amount of fluctuations in payment and settlements activity and more so for banks that made larger losses during the crisis. Third, using the payment and settlements activity as an instrument, we establish a causal effect of bank liquidity on overnight inter-bank rates, in both secured and unsecured markets, an effect that is virtually absent in the period before the crisis. Importantly, precautionary hoardings by some settlement banks raised lending rates for all settlement banks, suggestive of a contagion-style systemic risk operating through inter-bank rates. Finally, variability in overnight inter-bank rates appears to have affected rates and volumes in household as well as corporate lending.

"Market Liquidity and Funding Liquidity," Lasse Heje Pedersen, Markus K. Brunnermeier

ABSTRACT (Click here to open)

We provide a model that links an asset's market liquidity - i.e., the ease with which it is traded - and traders' funding liquidity - i.e., the ease with which they can obtain funding. Traders provide market liquidity, and their ability to do so depends on their availability of funding. Conversely, traders' funding, i.e., their capital and the margins they are charged, depend on the assets' market liquidity. We show that, under certain conditions, margins are destabilizing and market liquidity and funding liquidity are mutually reinforcing, leading to liquidity spirals. The model explains the empirically documented features that market liquidity (i) can suddenly dry up, (ii) has commonality across securities, (iii) is related to volatility, (iv) is subject to "flight to quality", and (v) comoves with the market, and it provides new testable predictions.