Skip to main content

Stephen Brown

Followers

7

Following

94

Public Views

School of the Art Institute of Chicago

Christopher Edward Peters

KTH Royal Institute of Technology

Duke University

Pratim Sengupta

Vanderbilt University

New York University

Université Paris-Est Créteil

José d'Encarnação

Universidade de Coimbra

Anna University

German Research Center for Artificial Intelligence

Harvard University

Interests

Uploads

Papers by Stephen Brown

Upside potential of hedge funds as a predictor of future performance

Journal of Banking & Finance, 2018

This paper measures upside potential based on the maximum monthly returns of hedge funds (MAX) ov... more This paper measures upside potential based on the maximum monthly returns of hedge funds (MAX) over a fixed time interval, and shows that MAX succesfully predicts cross-sectional differences in future fund returns. Hedge funds with strong upside potential generate 0.70% per month higher average returns than funds with weak upside potential. After controlling for alternative risk and performance measures and a large set of fund characteristics, the positive link between MAX and future returns remains highly significant. Moreover, funds with strong upside potential have higher probability of survival, attract more capital, and are rewarded with higher fees. The results indicate that the market/macro-timing ability of hedge funds together with their extensive use of dynamic trading strategies is the source behind MAX's predictive power.

Caught by the Tail: Tail Risk Neutrality and Hedge Fund Returns

SSRN Electronic Journal, 2006

We propose a simple and yet robust measure of tail neutrality. By this measure, hedge funds are m... more We propose a simple and yet robust measure of tail neutrality. By this measure, hedge funds are more sensitive to market risk when the market experiences a substantial decline. This is also true when we consider a number of distinct hedge fund styles. This source of risk is not diversifiable, and for this reason funds-of-funds as portfolios of hedge funds concentrate tail risk exposure rather than mitigate this effect. In today's uncertain market environment, the idea of investing in a fund immune from the day-today fluctuations in the market has a certain attraction. Indeed most hedge funds strategies generate returns that are reasonably uncorrelated with standard benchmarks. This leads many investors to believe that they are actually less risky than their active trading strategies would suggest. For many hedge funds this low correlation is illusory. Many active trading strategies that anticipate market movements will enter and leave the market with some frequency generating returns that are uncorrelated with benchmarks over the extended holding period of the average hedge fund investor. But this does not imply that they are low risk strategies, as in the kind of liquidity crisis that could prove fatal to the success of these trading schemes would cause the funds to fail just as the market is collapsing. This is of concern not only to investors but also to regulators as well. The bailout of LTCM in 1998 was occasioned by fears among regulators that liquidity problems at this fund could have a contagion effect spreading across the

Sensation Seeking, Sports Cars, and Hedge Funds

SSRN Electronic Journal, 2016

Sensation seeking, a stable personality characteristic defined by the seeking of varied, novel, c... more Sensation seeking, a stable personality characteristic defined by the seeking of varied, novel, complex, and intense sensations, would be a red flag in any operational due diligence review of fund management because it would suggest that fund managers take risk for its own sake and not to benefit fund investors. This attribute can lead to poor financial outcomes and in a worst case scenario, the failure of the fund. However, this characteristic is difficult to measure in any direct way due to privacy concerns and the need for such measures to be verifiable. Anecdotal evidence suggests that investment fiduciaries consider the purchase of high performance cars to be a red flag in this context, and at least one major fund management company does not allow employees to park such cars in their parking lot for this reason. However, to this point there has been no direct evidence that would suggest any link between car purchases and the kinds of risk taken by fund managers. Using a novel dataset of hedge fund manager automobile purchases, we show that, motivated by sensation seeking, managers often take risk for personal and non-pecuniary reasons. In line with the sensation seeking view, managers who own powerful sports cars take on more investment risk but do not deliver higher returns, resulting in lower Sharpe ratios. Moreover, funds managed by performance car owners exhibit higher operational risk and are more likely to fail. Performance car owners demonstrate other attributes associated with sensation seeking, such as a preference for lottery-like stocks, unconventional strategies, and active trading. For this reason, we consider car ownership a simple and, most importantly, a verifiable measure of sensation seeking behavior. We conclude that car ownership is information that is indeed material in any effective operational due diligence review. More generally, the results motivate the importance of effective due diligence in a fund management context.

Managerial Talent and Hedge Fund Performance

SSRN Electronic Journal, 2014

We propose a new measure of managerial skill based on the maximum monthly returns of hedge funds ... more We propose a new measure of managerial skill based on the maximum monthly returns of hedge funds over a fixed time interval and test if this new measure (pMAX) is an indicator of greater managerial talent leading to superior fund performance. We find significant cross-sectional variations and persistence in pMAX. Our main finding indicates that hedge funds in the highest pMAX quintile generate 8.4% more annual returns compared to funds in the lowest pMAX quintile. After controlling for a large set of fund characteristics, risk factors, and past performance measures, the positive relation between pMAX and future returns remains highly significant. We also show that the directional and semi-directional hedge fund managers can predict and exploit changes in the market and economic conditions by increasing (decreasing) fund exposures to risk factors when market risk and/or economic uncertainty is high (low). However, mutual funds do not have market-or macro-timing ability. Thus, we find no evidence of a significant link between managerial talent of mutual fund managers and their future returns. Overall, the results indicate that the predictive power of pMAX over future returns for hedge funds is driven by superior timing ability and better managerial skills of hedge funds.

On Tournaments and Seasonality in Mutual Fund Performance

SSRN Electronic Journal, 2015

We document a systematic seasonal component in the aggregate underperformance of active mutual fu... more We document a systematic seasonal component in the aggregate underperformance of active mutual funds. At the aggregate level, active funds underperform the market and other passive benchmarks only in the first month of a quarter. This intra-quarter performance seasonality holds across fund sizes and investment styles. The pattern is consistent with short-term stock return reversal effects along with aggregate window-dressing and, to a lesser extent, NAV-inflation practices around quarter-ends. We find marginal or no evidence of microstructure biases, fund investor flows, or cash distributions as sources of this seasonality. Our findings highlight new features of the active management underperformance puzzle.

Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows

SSRN Electronic Journal, 2002

We find evidence that is consistent with the hypothesis that daily mutual fund flows may be instr... more We find evidence that is consistent with the hypothesis that daily mutual fund flows may be instruments for investor sentiment about the stock market. We use this finding to construct a new index of investor sentiment, and validate this index using data from both the United States and Japan. In both markets exposure to this factor is priced, and in the Japanese case, we document evidence of negative correlations between "Bull" and "Bear" domestic funds. The flows to bear foreign funds in Japan display some evidence of negative correlation to domestic and foreign equity funds, suggesting that there is a foreign vs. domestic sentiment factor in Japan that does not appear in the contemporaneous U.S. data. By contrast, U.S. mutual fund investors appear to regard domestic and foreign equity mutual funds as economic substitutes. Please do not quote without permission. JEL classification: G15 * The authors thank Trimtabs, QUICK Corp. and Kinyu Data Services for providing data for analysis. We thank Geert Rouwenhorst for numerous helpful discussions and Jeffrey Busse for making his factor return data available. We

Conditions for Survival: Changing Risk and the Performance of Hedge Fund Managers and CTAs

SSRN Electronic Journal, 1998

The authors thank TASS for providing their data for analysis. We thank David Hsieh for his encour... more The authors thank TASS for providing their data for analysis. We thank David Hsieh for his encouragement with the project, Jennifer Carpenter, Ian Domowitz and Steven Heston for their helpful comments, and both Markus Karr and Jeremy Staum for able assistance programming and in preparation of the data. In addition, we acknowledge the contributions of participants at presentations at a December 1997 CBOT conference, the 1999 American Finance Association meetings and at Pennsylvania State University. All errors are the sole responsibility of the authors.

Systemic Risk and Cross-Sectional Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper examines the cross-sectional relation between hedge fund returns and systemic risk. Me... more This paper examines the cross-sectional relation between hedge fund returns and systemic risk. Measuring the systemic risk of an individual hedge fund by using the marginal expected shortfall (MES), we find evidence for a positive and statistically significant relation between systemic risk and hedge fund returns. The risk-adjusted return of a hedge fund portfolio with a high systemic risk is 0.64% per month higher than for one with a low systemic risk during 1994-2012, while negative performance is observed during crisis periods. The relation between systemic risk and hedge fund returns holds for both live and defunct funds. Moreover, the relation holds even after controlling for a large set of fund characteristics. Hence, systemic risk is a powerful determinant of cross-sectional variations in hedge fund returns. Our results imply that the positive relation between hedge fund returns and systemic risk is due to compensation for the realized losses during systemic events.

Concave Payoff Patterns in Equity Fund Holdings and Transactions

SSRN Electronic Journal, 2006

Recent results from the hedge fund literature provide evidence that patterns in fund returns sugg... more Recent results from the hedge fund literature provide evidence that patterns in fund returns suggestive of negative timing ability may in fact be evidence of concave payoff overlay strategies. These strategies increase short-term measures of portfolio performance at the possible expense of increased downside risk in the longer term. While prudential regulations limit access to these overlay strategies for many managed funds, trading activity may generate similar payoffs. We examine this hypothesis using a unique database of high-frequency holdings and transactions from a set of forty successful Australian equity funds, and find that high alpha measures are indeed associated with use of such concave payoff strategies.

Double or Nothing: Patterns of Equity Fund Holdings and Transactions

SSRN Electronic Journal, 2005

According to Jorion (1997) well publicized financial losses in Orange County and at Barings, Meta... more According to Jorion (1997) well publicized financial losses in Orange County and at Barings, Metallgesellschaft, Showa Shell and Daiwa are a major reason why industry groups and regulators advocate the use of value at risk (VaR). Unless monitored on a continuous trade-by-trade basis, fund managers subject to a performance review have an adverse incentive to evade VaR controls by engaging in zero net investment portfolio overlay strategies. These strategies have the unfortunate attribute that they can expose the fund investor to significant downside risk. Weisman (2002) uses the term "informationless investing" to describe this behavior, and argues that these strategies are "peculiar to the asset management industry in general, and the hedge fund industry in particular" and that these strategies "can produce the appearance of return enhancement without necessarily providing any value to an investor." We devise a simple procedure to determine whether a given pattern of trading is consistent with informationless investing and apply it to a unique database of daily transactions and holdings of a set of forty successful Australian equity managers. Contrary to Weisman's conjecture, this behavior does not appear to be widespread. While a minority of managers appear to engage in a pattern of trading consistent with informationless investing, this phenomenon is limited to positions taken in individual securities, and seems to be more closely related to both behavioral patterns of trading and seasonal window dressing, rather than as a specific response to adverse incentives of money managers.

Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?

SSRN Electronic Journal, 2011

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of... more Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds. (JEL G11, G29) † We thank Martin Gruber, Jerchern Lin, Richard Oberuc Sr. and Theodore Wagner for helpful discussions, as well as the extremely interesting comments and feedback from the referee and the Editor, Wayne Ferson. We would like to thank Sol Waksman at www.BarclayHedge.com for providing the data and also Beto Carminhato at Barclay Hedge for answering some questions on the data.

The Impact of Mandatory Hedge Fund Portfolio Disclosure

SSRN Electronic Journal, 2011

In this paper, we examine the use of hedge funds" 13(f) filings by market participants. While man... more In this paper, we examine the use of hedge funds" 13(f) filings by market participants. While many argue disclosure of equity holdings in these filings could harm investment funds, we find hedge funds largely benefit from disclosure while providing little private information to the marketplace. We detect abnormal trading volume around disclosure dates and also find significant, positive abnormal returns immediately after disclosure, suggesting the presence of copycat traders. Fund companies have a period of time, usually up to 45 days after the end of the quarter, to announce their quarter end holdings. We find evidence of significant trading in the days leading up to the public announcement, which raises the possibility that some traders are taking positions in anticipation of the possible market impact of the 13(f) disclosure. Indeed, a long-short portfolio of these companies" expanded-contracted positions purchased prior to the disclosure date earns positive, significant abnormal returns through the disclosure period. Finally, we find no evidence disclosed holdings offer long-term investors access to profitable information.

Economic Uncertainty and the Cross-Section of Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper estimates hedge funds' exposures to alternative measures of economic uncertainty and e... more This paper estimates hedge funds' exposures to alternative measures of economic uncertainty and examines the performance of these uncertainty betas in predicting the cross-sectional variation in hedge fund returns. The results indicate a positive and significant link between uncertainty beta and future hedge fund returns. Funds in the highest uncertainty beta quintile generate 5.5% to 7.5% more average annual returns compared to funds in the lowest uncertainty beta quintile. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty beta and future returns remains economically and statistically significant. We also use a novel statistical approach to construct a hedge fund related economic uncertainty index and find a significantly positive link between funds' exposures to the broad uncertainty index and future fund returns. Hence, economic uncertainty is a powerful determinant of the cross-sectional differences in hedge fund returns.

Macroeconomic Risk and Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroecono... more This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors considered in earlier work, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of crosssectional differences in hedge fund returns. We also show that directional and semi-directional hedge fund managers have the ability to time macroeconomic changes by increasing (decreasing) their portfolios' exposure to macroeconomic risk factors when economic uncertainty is high (low). However, the same is not true for non-directional hedge funds and mutual funds, both of which lack significant macro-timing ability. Thus, the predictive power of uncertainty betas seems to arise from the ability of hedge funds to detect fluctuations in financial markets and to adjust their positions in a timely fashion as macroeconomic conditions change.

Hedge Funds and the Asian Currency Crisis of 1997

Hedge Funds with Style

The Journal of Portfolio Management, 2003

Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

The Journal of Finance, 2001

for his encouragement with the project, Carl Ackerman, Jennifer Carpenter, Ian Domowitz and Steve... more for his encouragement with the project, Carl Ackerman, Jennifer Carpenter, Ian Domowitz and Steven Heston for their helpful comments, and both Markus Karr and Jeremy Staum for able assistance programming and in preparation of the data. In addition, we acknowledge the contributions of participants at presentations at

Hedge funds: Omniscient or just plain wrong

Pacific-Basin Finance Journal, 2001

The objective of this paper is to set a framework for a reasoned discussion of hedge funds. I sha... more The objective of this paper is to set a framework for a reasoned discussion of hedge funds. I shall first describe what they are and what they do. The compensation arrangements for hedge funds would appear to encourage risk taking behavior that generates extraordinary returns. Interestingly enough, hedge fund returns are not extraordinary. They are not the gunslinging risktakers of public perception. In fact, an analysis of the events of 1997 suggest, if anything, that they were somewhat gun-shy. We shall examine why this is the case. We shall conclude by examining their widely publicized role in the Asian currency crisis.

An analysis of the relative performance of Japanese and foreign money management

Pacific-Basin Finance Journal, 2003

Foreign investment management firms have recently started to play a major role in the investment ... more Foreign investment management firms have recently started to play a major role in the investment trust business in Japan. In terms of assets under management, their size and market share have almost doubled in the past several years. In part, the relative success of foreign managed firms in attracting market share may be attributed to the fact that Japanese investment trusts have underperformed benchmarks in quite a dramatic fashion over the past two decades. This is at best indirect evidence that Japanese funds underperform their foreign counterparts. In a recent paper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) we show that the underperformance can be attributed almost entirely to the unique tax environment of Japanese investment trusts, which had the effect of heavily penalizing early withdrawals. The relaxation of these regulations coincided with a major inflow of new money into the investment trust business. We examine the relative performance of Japanese and foreign investment management firms before and after this change in tax regulations, and find that the poor relative performance of Japanese funds from April 2000 through December 2001 may in part be attributed to the huge inflow of new money into this sector and the style shifts made necessary to accommodate this flow. An analysis of the relative performance of Japanese and foreign money management

Do Hedge Funds Outperform Stocks and Bonds?

Management Science, 2013

Hedge funds' extensive use of derivatives, short selling, and leverage and their dynamic trad... more Hedge funds' extensive use of derivatives, short selling, and leverage and their dynamic trading strategies create significant nonnormalities in their return distributions. Hence, the traditional performance measures fail to provide an accurate characterization of the relative strength of hedge fund portfolios. This paper uses the utility-based nonparametric and parametric performance measures to determine which hedge fund strategies outperform the U.S. equity and/or bond markets. The results from the realized and simulated return distributions indicate that the long/short equity hedge and emerging markets hedge fund strategies outperform the U.S. equity market, and the long/short equity hedge, multistrategy, managed futures, and global macro hedge fund strategies dominate the U.S. Treasury market. This paper was accepted by Wei Jiang, finance.

Upside potential of hedge funds as a predictor of future performance

Journal of Banking & Finance, 2018

This paper measures upside potential based on the maximum monthly returns of hedge funds (MAX) ov... more This paper measures upside potential based on the maximum monthly returns of hedge funds (MAX) over a fixed time interval, and shows that MAX succesfully predicts cross-sectional differences in future fund returns. Hedge funds with strong upside potential generate 0.70% per month higher average returns than funds with weak upside potential. After controlling for alternative risk and performance measures and a large set of fund characteristics, the positive link between MAX and future returns remains highly significant. Moreover, funds with strong upside potential have higher probability of survival, attract more capital, and are rewarded with higher fees. The results indicate that the market/macro-timing ability of hedge funds together with their extensive use of dynamic trading strategies is the source behind MAX's predictive power.

Caught by the Tail: Tail Risk Neutrality and Hedge Fund Returns

SSRN Electronic Journal, 2006

We propose a simple and yet robust measure of tail neutrality. By this measure, hedge funds are m... more We propose a simple and yet robust measure of tail neutrality. By this measure, hedge funds are more sensitive to market risk when the market experiences a substantial decline. This is also true when we consider a number of distinct hedge fund styles. This source of risk is not diversifiable, and for this reason funds-of-funds as portfolios of hedge funds concentrate tail risk exposure rather than mitigate this effect. In today's uncertain market environment, the idea of investing in a fund immune from the day-today fluctuations in the market has a certain attraction. Indeed most hedge funds strategies generate returns that are reasonably uncorrelated with standard benchmarks. This leads many investors to believe that they are actually less risky than their active trading strategies would suggest. For many hedge funds this low correlation is illusory. Many active trading strategies that anticipate market movements will enter and leave the market with some frequency generating returns that are uncorrelated with benchmarks over the extended holding period of the average hedge fund investor. But this does not imply that they are low risk strategies, as in the kind of liquidity crisis that could prove fatal to the success of these trading schemes would cause the funds to fail just as the market is collapsing. This is of concern not only to investors but also to regulators as well. The bailout of LTCM in 1998 was occasioned by fears among regulators that liquidity problems at this fund could have a contagion effect spreading across the

Sensation Seeking, Sports Cars, and Hedge Funds

SSRN Electronic Journal, 2016

Sensation seeking, a stable personality characteristic defined by the seeking of varied, novel, c... more Sensation seeking, a stable personality characteristic defined by the seeking of varied, novel, complex, and intense sensations, would be a red flag in any operational due diligence review of fund management because it would suggest that fund managers take risk for its own sake and not to benefit fund investors. This attribute can lead to poor financial outcomes and in a worst case scenario, the failure of the fund. However, this characteristic is difficult to measure in any direct way due to privacy concerns and the need for such measures to be verifiable. Anecdotal evidence suggests that investment fiduciaries consider the purchase of high performance cars to be a red flag in this context, and at least one major fund management company does not allow employees to park such cars in their parking lot for this reason. However, to this point there has been no direct evidence that would suggest any link between car purchases and the kinds of risk taken by fund managers. Using a novel dataset of hedge fund manager automobile purchases, we show that, motivated by sensation seeking, managers often take risk for personal and non-pecuniary reasons. In line with the sensation seeking view, managers who own powerful sports cars take on more investment risk but do not deliver higher returns, resulting in lower Sharpe ratios. Moreover, funds managed by performance car owners exhibit higher operational risk and are more likely to fail. Performance car owners demonstrate other attributes associated with sensation seeking, such as a preference for lottery-like stocks, unconventional strategies, and active trading. For this reason, we consider car ownership a simple and, most importantly, a verifiable measure of sensation seeking behavior. We conclude that car ownership is information that is indeed material in any effective operational due diligence review. More generally, the results motivate the importance of effective due diligence in a fund management context.

Managerial Talent and Hedge Fund Performance

SSRN Electronic Journal, 2014

We propose a new measure of managerial skill based on the maximum monthly returns of hedge funds ... more We propose a new measure of managerial skill based on the maximum monthly returns of hedge funds over a fixed time interval and test if this new measure (pMAX) is an indicator of greater managerial talent leading to superior fund performance. We find significant cross-sectional variations and persistence in pMAX. Our main finding indicates that hedge funds in the highest pMAX quintile generate 8.4% more annual returns compared to funds in the lowest pMAX quintile. After controlling for a large set of fund characteristics, risk factors, and past performance measures, the positive relation between pMAX and future returns remains highly significant. We also show that the directional and semi-directional hedge fund managers can predict and exploit changes in the market and economic conditions by increasing (decreasing) fund exposures to risk factors when market risk and/or economic uncertainty is high (low). However, mutual funds do not have market-or macro-timing ability. Thus, we find no evidence of a significant link between managerial talent of mutual fund managers and their future returns. Overall, the results indicate that the predictive power of pMAX over future returns for hedge funds is driven by superior timing ability and better managerial skills of hedge funds.

On Tournaments and Seasonality in Mutual Fund Performance

SSRN Electronic Journal, 2015

We document a systematic seasonal component in the aggregate underperformance of active mutual fu... more We document a systematic seasonal component in the aggregate underperformance of active mutual funds. At the aggregate level, active funds underperform the market and other passive benchmarks only in the first month of a quarter. This intra-quarter performance seasonality holds across fund sizes and investment styles. The pattern is consistent with short-term stock return reversal effects along with aggregate window-dressing and, to a lesser extent, NAV-inflation practices around quarter-ends. We find marginal or no evidence of microstructure biases, fund investor flows, or cash distributions as sources of this seasonality. Our findings highlight new features of the active management underperformance puzzle.

Investor Sentiment in Japanese and U.S. Daily Mutual Fund Flows

SSRN Electronic Journal, 2002

We find evidence that is consistent with the hypothesis that daily mutual fund flows may be instr... more We find evidence that is consistent with the hypothesis that daily mutual fund flows may be instruments for investor sentiment about the stock market. We use this finding to construct a new index of investor sentiment, and validate this index using data from both the United States and Japan. In both markets exposure to this factor is priced, and in the Japanese case, we document evidence of negative correlations between "Bull" and "Bear" domestic funds. The flows to bear foreign funds in Japan display some evidence of negative correlation to domestic and foreign equity funds, suggesting that there is a foreign vs. domestic sentiment factor in Japan that does not appear in the contemporaneous U.S. data. By contrast, U.S. mutual fund investors appear to regard domestic and foreign equity mutual funds as economic substitutes. Please do not quote without permission. JEL classification: G15 * The authors thank Trimtabs, QUICK Corp. and Kinyu Data Services for providing data for analysis. We thank Geert Rouwenhorst for numerous helpful discussions and Jeffrey Busse for making his factor return data available. We

Conditions for Survival: Changing Risk and the Performance of Hedge Fund Managers and CTAs

SSRN Electronic Journal, 1998

The authors thank TASS for providing their data for analysis. We thank David Hsieh for his encour... more The authors thank TASS for providing their data for analysis. We thank David Hsieh for his encouragement with the project, Jennifer Carpenter, Ian Domowitz and Steven Heston for their helpful comments, and both Markus Karr and Jeremy Staum for able assistance programming and in preparation of the data. In addition, we acknowledge the contributions of participants at presentations at a December 1997 CBOT conference, the 1999 American Finance Association meetings and at Pennsylvania State University. All errors are the sole responsibility of the authors.

Systemic Risk and Cross-Sectional Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper examines the cross-sectional relation between hedge fund returns and systemic risk. Me... more This paper examines the cross-sectional relation between hedge fund returns and systemic risk. Measuring the systemic risk of an individual hedge fund by using the marginal expected shortfall (MES), we find evidence for a positive and statistically significant relation between systemic risk and hedge fund returns. The risk-adjusted return of a hedge fund portfolio with a high systemic risk is 0.64% per month higher than for one with a low systemic risk during 1994-2012, while negative performance is observed during crisis periods. The relation between systemic risk and hedge fund returns holds for both live and defunct funds. Moreover, the relation holds even after controlling for a large set of fund characteristics. Hence, systemic risk is a powerful determinant of cross-sectional variations in hedge fund returns. Our results imply that the positive relation between hedge fund returns and systemic risk is due to compensation for the realized losses during systemic events.

Concave Payoff Patterns in Equity Fund Holdings and Transactions

SSRN Electronic Journal, 2006

Recent results from the hedge fund literature provide evidence that patterns in fund returns sugg... more Recent results from the hedge fund literature provide evidence that patterns in fund returns suggestive of negative timing ability may in fact be evidence of concave payoff overlay strategies. These strategies increase short-term measures of portfolio performance at the possible expense of increased downside risk in the longer term. While prudential regulations limit access to these overlay strategies for many managed funds, trading activity may generate similar payoffs. We examine this hypothesis using a unique database of high-frequency holdings and transactions from a set of forty successful Australian equity funds, and find that high alpha measures are indeed associated with use of such concave payoff strategies.

Double or Nothing: Patterns of Equity Fund Holdings and Transactions

SSRN Electronic Journal, 2005

According to Jorion (1997) well publicized financial losses in Orange County and at Barings, Meta... more According to Jorion (1997) well publicized financial losses in Orange County and at Barings, Metallgesellschaft, Showa Shell and Daiwa are a major reason why industry groups and regulators advocate the use of value at risk (VaR). Unless monitored on a continuous trade-by-trade basis, fund managers subject to a performance review have an adverse incentive to evade VaR controls by engaging in zero net investment portfolio overlay strategies. These strategies have the unfortunate attribute that they can expose the fund investor to significant downside risk. Weisman (2002) uses the term "informationless investing" to describe this behavior, and argues that these strategies are "peculiar to the asset management industry in general, and the hedge fund industry in particular" and that these strategies "can produce the appearance of return enhancement without necessarily providing any value to an investor." We devise a simple procedure to determine whether a given pattern of trading is consistent with informationless investing and apply it to a unique database of daily transactions and holdings of a set of forty successful Australian equity managers. Contrary to Weisman's conjecture, this behavior does not appear to be widespread. While a minority of managers appear to engage in a pattern of trading consistent with informationless investing, this phenomenon is limited to positions taken in individual securities, and seems to be more closely related to both behavioral patterns of trading and seasonal window dressing, rather than as a specific response to adverse incentives of money managers.

Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?

SSRN Electronic Journal, 2011

Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of... more Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are naïve 1/N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds. (JEL G11, G29) † We thank Martin Gruber, Jerchern Lin, Richard Oberuc Sr. and Theodore Wagner for helpful discussions, as well as the extremely interesting comments and feedback from the referee and the Editor, Wayne Ferson. We would like to thank Sol Waksman at www.BarclayHedge.com for providing the data and also Beto Carminhato at Barclay Hedge for answering some questions on the data.

The Impact of Mandatory Hedge Fund Portfolio Disclosure

SSRN Electronic Journal, 2011

In this paper, we examine the use of hedge funds" 13(f) filings by market participants. While man... more In this paper, we examine the use of hedge funds" 13(f) filings by market participants. While many argue disclosure of equity holdings in these filings could harm investment funds, we find hedge funds largely benefit from disclosure while providing little private information to the marketplace. We detect abnormal trading volume around disclosure dates and also find significant, positive abnormal returns immediately after disclosure, suggesting the presence of copycat traders. Fund companies have a period of time, usually up to 45 days after the end of the quarter, to announce their quarter end holdings. We find evidence of significant trading in the days leading up to the public announcement, which raises the possibility that some traders are taking positions in anticipation of the possible market impact of the 13(f) disclosure. Indeed, a long-short portfolio of these companies" expanded-contracted positions purchased prior to the disclosure date earns positive, significant abnormal returns through the disclosure period. Finally, we find no evidence disclosed holdings offer long-term investors access to profitable information.

Economic Uncertainty and the Cross-Section of Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper estimates hedge funds' exposures to alternative measures of economic uncertainty and e... more This paper estimates hedge funds' exposures to alternative measures of economic uncertainty and examines the performance of these uncertainty betas in predicting the cross-sectional variation in hedge fund returns. The results indicate a positive and significant link between uncertainty beta and future hedge fund returns. Funds in the highest uncertainty beta quintile generate 5.5% to 7.5% more average annual returns compared to funds in the lowest uncertainty beta quintile. After controlling for a large set of fund characteristics and risk factors, the positive relation between uncertainty beta and future returns remains economically and statistically significant. We also use a novel statistical approach to construct a hedge fund related economic uncertainty index and find a significantly positive link between funds' exposures to the broad uncertainty index and future fund returns. Hence, economic uncertainty is a powerful determinant of the cross-sectional differences in hedge fund returns.

Macroeconomic Risk and Hedge Fund Returns

SSRN Electronic Journal, 2013

This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroecono... more This paper estimates hedge fund and mutual fund exposure to newly proposed measures of macroeconomic risk that are interpreted as measures of economic uncertainty. We find that the resulting uncertainty betas explain a significant proportion of the cross-sectional dispersion in hedge fund returns. However, the same is not true for mutual funds, for which there is no significant relationship. After controlling for a large set of fund characteristics and risk factors considered in earlier work, the positive relation between uncertainty betas and future hedge fund returns remains economically and statistically significant. Hence, we argue that macroeconomic risk is a powerful determinant of crosssectional differences in hedge fund returns. We also show that directional and semi-directional hedge fund managers have the ability to time macroeconomic changes by increasing (decreasing) their portfolios' exposure to macroeconomic risk factors when economic uncertainty is high (low). However, the same is not true for non-directional hedge funds and mutual funds, both of which lack significant macro-timing ability. Thus, the predictive power of uncertainty betas seems to arise from the ability of hedge funds to detect fluctuations in financial markets and to adjust their positions in a timely fashion as macroeconomic conditions change.

Hedge Funds and the Asian Currency Crisis of 1997

Hedge Funds with Style

The Journal of Portfolio Management, 2003

Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry

The Journal of Finance, 2001

for his encouragement with the project, Carl Ackerman, Jennifer Carpenter, Ian Domowitz and Steve... more for his encouragement with the project, Carl Ackerman, Jennifer Carpenter, Ian Domowitz and Steven Heston for their helpful comments, and both Markus Karr and Jeremy Staum for able assistance programming and in preparation of the data. In addition, we acknowledge the contributions of participants at presentations at

Hedge funds: Omniscient or just plain wrong

Pacific-Basin Finance Journal, 2001

The objective of this paper is to set a framework for a reasoned discussion of hedge funds. I sha... more The objective of this paper is to set a framework for a reasoned discussion of hedge funds. I shall first describe what they are and what they do. The compensation arrangements for hedge funds would appear to encourage risk taking behavior that generates extraordinary returns. Interestingly enough, hedge fund returns are not extraordinary. They are not the gunslinging risktakers of public perception. In fact, an analysis of the events of 1997 suggest, if anything, that they were somewhat gun-shy. We shall examine why this is the case. We shall conclude by examining their widely publicized role in the Asian currency crisis.

An analysis of the relative performance of Japanese and foreign money management

Pacific-Basin Finance Journal, 2003

Foreign investment management firms have recently started to play a major role in the investment ... more Foreign investment management firms have recently started to play a major role in the investment trust business in Japan. In terms of assets under management, their size and market share have almost doubled in the past several years. In part, the relative success of foreign managed firms in attracting market share may be attributed to the fact that Japanese investment trusts have underperformed benchmarks in quite a dramatic fashion over the past two decades. This is at best indirect evidence that Japanese funds underperform their foreign counterparts. In a recent paper (Brown, Goetzmann, Hiraki, Otsuki and Shiraishi 2001) we show that the underperformance can be attributed almost entirely to the unique tax environment of Japanese investment trusts, which had the effect of heavily penalizing early withdrawals. The relaxation of these regulations coincided with a major inflow of new money into the investment trust business. We examine the relative performance of Japanese and foreign investment management firms before and after this change in tax regulations, and find that the poor relative performance of Japanese funds from April 2000 through December 2001 may in part be attributed to the huge inflow of new money into this sector and the style shifts made necessary to accommodate this flow. An analysis of the relative performance of Japanese and foreign money management

Do Hedge Funds Outperform Stocks and Bonds?

Management Science, 2013

Hedge funds' extensive use of derivatives, short selling, and leverage and their dynamic trad... more Hedge funds' extensive use of derivatives, short selling, and leverage and their dynamic trading strategies create significant nonnormalities in their return distributions. Hence, the traditional performance measures fail to provide an accurate characterization of the relative strength of hedge fund portfolios. This paper uses the utility-based nonparametric and parametric performance measures to determine which hedge fund strategies outperform the U.S. equity and/or bond markets. The results from the realized and simulated return distributions indicate that the long/short equity hedge and emerging markets hedge fund strategies outperform the U.S. equity market, and the long/short equity hedge, multistrategy, managed futures, and global macro hedge fund strategies dominate the U.S. Treasury market. This paper was accepted by Wei Jiang, finance.