Essays on Hedge Funds: Performance and Trading Strategies
This thesis is concerned with factors which affect the performance of global hedge funds as well as the relative performance of long/short strategies employed by the largest subset of these funds. An analysis of the factors which affect both returns performance and the abnormal returns generated by hedge funds provides important information to hedge fund managers seeking to maximise their alphas as well as hedge fund investors such as fund-of-funds who seek to incorporate hedge funds into their diversified portfolios.
This dissertation is largely based on three separate but broadly related papers, the results of the first of which are presented across two separate chapters. The first paper investigates the relationship between the location of a hedge fund and the estimated abnormal returns generated by it. Do ‘local’ hedge funds which invest in or close to the market where they are located earn higher returns than ‘foreign’ hedge funds which invest in the same market? There is documented evidence to suggest that informational asymmetries between local and foreign investors and mutual funds can result in a home-bias effect, which is observed as higher reported returns by local investors. This is one of the few papers which examine the impact of fund location on fund performance and the first to do so on a global scale with hedge funds sampled from the US, the UK and Asia. The paper specifically examines whether the mean alpha generated by a sample of 232 hedge funds with an investment presence in the region of investment is significantly greater than the mean alpha of hedge funds without an investment presence in the region of investment. The results of this paper have important implications for the asset allocation decisions of hedge fund managers, sophisticated investors who wish to invest in hedge funds and for managed funds which assign a portion of their portfolio to hedge funds
In addition this paper also examines the impact of the location of a hedge fund on its’ market timing and stock selection ability for a sample of global hedge funds. Treynor and Mazuy (1966) pioneered the decomposition of fund performance into a market timing component and a stock selection component, and an exhaustive literature exists in the mutual fund industry to ascertain these abilities within fund managers. Recently, researchers such as Fung et al. (2002) and Chen and Liang (2008), have examined whether hedge funds also exhibit timing ability and stock selection skill. The first paper of this dissertation makes an original contribution to the literature by specifically examining whether the location of a hedge fund impacts either the stock selection skill or market timing component. Using Bolle and Busse (2001) forms of common timing models this paper finds, in keeping with the literature, no evidence of market timing skill but weak evidence of superior stock selection skill by local hedge fund managers.
The second paper evaluates the performance of the Australian hedge fund industry, which currently lags only behind the United States and the United Kingdom in terms of size. Australia has established itself as the largest hedge fund centre in Asia-Pacific in terms of assets under management and number of funds, overtaking Japan, Hong Kong and Singapore, as the preferred destination for hedge funds looking to establish a regional presence. The relative performance of hedge funds has attracted the attention of the local superannuation funds industry which has allocated a portion of their capital to local hedge funds. The major contribution of this paper is that it re-examines the local industry using the largest sample of Australian based funds till date. The distributions of live and dead funds are examined and the returns generated by several hedge fund styles are analysed using a series of mean-variance based and non-parametric measures. Evaluating the impact of managerial characteristics on fund performance: the performance fee; fund age and lockup period are significant in explaining positive risk adjusted returns. Finally, the alpha generated by these different trading styles is evaluated against two augmented Sharpe (1992) style factor models, to gauge the best performing trading strategy over a ten year period. The novel contribution of this paper over prior research by Do et al. (2002) is that it considers a larger dataset of fund returns over a ten year period, whereas past research did not focus on the Australian hedge fund industry prior to 2000. Moreover, this the first paper to estimate Australian hedge fund alphas using the Fung and Hsieh (2004a) factor model which is prolific in the hedge literature due to its proficiency in closely modelling the option-like payoffs exhibited by hedge funds.
The third paper concerns the localised performance of two variations of a common long/short equity strategy employed by hedge funds, known as the 130/30, in the Australian equities market. The 130/30 has over the past several years become one of the most popular hedge fund strategies, and its performance has spawned a subset of funds with total assets under management of $53 billion by October 2007. While a considerable body of literature exists documenting the theoretical improvement that active extension strategies such as the 130/30 provide over more passive buy and hold strategies, there is little work which empirically tests the performance of such a strategy. This essay represents the first attempt to gauge the risk-adjusted performance and ‘alpha’ of an active extension strategy in a local market. Constructing a momentum driven and value driven 130/30 using the top 50 stocks by market capitalisation listed on the ASX, the performance of these strategies is back tested against benchmark long-biased strategies and market indices. Out of sample performance testing is considered and the relative performance of these strategies is evaluated using non-parametric and active portfolio performance measures.
Notwithstanding these separate contributions, this thesis also contributes to the extant knowledge base of hedge funds in a general sense. The literature on hedge funds is in its adolescence with unreliable data and contradicting studies obfuscating the performance literature. Using a more transparent and extensive data set, this thesis examines the impact of a hereunto unconsidered factor on hedge fund performance and provides insights into the performance of an ‘emerging market’ hedge fund centre. A contribution is also made to understanding the performance of a popular long-short strategy and empirically demonstrating its dominance over less active strategies followed by more traditional funds.