EDHEC Publications
Response to the "Statement of the Financial Economists Roundtable on Hedge Funds"
2006
Following its meeting in Sonoma, California on July 10-11, 2005, the Financial Economists Roundtable (FER), an international group of senior financial economists, issued a statement in which it warned about the risks involved in investing in hedge funds. The EDHEC Risk and Asset Management Research Centre, which has carried out a multi-faceted research programme on hedge funds over the past three years, has published a paper by Noël Amenc, PhD, and Mathieu Vaissié in response to the FER statement in which it comments on the FER’s recommendations.
Comparative Analysis of Hedge Fund Returns
2006
Hedge funds have an absolute return performance objective stated independently of the global market conditions. Nevertheless they have been compared to classical bond and equity indices by academics since the late 90s. Independently of their absolute or relative performance it is of particular importance to determine if some hedge funds consistently outperform their peers. This is exactly the objective of this study: Do some hedge funds consistently and significantly outperform others? Do some individual funds or some strategies continuously create alpha in comparison to others?
Commodities – Active Strategies for Enhanced Return
2005
In this article, the authors note how a set of active commodity strategies could potentially add value to an investor’s commodity allocation. But they also emphasize the due care that must be taken in risk management and implementation discipline, given the “violence of the fluctuations which normally affect the prices of many … commodities,” as Keynes (1934) put it. A revisited version of this paper was published in the Fall 2005 issue of The Journal of Wealth Management.
Investing in Hedge Funds: Adding Value through Active Style Allocation Decisions
2005
One of the by-products of the bull market of the 90’s has been the consolidation of hedge funds as an important segment of financial markets. It was recently announced that the value of the hedge fund industry worldwide had passed the $1 trillion mark for the first time, with approximately 7,000 hedge funds in the world, around 1,000 of which were launched in 2003. One of the key reasons behind the success of hedge funds in institutional money management is that such alternative investment strategies seem to provide diversification benefits with respect to other existing investment...
Edhec Funds of Hedge Funds Reporting Survey
2005
In 2004, Edhec launched an international consultation process on the implementation of a new framework for Funds of Hedge Funds reporting. This consultation process was based on a series of recommendations proposed by Edhec with regard to the academic state-of-the-art on risk measurement in the alternative universe. The results of this consultation were presented to a panel of journalists on February 17th in London at a meeting hosted by FIMAT. A revisited version of this study was published in The Journal of Risk Finance 1st Quarter 2006.
Dynamic Portfolio Choice with Parameter Uncertainty and the Economic Value of Analysts’ Recommendations
2005
In this paper, the authors derive a closed-form solution for the optimal portfolio of a non-myopic utility maximizer who has incomplete information about the “alphas”, or abnormal returns of risky securities. They show that the hedging component induced by learning about the expected return can be a substantial part of our demand. A revisited version of this paper was published in the Winter 2006 issue of the Review of Financial Studies.
Structured Forms of Investment Strategies in Institutional Investors’ Portfolios
2005
Institutional investors in general and pension funds in particular have been dramatically affected by recent market downturns. This seems to be surprising given that an increasingly thorough range of structured products has been developed over the past few years, which allows investors to tailor the risk-return profile of their portfolio in a more efficient way than simple linear exposure to traditional asset classes. The salient characteristic of structured products is the repackaging of strategies that involve long and short positions in derivatives and the underlying or a risk-free asset...
Is there a gain to explicitly modelling extremes? A risk management analysis
2005
When risk managers make decisions, they need them to be based upon reliable measures. Strong assumptions are often made to simplify the risk estimation process and there has to be a trade-off between ease of estimate and accuracy. In this paper, “Is there a gain to explicitly modelling extremes? A risk measurement analysis”, Jean-Christophe Meyfredi of the Edhec Risk and Asset Management Research Centre develops a copula-based approach in order to estimate the Value-at-Risk of portfolios containing financial assets. He proposes a survival copula, the Heavy Right Tail copula, which could solve...
The Right Place for Alternative Betas in Hedge Fund Performance: An Answer to the Capacity Effect Fantasy
2005
Two studies, by Watson Wyatt and UBS (both from March 2005), give a pessimistic view of the hedge fund industry’s capacity to generate long-term returns, due to its increasing size. Unfortunately, these studies focus almost exclusively on alpha. In the present paper, we show the importance of considering not only the exposure to the market (the traditional beta), but also the other exposures (the alternative betas) to cover all the sources of hedge fund returns. To do so, we examine the real extent to which the variability and level of hedge fund returns are affected by (static) betas,...
Mitigating Hedge Funds’ Operational Risks: Benefits and limitations of managed account platforms
2005
Operational risk is by far the most complex and intriguing issue investors are dealing with when allocating capital to hedge funds. Due to sophisticated trading strategies, potentially high levels of portfolio turnover, investment in illiquid or difficult to price instruments and a moderately regulated environment, hedge funds tend to exhibit high levels of extreme risks related to non-financial events (fraud and misappropriation, misrepresentation, model risk, infrastructure risk, etc.).
Neutrality of Market Neutral Funds
2005
Using an original database of 634 market neutral hedge funds, this study formally analyses the market neutrality of market neutral funds which are particular in the hedge fund universe since the only objective of these funds is to provide positive returns completely independent of the market conditions. We start by analysing this neutrality using various market neutral indices before focusing on individual fund returns. Finally, an analysis based on ex-post beta helps us explaining and confirming our previous results. We perform this analysis over the global January 1993- December 2002 period...
Natural Resources Fund-of-Funds : Active Management, Risk Management, and Due Diligence
2005
This article comprehensively covers the new field of natural-resources fund-of-funds investing. The authors first explain why the demand for such an investment has emerged, and then discuss the opportunities that an actively-managed natural-resources fund-of-funds can potentially exploit.
Mean-Variance-Skewness Portfolio Performance Gauging: A General Shortage Function and Dual Approach
2005
This paper proposes a nonparametric efficiency measurement approach for the static portfolio selection problem in mean-variance-skewness space. A shortage function is defined that looks for possible increases in return and skewness and decreases in variance. Global optimality is guaranteed for the resulting optimal portfolios. We also establish a link to a proper indirect mean-variance-skewness utility function. For computational reasons, the optimal portfolios resulting from this dual approach are only locally optimal. This framework makes it possible to differentiate between portfolio...
Portfolio Risk Measurement in Commodity Futures Investments
2005
Commodity futures investing has only recently entered the mainstream. As recently as 2001, there was only $10 billion invested in commodity indexes whereas during the fall of 2005 this figure had increased to over $70 billion, according to Rodger (2005). Once an institution has obtained its core commodity exposure through a commodity index investment, the next logical step is to include active commodity managers for further value-added.
Survey of Recent Hedge Fund Articles
2005
In this article, the authors provide the busy reader with a survey of articles that were written over the past four years on hedge funds. Specifically, they review the economic basis for hedge fund returns and then discuss some of the logical consequences of these observations. Next, they summarize the general statistical properties of hedge fund strategies. They then examine what the appropriate performance measurement and risk management techniques are for these investments. And lastly, they briefly cover ways that investors can consider incorporating hedge funds within their overall...
Challenges in Commodities Risk Management
2005
The recent outperformance of commodities versus equities has caused a positive re-evaluation of commodities by both retail and institutional investors. While the commodity markets provide a manager with ample opportunities for creating portfolios of diverse strategies, there are a number of challenges in doing so. In this article, the authors provide two examples of those challenges: (1) the correlations amongst commodities vary seasonally due to meaningful weather events, and (2) the entrée of China as a dominant force in the commodity markets has created new correlation footprints. The main...
Hedge fund industry: is there a capacity effect?
2005
In a major survey of 183 industry players, including institutional investors and hedge fund and fund of hedge fund managers, conducted from May 31st to July 8th 2005, the EDHEC Risk and Asset Management Research Centre has found that alternative investment professionals are upbeat about future prospects for the industry and do not see the so-called “capacity effect” as a major threat to future profitability.
Absolute Returns in Commodity (Natural Resource) Futures Investments
2005
In this article, the authors introduce readers to commodity (natural resource) futures programs. They begin the article by describing the present investment landscape as one where return compression in a number of popular hedge fund strategies has led absolute-return investors to investigate other promising return sources. This includes the highly volatile natural-resource markets, which Lammey (2004) describes as a "paradise for speculators."
Pricing Traditional versus Alternative Asset Management Services
2005
The delegation of asset management services is a source of potential agency problems between investors and their portfolio managers. Most of these problems can be avoided by using an adequate compensation theme. While the academic literature tends to be somewhat inconclusive as to whether or not, and to what degree optimal compensation should be linked to relative or absolute performance, industry practice seems to show a clear pattern: mutual funds charge an asset-based fee, while hedge funds charge both an asset-based fee and a performance fee. In this article, the author discusses the...
From Delivering to the Packaging of Alpha
2005
In this paper, "From Delivering to the Packaging of Alpha. Illustration from Active Bond Portfolio Management: Using Fixed-Income Derivatives to Design Hedge Fund Type Offerings that Better Fit Investors’ Needs", the authors emphasize the need for the hedge fund industry to adopt a consumer (investor)-driven approach, as opposed to the current producer (manager) perspective, and call for the emergence of new types of offering with characteristics better suited to the needs of institutional investors. Using active bond portfolio management as an example, they present evidence on the use of...
Hedge Funds from the Institutional Investor’s Perspective
2005
As a consequence of entering a more mature stage, the hedge fund industry has extended its investor base to institutional investors, who are now faced with a large number of product offerings including not only single hedge funds, but also funds of funds and, more recently, investable indexes. Although the existing literature seems to concur on the interest of hedge funds as valuable investment alternatives, there still remain a large a large number of institutional investors who wonder whether they should invest in hedge funds, and more importantly, how they should do it. In order to address...
Static Mean-Variance Analysis with Uncertain Time Horizon
2005
In this paper, we generalize Markowitz analysis to the situations involving an uncertain exit time. Our approach preserves the form of the original problem in that an investor minimizes portfolio variance for a given level of the expected return. However, inputs are now given by the generalized expressions for mean and variance-covariance matrix involving moments of the random exit time in addition to the conditional moments of asset returns. While efficient frontiers in the generalized and the standard Markowitz case may coincide under certain conditions, we demonstrate, by means of an...
Hedge Fund Strategy Benchmarks: Tricks of the Light or Lighthouses?
2005
The construction of an appropriate benchmark is one of the major challenges of the performance measurement process. Without quality benchmarks, it is not possible to differentiate between returns due to the investment style of the manager and returns due to the talent of the manager, which in turn makes it difficult to measure relative returns. This paper examines the issue of hedge fund strategy benchmarks in the light of improvements in hedge fund index construction methodologies and management principles, and with the launch of new series of investable hedge fund indices. The paper notably...
Exploiting Predictability in the Time-Varying Shape of the Term Structure of Interest Rates
2005
This paper presents evidence of predictability in the time-varying shape of the U.S. term structure of interest rates using a robust recursive modelling approach based on a Bayesian mixture of multi-factor models. We find that variables such as default spread, equity volatility, short-term and forward rates, among others, can be used to predict changes in the slope of the yield curve, and also, albeit to a lesser extent, changes in the curvature of the yield curve. By using systematic trading strategies based on butterfly swaps, we also find that this evidence of predictability in the shape...
Hedge Fund Indices from an Academic Perspective: Reconciling Investability and Representativity
2004
Following a growing concern among investors about the quality of hedge fund index return data, and given the lack of capacity and transparency specific to that industry, this paper questions from an academic perspective whether it is feasible or not to design hedge fund benchmarks satisfying all defining properties for a good index. In particular, in an attempt to test whether achieving investability necessarily comes at the cost of representatitivity, as sometimes claimed by hedge fund index providers, we borrow from the asset pricing literature the concept of factor replicating portfolios...
History of the Risk Concept and Risk Modeling
2004
What is risk? The answer is far from simple. The definition depends on the context and is highly subjective. A first attempt is to define risk as the possibility of something unexpected occurring. But what could the constituents of those expected and unexpected events be? Again there is no single answer. The field of finance is a symptomatic example where risk is multiform. It is usual to distinguish between market risk, credit risk, liquidity, operational and legal risks.
The Benefits and Costs of Illiquidity
2004
This article discusses how to explicitly take into consideration the illiquid nature of alternative investments, particularly including hedge funds. It specifically examines the benefits and costs of illiquidity along with proposed quantitative adjustments that enable one to compare illiquid investments on a level playing field with liquid investments.
In Search of Quality Benchmarks for Hedge Fund Strategies
2004
Over the last few years, alternative investment strategies have dramatically gained in popularity. Initially reserved for High Net Worth Individuals (HNWI), they progressively drew the attention of individual and institutional investors, to reach approximately 1 trillion dollars in assets under management today. However, while HNWI were looking for absolute returns, private and institutional investors are more focused on capital preservation and/or risk-adjusted performance.
Using Index Options to Improve the Performance of Dynamic Asset Allocation Strategies
2004
It has long been argued that equity managers can use derivatives markets to help implement a systematic risk management process designed to enhance the performance of their portfolio (see for example Ineichen (2002) for a recent reference). These derivatives instruments can be used in the context of completeness portfolios that are designed not to interfere with the original portfolio composition, so that they can be used to generate what have been labeled portable beta benefits (Amenc et al. (2004)). Consider for example the case of long/short equity hedge fund managers. A revisited version...
The Fund of Hedge Fund Reporting Puzzle: Reconciling Investors’ Expectations and Fund Managers’ Constraints
2004
The development of alternative investment has not yet been accompanied by a genuine consideration of the specific characteristics of the risks and returns of hedge funds with regard to the provision of information to investors. This inadequacy came to light in a study published by EDHEC in 2003, a study that showed that a very large majority of European hedge fund managers were satisfied with a reporting method designed for investment in traditional asset classes. This method proposes a mean variance-structure that is inappropriate for the risk and return profiles of alternative investment...
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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.
