EDHEC Publications
Fees at Risk
2008
Hull (2007) writes: “For an asset manager the greatest risk is operational risk”. In 2008, however, asset management companies came under severe pressure not from operational risk, but from market risk. What had been seen as an annuity stream that was thought to expose firms to little or no earnings risk turned out to be directional stock market exposure combined with high operational leverage. A revisited version of this working paper was published in the Fall 2010 issue of the Journal of Applied Corporate Finance.
Prudence with Multiplicative Risk
2008
In this paper we analyze the conditions under which the presence of a multiplicative background risk induces a more “prudent” behavior. We show that the results from Kimball (1990) concerning the convexity of the marginal utility are no longer sufficient with multiplicative risk. An agent is multiplicative risk prudent when the coefficient of relative prudence is greater than two. We introduce the concept of quintessence in order to guarantee the decrease of relative temperance. Both decreasing relative prudence and decreasing relative temperance are sufficient to guarantee more “prudent”...
Overlay Hedging in a Fund of Funds
2008
Hedge funds are often referred to as absolute return strategies, yet investors are aware that most hedge funds do in fact take on a variety of systematic and quasi-systematic exposures. If a manager of a fund of hedge funds (FoF) finds that the exposure of the FoF to a certain systematic exposure or the risk level broadly has become excessive, then the FoF manager may want to hedge. The purpose of this article is to outline the major issues involved with overlay hedging in a fund of funds portfolio and to provide relevant solutions to these issues. These include the determination of whether...
Production-Based Asset Pricing in a Monetary Economy: Theory and Evidence
2008
This paper develops a capital asset pricing model based on the production side of a monetary economy. Relying on a general version of the standard Real Business Cycle model with cash and credit goods, we find that the factors determining the mean excess returns on financial assets are i) real capital growth, ii) the nominal interest rate and iii) the capital-to-wealth ratio. Our model is parsimonious in that the results rely neither on any particular specification of the production function nor on capital adjustment costs. Empirical evidence gives strong support to the presence of the...
Some Insiders Are Indeed Smart Investors
2008
Not all insiders are the same; some are more effective than others in processing the information they have access to, and invest their own wealth accordingly. We used a database with transactions from the U.K. market to identify insiders with superior market timing abilities. For the period 1994 to 2006 we showed that informative insider trades can be identified ex ante through certain characteristics of the transactions and the firm itself. Moreover, we showed how outsiders could benefit from this information.
EDHEC European Real Estate Investment and Risk Management Survey
2007
The EDHEC Risk and Asset Management Research Centre has released a new survey that is drawn from its research programme in asset allocation and alternative diversification. This programme has led to extensive research on the benefits, risks, and integration methods of alternative classes and instruments in asset allocation.
Rating the Ratings: A Critical Analysis of Fund Rating Systems
2007
Fund ratings are a widely used tool for fund promoters and fund subscribers. They serve to evaluate fund performance on a risk and return basis in an easily understandable way, and allow the performance of different funds to be compared. In this context, the quality and the robustness of the ratings is a critical subject for both investment management firms and investors. Though the predictive capability of fund ratings has not been proved, numerous studies performed on US mutual funds have concluded that fund subscribers are widely influenced by fund ratings in making their choice. A...
Hide-and-Seek in the Market : Placing and Detecting Hidden Orders
2007
This paper investigates why traders hide their orders and how other traders respond to hidden depth. Using a logit model, the authors provide empirical findings suggesting that traders use hidden orders to manage both exposure risk and picking off risk. Using probit models, they show that hidden depth increases order aggressiveness. The authors' interpretation of this empirical evidence is threefold. First, hidden depth detection is possible and frequent. Second, when traders detect hidden volume at the best opposite quote, they strategically adjust their order submission to seize the...
Momentum Strategies in Commodity Futures Markets
2007
The article looks at the performance of 56 momentum and contrarian strategies in commodity futures markets. The authors build on the research of Erb and Harvey (2006) who focus on one momentum strategy. While contrarian strategies do not work, 13 momentum strategies are found to be profitable in commodity futures markets over horizons that range from 1 to 12 months. A revisited version of this paper was published in the June 2007 issue of the Journal of Banking and Finance.
Reactions to the EDHEC Study "Assessing the Quality of Stock Market Indices"
2007
A recent publication by the EDHEC Risk and Asset Management Research Centre has drawn conclusions that highlight the shortcomings of well known capitalisation- or price-weighted stock market indices and argues that the choice of benchmark for asset allocation or performance measurement is a task requiring particular care. In a call for reactions to this publication, EDHEC finds that the answers of the more than eighty respondents (asset management firms, pension funds, insurance companies, private banks, etc.) tend to reinforce the conclusions drawn by the original publication. Although it...
Three Early Lessons from the Subprime Lending Crisis: A French Answer to President Sarkozy
2007
European leaders, eager for an explanation absolving them of responsibility, have once again laid blame on the seemingly detrimental role played by hedge funds in this summer’s crisis. This crisis is the result of a sudden fall in asset prices, combined with increased aversion to risk on the part of investors. To suggest that hedge funds are to blame for this crisis is simplistic but tempting, as their speculative, unregulated, and opaque nature make them easy targets - all the while, more delicate market and regulatory issues are avoided. So, as a counterpoint to these accusations that often...
A Comparison of Alternative Approaches for Determining the Downside Risk of Hedge Fund Strategies
2007
This paper compares a number of different approaches for determining the Value at Risk (VaR) and Expected Shortfall (ES) of hedge fund investment strategies. The authors compute VaR and ES through completely model-free methods, as well as through mean/variance and distribution model-based methods. Among the models considered certain specifications can technically address autocorrelation, asymmetry, fat tails, and time-varying variances which are typical characteristics of hedge fund returns. They find that conditional mean/variance models coupled with appropriate distributional assumptions...
Hedge Fund Indices for the Purpose of UCITS: Answers to the CESR Issues Paper
2007
In a reply to the CESR Issues Paper on the eligibility of hedge fund indices for the purpose of UCITS, the EDHEC Risk and Asset Management Research Centre argues that hedge fund indices should not be required to offer more controls and more transparency than existing financial indices such as stock market indices. Likewise, their construction should not be subjected to detailed rules for choosing constituents and implementing rebalancing and weighting mechanisms.
Revisiting the Limits of Hedge Fund Indices: a Comparative Approach
2007
Hedge fund indices have been criticised for a lack of representativity and for their biases, to the point that serious doubts about the usefulness of hedge fund indices have been raised by investors and regulators. This paper examines whether the problems that are outlined for hedge fund indices also exist for other indices that seem to be widely accepted. The drawbacks of hedge fund indices pointed out in the literature do indeed exist. However, in this paper, the authors point out that there are possible solutions to these problems. A revisited version of this paper was published in the...
Optimal Investment Decisions When Time Horizon is Uncertain
2007
Many investors do not know with certainty when their portfolio will be liquidated. Should their portfolio selection be influenced by the uncertainty of exit time? In order to answer this question, we consider a suitable extension of the familiar optimal investment problem of Merton (1971), where we allow the conditional distribution function of an agent’s time horizon to be stochastic and correlated to returns on risky securities. In contrast to existing literature, which has focused on an independent time horizon, we show that the portfolio decision is affected. A revisited version of this...
Trading Strategies in the Current Commodity Market Environment
2007
This brief article suggests three approaches for how to benefit from structural opportunities in the commodity markets, drawing from the recently published book, “Intelligent Commodity Investing.” The author notes how over long time horizons, the term structure of a commodity futures curve becomes the dominant driver of return for individual futures contracts. For shorter time horizon opportunities, the author discusses mean-reverting commodity spread trades that have approximately seasonal frequencies.
The Amaranth Collapse: What Happened and What Have We Learned Thus Far?
2007
On September 18th, 2006, market participants were made aware of a large hedge fund’s distress. On that date, Nick Maounis, the founder of Amaranth Advisors, LLC, had issued a letter to his investors, informing them that the fund had lost an estimated 50% of their assets month-to-date. By the end of September 2006, these losses amounted to $6.6-billion, making Amaranth’s collapse the largest hedge-fund debacle to have thus far occurred. There were (and are) many surprising aspects of this debacle. A revisited version of this paper was published in the Spring 2008 issue of the Journal of...
Assessing and Valuing the Non-Linear Structure of Hedge Fund Returns
2007
Several studies have put forward that hedge fund returns exhibit a non-linear relationship with equity market returns, captured either through constructed portfolios of traded options or piece-wise linear regressions. This paper provides a statistical methodology to unveil such non-linear features with the returns on any selected benchmark index. It estimate a portfolio of options that best approximates the returns of a given hedge fund, accounts for this search in the statistical testing of the contingent claim features, and tests whether the identifed non-linear features have a positive...
The Economic Consequences of Legal Origins
2007
In the last decade, economists have produced a considerable body of research suggesting that the historical origin of a country's laws is highly correlated with a broad range of its legal rules and regulations, as well as with economic outcomes. This paper summarizes this evidence and attempts a unified interpretation. It also addresses several objections to the empirical claim that legal origins matter. Finally, it assesses the implications of this research for economic reform. A revisited version of this paper was published in the June 2008 issue of the Journal of Economic Literature.
How Do Performance Measures Perform?
2007
The relevance of the information ratio and the alpha, two leading performance measures for multi-index models, depends on the type of portfolio held by investors. This paper compares these measures with the generalized treynor ratio (GTR) on the quality of the rankings they produce. A precise measure yields similar rankings with alternative benchmarks. A revisited version of this paper was published in the Summer 2007 issue of the Journal of Portfolio Management.
MiFID: the (in)famous European Directive?
2007
In this study, EDHEC-Risk Institute, while recognising that the directive allows the conditions in which investment companies can operate on the regulated markets or over-the-counter to be harmonised, warns of the eventual adverse effects relating to the obligation of transparency for systematic "internalisers" and the obligation of "best execution". The authors find, in the case of the obligation imposed on systematic “internalisers” to maintain a public spread of prices, that it is prejudicial for this restriction to be removed for the least liquid securities. This provision will lead, in a...
Momentum Profits and Non-Normality Risks
2007
This paper examines the role of non-normality risks in explaining the momentum puzzle of equity returns. It shows that momentum returns are not normally distributed. About 70 basis points of the annual momentum profits can be attributed to systematic skewness risk. This finding is pervasive across nine strategies and is reinforced when time dependencies in abnormal returns and risks are explicitly modeled. The analysis also reveals that the market and skewness risks of momentum portfolios evolve over the business cycle in a manner that is consistent with market timing and risk aversion. A...
Shedding Light on Alternative Beta : A Volatility and Fixed Income Asset Class Comparison
2007
Volatility is an alternative beta—a risk premium captured by hedge fund managers and investment bank proprietary traders—that is today moving closer to the mainstream and should be thought of as a veritable asset class. For many investors, it is difficult to derive intuition as to why volatility should deserve an ongoing allocation within a larger portfolio. If volatility is an asset class, then to what accepted asset class can it be compared?
Approximating Independent Loss Distributions with an Adjusted Binomial Distribution
2007
The author describes an approximation methodology for constructing independent loss distributions based on adjusting the binomial distribution. This method can handle both homogeneous and heterogeneous loss portfolios. He finds that this simple algorithm provides an excellent fit to the exact distribution for a broad range of correlations and portfolio credit quality.
Equity Hedge Fund ABS Models: Choosing the Volatility Factor
2007
The use of asset-based style analysis (ABS) in the context of hedge fund investments continues to take hold within the industry. Many of the factors used in performing this analysis are straightforward and well-accepted—particularly in the area of equity hedge funds, where a long market index factor, a small-minus-large factor, and a value-minus growth factor seem to be well-accepted components of an equity hedge fund ABS model. Little attention, however, has been given to understanding the most relevant volatility factors and the relative merits of various instruments in this context.
New Developments in the Commodity Markets
2007
In 2007, the highly dynamic commodity markets had attracted new classes of participants such as algorithmic high-frequency traders; sophisticated product structurers; and Chinese entrepreneurs. This article will briefly cover the market developments that brought in these new participants.
The Myths and Limits of Passive Hedge Fund Replication: An Attractive Concept… Still a Work-in-Progress
2007
Following recent initiatives by major investment banks such as Merrill Lynch and Goldman Sachs, EDHEC researchers have undertaken a detailed critical analysis of the various methodologies involved in hedge fund replication offers, examining the benefits and limits of the “factor-based” and “pay-off” distribution approaches. In the study, “The Myths and Limits of Passive Hedge Fund Replication,” co-written by Lionel Martellini with Noël Amenc, Walter Géhin and Jean-Christophe Meyfredi, the authors find that overall, one could only possibly hope to achieve truly satisfying results by combining...
QIS3: Meaningful progress towards the implementation of Solvency II but ground remains to be covered
2007
This document outlines our position on the third quantitative impact survey on the standard formula for the calculation of capital requirements for insurance companies under Solvency II. Before reviewing the principles that underlie the standard formula, we will give a brief introduction to Solvency II. In light of this introduction, we will then review the changes that QIS3 has brought about in the design of Solvency II; we will also point out major improvements as well as changes that are inconsistent with the very principles of this body of regulations.
Conditional Risk Premia and Correlations in Commodity Futures Markets
2007
In this paper, the authors study the conditional risk premia of commodity futures and the way their returns vary over time with those of traditional asset classes (S&P500 stocks and US T-bonds). They draw the following two conclusions. First, that historically investors earned significant risk premia on 19 of the 21 commodity futures markets studied. Second, that the conditional correlations between equity and commodity futures returns fell over time.
Hedge Fund Performance in 2006: A Vintage Year for Hedge Funds?
2007
In a report entitled “Hedge Fund Performance: A Vintage Year for Hedge Funds?”, Véronique Le Sourd, Senior Research Engineer with the EDHEC Risk and Asset Management Research Centre provides a comprehensive account of the performance of each hedge fund strategy included in the EDHEC Alternative Indexes. The author reveals that funds of hedge funds, which are often taken to give an aggregate view of the industry’s performance, yielded a solid return of 11.25% in 2006.
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About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
