Home Bias and Local Contagion: Evidence from Funds of Hedge Funds

Our paper analyzes the geographical preferences of hedge fund investors and the implication of these preferences for hedge fund performance. We find that funds of hedge funds overweigh their investments in hedge funds located in the same geographical areas and that funds with a stronger local bias exhibit superior performance. Local bias also gives rise to excess flow comovement and extreme return clustering within geographic areas. Overall, our results suggest that while funds of funds benefit from local advantages, their local bias also creates market segmentation that can destabilize the underlying hedge funds.

Liquidity Transformation and Financial Fragility: Evidence from Funds of Hedge Funds

We examine liquidity transformation by funds of hedge funds (FoFs) by developing a new measure, illiquidity gap, that captures the mismatch between the liquidity of their portfolios and the liquidity available to their investors. We find that higher liquidity transformation is driven by FoFs’ incentives to attract more capital and earn higher compensation. Greater liquidity transformation is associated with higher exposure to investor runs and worse performance during crisis periods. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers.

A Coskewness Shrinkage Approach for Estimating the Skewness of Linear Combinations of Random Variables*

Decision-making in finance often requires an accurate estimate of the coskewness matrix to optimize the allocation to random variables with asymmetric distributions. The classical sample estimator of the coskewness matrix performs poorly for small sample sizes. A solution is to use shrinkage estimators, defined as the convex combination between the sample coskewness matrix and a target matrix. We propose unbiased consistent estimators for the MSE loss function and include the possibility of having multiple target matrices. In a portfolio application, we find that the proposed shrinkage coskewness estimators are useful in mean–variance–skewness efficient portfolio allocation of funds of hedge funds.

Hedge Fund Pricing

The two main differentiating features of hedge fund managers compared to traditional investment managers are their ability to leverage and to take both short and long positions. Asset-pricing models used in traditional investment management appraisal have evolved to take these two features into account to correctly specify the pricing of hedge funds. Modern hedge fund asset-pricing theory has its roots in two venerable fields of financial economics research: capital asset pricing and the theory of the firm. This chapter presents the theory and intuition behind the most widely used models for hedge fund performance analysis. MATLAB is used as a computational platform for examples in the chapter using 10 hypothetical hedge fund return vectors. Quants and managers of funds of hedge funds deal mostly with data as presented in net monthly column vectors typically in a Microsoft Excel format.

Multistrategy Hedge Funds

This chapter examines single multistrategy hedge funds and multistrategy funds of hedge funds. The chapter’s purpose is to explain, illustrate, and differentiate both offerings. It offers a complete quantitative analysis of multistrategy hedge funds over a 15-year period, which includes difficult market conditions. The analysis includes a comparative risk-return analysis in absolute terms and relative to traditional investments and hedge funds. A rolling statistical analysis is also performed that focuses on correlation and beta relative to traditional markets. The results indicate that for investors multistrategy hedge funds offer a particularly attractive profile that differentiates multistrategy hedge funds from most single hedge fund strategies. The findings also explain why this strategy recently attracted attention, particularly for multistrategy funds offering an attractive risk-return ratio with limited volatility.

Financial Crises and Evaporating Diversification Benefits of Hedge Funds

Diversification of risk is a potential benefit of investing in hedge funds. Using CSFB/Tremont hedge fund indices, this chapter shows that hedge fund strategies have different returns, volatility, and exposures to various systematic risk factors during tranquil times. This relation has led to the growth of the hedge industry and in particular funds of hedge funds, which provide diversification benefits by investing across different hedge fund styles. However, during financial crises, different hedge fund strategies are exposed to similar systematic risk factors. Most of the strategies become exposed to market liquidity and credit risk factors. Moreover, during the financial crises of 1998 and 2007–2008, all strategies were loading positively on the latent factor that induced positive correlation among hedge fund strategy residuals. As a result, diversification benefits incurred due to investing in different hedge fund strategies evaporated during these financial crises.