EDHEC Publications
Desperately Seeking Pure Style Indexes
2003
There is an urgent need for improved measurement and benchmarking of size and book-to-market (style) performance. Given the proliferation of choice, a potentially serious problem is that existing style indexes can provide a somewhat confusing picture of the return on these factors.
A Stochastic Network Approach for Integrating Pension and Corporate Financial Planning
2003
This paper presents a multi-period stochastic network model for integrating corporate financial and pension planning. Pension planning in the United States has gained importance with the population aging and the growth of retirement accounts. In certain cases, the pension plan assets are several times larger than the value of the company itself (e.g. General Motors – Market cap: $19 billion, Pension plan assets: $67 billion, Estimated pension fund deficit: $25 billion – in December 31, 2002; see General Motors Corporation (2003)).
Tactical Style Allocation - A New Form of Market Neutral Strategy
2003
Even though there is little evidence of predictability in stock specific risk in the absence of private information, most equity market neutral managers still rely on stock picking as the preferred way to generate abnormal returns. In this paper, we document the benefits of a new form of market-neutral portfolio strategy that aims at deliver absolute return over the full business cycle through systematic equity style timing decisions. A revisited version of this paper was published in the Summer 2003 issue of the Journal of Alternative Investments.
How to Price Hedge Funds: From Two- to Four-Moment CAPM
2003
In the last decade, the hedge fund industry grew impressively. Many studies show that hedge funds have a superior performance and that the introduction of hedge funds in a classical portfolio enhances the portfolio's performance. The attractive performance of hedge funds may be due to inadequate measurement techniques of the risk-return profile of hedge funds. The main aim of this paper is to investigate how to price hedge funds and, in particular, the validity of the traditional asset pricing models in measuring the risk-return trade-off in hedge fund investment.
Risk Measurement of Investments in the Satellite Ring of a Core-Satellite Portfolio: Traditional versus Alternative Approaches
2003
This paper provides a risk framework for fiduciaries considering using a core-satellite approach to investing. While the article mainly covers the additional risk measurement techniques, which are needed when investing in hedge funds, its recommendations are also relevant for other investments that have default, devaluation, and/or liquidity risks associated with them. While the article’s focus is on quantitative techniques, the author notes that a fiduciary must also understand the economic basis for each investment’s returns.
The Alpha and Omega of Hedge Fund Performance Measurement
2003
That hedge funds start gaining wide acceptance while they still remain a somewhat mysterious asset class enhances the need for a better measurement their performance. This paper is an attempt to test the ability of hedge fund managers to generate superior performance.
Optimal Allocation to Hedge Funds: An Empirical Analysis
2003
What percentage of their portfolio should investors allocate to hedge funds? The only available answers to the above question are set in a static mean-variance framework, with no explicit accounting for uncertainty on the active manager’s ability to generate abnormal return, and usually generate unreasonably high allocations to hedge funds. In this paper, we apply the model introduced in Cvitanic, Lazrak, Martellini and Zapatero (2002) for optimal investment strategies in the presence of uncertain abnormal returns to a database of hedge funds. Wefind that the presence of model risk...
EDHEC Alternative Indexes
2003
Different hedge fund indexes available on the market are constructed from different data, according to diverse selection criteria and methods of construction, and they evolve at differing paces. As a result of this heterogeneity, investors cannot rely on competing hedge fund indexes to obtain a “true and fair” view of hedge fund performance. Investors are therefore at a loss when selecting benchmarks. As a response to the needs of investors, the Edhec Risk and Asset Management Research Center proposes an original solution by constructing an “index of indexes.” The aim of the methodology used...
Evaluating Hedge Fund Investments: The Role of Pure Style Indices
2003
Over the past decade, the hedge fund industry has grown – big time. According to estimates, the number of hedge funds increased from 2,000 to 8,000, assets under management went from US $67 billion to US $800 billion, and inflows of money to hedge funds have never been greater. This growth was essentially driven by the attractive risk-adjusted performance achieved by hedge funds, their ability to protect capital in negative equity markets, and the shrinkage in proprietary trading activities, which coincided neatly with a welter of hedge fund launches.
Indexing Hedge Fund Indexes
2003
As a response to the needs of investors, the Edhec Risk and Asset Management Research Centre proposes an original solution by constructing an “index of indexes”, the performance of which is posted on a dedicated web site (www.edhec-risk.com). The aim of the methodology used to construct this “index of indexes” is to construct a benchmark with degrees of representativity and stability that are significantly higher than those of the indexes available on the market. This methodology was first introduced in Amenc, Martellini (2002a).
Portable Alpha and Portable Beta Strategies in the eurozone: Implementing Active Asset Allocation Decisions using Equity Index Options and Futures
2003
In this paper, we show how portfolio managers in the Euro-zone can benefit from using derivatives markets to actively manage their asset allocation decisions in a systematic manner. Using a robust econometric process based on a non-linear multi-factor thick and recursive modeling approach, we report statistically and economically significant evidence of predictability in Dow Jones EURO STOXX 50 excess return. These econometric forecasts can be turned into active portfolio decisions and implemented via Eurex index futures to generate active asset allocation portable alpha benefits. A revisited...
The Generalised Treynor Ratio
2003
This paper presents a generalization of the Treynor ratio in a multi-index setup. The solution proposed in this paper is the simplest measure that keeps Treynor's original interpretation of the ratio of abnormal excess return (Jensen's alpha) to systematic risk exposure (the beta) and preserves the same key geometric and analytical properties as the original single index measure.
An Analysis of Hedge Fund Performance 1984-2000
2003
Using one of the largest hedge fund databases ever used (2796 individual funds including 801 dissolved), this paper investigates hedge funds performance using various asset pricing models, and a new factor that takes into account the fact that some hedge funds invest in emerging bond markets.
Evidence of Predictability in Bond Indices and Implications for Fixed-Income Tactical Style Allocation Decisions
2003
There is now a consensus in empirical finance that expected asset returns, and also variances and covariances, are, to some extent, predictable. The use of predetermined variables to predict asset returns has produced new insights into asset pricing models, and the literature on optimal portfolio selection has recognized that these insights can be exploited to improve on existing policies based upon unconditional estimates. While the performance of tactical style allocation models is well documented in equity markets, very little evidence is available on the performance of systematic dynamic...
On the Role of Hedge Funds in Institutional Portfolios: Comprehensive Version
2003
This paper reviews both academic and practitioner research from the standpoint of a hypothetical institutional investor who is looking into whether hedge funds make sense for their portfolio. A condensed version of this article appeared in the Spring 2004 issue of The Journal of Alternative Investments.
Towards the Integration of Extreme Values in Obtaining the Value-at-Risk
2003
In this paper we aim to show how risk managers can benefit from this integration of EVT (Extreme Value Theory) into their VaR calculation and how they could easily reduce the effects of some of the important drawbacks that VaR presents.
Improving the Market Model: The 4-State Model Alternative
2003
The present paper conducts an empirical study by examining the Market Model and the three versions of the 4-State Model (translated, rotated and un-rotated) in a mean-beta framework. Using daily returns from the CAC 40 Index's assets, we find that the explanatory power of the 4- State Model is greater than the one of the Market Model and this effect is improved by rotation. A reduction in the non-systematic risk is also observed when switching from Market Model to 4- State Models. Surprisingly, the betas are more stable when using any version of the 4-State Model. This could have a strong...
Grafting Information in Scenario Trees Application to Option Prices
2003
Many mathematical models used in management science do not impose any complex restrictions on the parameter values arising in a given problem. As a consequence, when the instances arise from a specific real-world application, the models under consideration are usually sufficiently robust to remain meaningful even if their numerical parameters are not estimated with very high accuracy or, alternatively, if small perturbations are applied to the parameter values. Things can be quite different, however, with models developed for financial applications. Indeed, in such applications, many models...
On the Valuation and Incentive Effects of Executive Cash Bonus Contracts
2003
Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, i.e., before uncertainties are resolved, cash bonuses are valued ex-post, i.e., by discounting the realized cash grants. Such a lack of consistency can, potentially, distort empirical results. A related, yet mostly overlooked, problem is that when ex-post valuation is used pay-performance measures can not be well defined. Consistent use of ex-ante valuation for all components of a compensation package would simultaneously resolve both of these problems...
Tactical Asset Allocation
2003
Tactical Asset Allocation (TAA) broadly refers to active strategies that seek to enhance portfolio performance by opportunistically shifting the asset mix in a portfolio in response to the changing patterns of return and risk.
Portfolio optimisation and hedge fund style allocation decisions
2003
This paper attempts to evaluate the out-of-sample performance of an improved estimator of the covariance structure of hedge fund index returns, focusing on its use for optimal portfolio selection. A revisited version of this paper was published in the Fall 2002 issue of the Journal of Alternative Investments.
Four-State Model vs. Market Model: Part I
2002
The present paper conducts an empirical study by examining the Market Model and the three versions of the 4-State Model (translated, rotated and un-rotated) in a mean-beta framework. Using daily returns from the CAC 40 Index’s assets, we find that the explanatory power of the 4-State Model is greater than the one of the Market Model and this effect is improved by rotation. A reduction in the non-systematic risk is also observed when switching from Market Model to 4-State Models. Surprisingly, the betas are more stable when using any version of the 4-State Model.
Asset Allocation
2002
Two competing approaches are used in practice to build portfolios: bottom-up and topdown. The bottom-up approach is the older and the more traditional, and focuses on individual stock picking. The top-down approach gives more importance to the choice of different markets as opposed to individual security selection, and, as such emphasizes the importance of asset allocation.
The Brave New World of Hedge Fund Indices
2002
The fact that hedge funds have started to gain widespread acceptance while remaining a somewhat mysterious asset class enhances the need for better measurement and benchmarking of their performance. One serious problem is that existing hedge fund indices provide a somewhat confusing picture of the investment universe. In this paper, we first present detailed evidence of strong heterogeneity in the information conveyed by competing indices. We also attempt to provide remedies to the problem and suggest various methodologies designed to help build a “pure style index”, or “index of the indices...
Methodology Applied for the Agefi Asset Management Awards
2002
Fund performance measurement is an important issue both for professionals, for whom it is the justification of their remuneration, and for researchers, for whom the right evaluation of returns and risks constitutes the very core of modern portfolio theory. This twofold academic and professional issue underlies extensive research and numerous methods for evaluating the performance of funds. Indeed, the diversity of the resulting models and methods has consequences on fund performance rankings and the evaluation of fund performance. Identifying the best managers actually presupposes taking two...
Mean-Modified Value-at-Risk Optimization with Hedge Funds
2002
Based on the normal Value-at-Risk, we develop a new Value-at-Risk method called Modified Value-at-Risk. This Modified Value-at-Risk has the property to adjust the risk, measuring with the volatility only, with the skewness and the kurtosis of the distribution of returns. The Modified Value-at-Risk allows to measure first the risk of portfolio with assets non normally distributed like hedge funds or technology stocks and to compute optimal portfolio by minimizing the Modified Value-at-Risk at a given confidence level. A revisited version of this paper was published in the Autumn 2002 issue of...
Trend-following Hedge Funds and Multi-period Asset Allocation
2002
Selected hedge funds employ trend-following strategies in an attempt to achieve superior risk adjusted returns. The authors employ a lookback straddle approach for evaluating the return characteristics of a trend following strategy. The strategies can improve investor performance in the context of a multi-period dynamic portfolio model. The gains are achieved by taking advantage of the funds’ high level of volatility.
Evidence of Predictability in Hedge Fund Returns and Multi-Style Multi-Class Tactical Style Allocation Decisions
2002
While there has been a significant amount of research on the predictability of traditional asset classes, very little is known about the predictability of returns emanating from alternative vehicles such as hedge funds. This paper attempts to fill this gap by documenting evidence of predictability in hedge fund returns. A revisited version of this paper was published in the September/October 2003 issue of the Financial Analysts Journal.
The Difficulties of Measuring the Benefits of Hedge Funds
2002
In this paper, the use mean-variance approach for the determination of the benefits of allocations to hedge funds is critically evaluated. The advantages of investing in hedge funds are often explained and demonstrated with reference to a shift in the efficiency frontier of traditional portfolios. The added value of hedge funds is almost always indicated in a mean-standard deviation environment and should in our view be reconsidered. The estimated risk exposure can be quantified by the introduction of Value-at-risk analysis corrected according to higher moments of distribution. With this new...
Benefits and Risks of Alternative Investment Strategies
2002
The growth of alternative investment has been considerable in recent years. For both institutional and private investors, it seems that alternative investment now constitutes a distinct class within their overall asset allocation. A revisited version of this paper was published in the July 2003 issue of the Journal of Asset Management.
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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.
