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Hedge funds
In this section, the reports deal with articles on hedge funds: their risk and return performance, their specificities,  whether they can be replicated etc...

Hearings on Hedge Funds and Financial Markets

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The US Oversight Committee has held on 13 November 2008 some very interesting hearings on hedge funds and financial markets.

This is the link to the hearings and all the background documents in pdf : click here

 

Do funds-of-funds deserve their fees-on-fees?

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Do funds-of-funds deserve their fees-on-fees?

1 Introduction

The working paper, authored by Andrew Ang, Matthew Rhodes-Kropf and Rui Zhao, discuss whether fund-of-funds deserve their fees-on-fees. Since the after-fee returns of funds-of-funds are lower than hedge fund returns, it is easy to deduce that funds-of-funds do not add value compared to hedge funds.

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Hedge fund contagion and liquidity

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Hedge fund contagion and liquidity

The authors Nicole M. Boyson, Christof W. Stahel, René M. Stulz, use logit and Poisson regression models to study contagion within the hedge fund industry as well as between hedge funds and the main markets.

 

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What Happened to the Quants in August 2007?

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What Happened to the Quants in August 2007?

Amir Khandani and Andrew Lo

in this paper, the authors revisit the recent events that have hit the small world of quantitative hedge funds, especially the ones involved in equity long short strategies and equity market neutral strategies (EMNs). Large unexpected losses occurred between August 6 and August 9, 2007 despite relative small market movements. The strategies rebounded on August 10, 2007 but after several hedge funds had to deleverage.

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Limited Arbitrage in Equity Markets

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Limited Arbitrage in Equity Markets


In this paper, the authors, Mark Mitchell, Todd Pulvino and Erik Stafford, illustrate the limits of arbitrage in equity markets using discrepancies between the market values of a parent company and its subsidiary. If the value of the parent company is smaller that its stake in a traded subsidiary (a negative stub value), there should be an arbitrage opportunity by going long the parent company and short the subsidiary.
They show that these opportunities are however not riskless because of:

  • Uncertainty of the nature of the mispricing and of the expected payoff can restrict arbitrage activities
  • Undiversified arbitrageurs who need to specialize to gain expertise are exposed to idiosyncratic trading risk and might not be fully invested.
  • The timing of trade convergence is often uncertain
  • Some trades do not converge before a breakout of the link between a parent company and its subsidiary
  • Financing risk: because of the volatility of returns, the amount of required collateral (margins) to insure against large losses can undermine the profitability of these trades.

They use pairs of companies with negative stub value between 1985 and 2000. Data come from CRSP, Datastream and SDC.
The negative stub value is defined by either:

  • Rule 1: The market value of the company stake in its subsidiary is larger than the market value of the company itself (70 pairs)
  • Rule 2: The sum of the market value of the company stake in its subsidiary and the book value of non-subsidiary assets is larger than the market value of the company itself (82 pairs)

The trades are implemented using entry and exit rules, some financial leverage and margin requirements.
They explore three different types of leverage:

  • A textbook leverage based on a percentage of initial investment (Regulation T initial margin, 50% of the long investment and 50% of the short position) and not maintenance margin calls
  • A textbook leverage based on a percentage of initial investment (Regulation T initial margin, 50% of the long investment and 50% of the short position) with maintenance margin calls (25% of long positions and 30% of short positions, mark-to-market, margins met by liquidating assets).
  • A perfect foresight leverage, with a amount sufficient to avoid margin calls

The authors discuss in detail the different risks of the trades:

  • Fundamental risk (risk of no convergence)
  • Financing risk:
    o  Uncertainty of the timing of the convergence or horizon risk,
    o Margin risk
    o Inability to maintain a short position or buy-in risk (lenders of shares ask the shares to be returned)
    o Specialization of the arbitrageur

They argue convincingly that such strategies are rarely implemented on their own but are combined in special situation funds so that the financing risk is reduced.  Why do these negative stub values seem to persist? It is most likely because of the imperfect information on the distribution of returns of these arbitrage trades combined with the previously mentioned risks.

Mark Mitchell, Todd Pulvino, Erik Stafford , “Limited Arbitrage in Equity Markets”, The Journal of Finance, Vol. 57, No. 2 (Apr., 2002), pp. 551-584

 
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