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Hedge Funds’ Performance During The Bear Market Of 2007-2010

COPENHAGEN BUSINESS SCHOOL

Hedge Funds’ Performance During The


Bear Market Of 2007-2010
Master thesis
Authors:

Adam Makarewicz, M.Sc. AEF, CPR. 270883-2785

Ivan Mihaylov, M.Sc. FSM, CPR. 020375-3519

Date of submission: December 2010

Supervisor:

Peter Belling

CEO of Stillwell Burroughs Advisory Services


Hedge Funds’ Performance During The Bear Market Of 2007-2010

Executive Summary
Hedge funds are loosely regulated alternative asset class, whose popularity grew exponentially in
the last 15 years. They employ sophisticated and highly dynamic investment styles, which allow
for a big trading flexibility. Hedge funds’ main objective is to deliver absolute returns to their
investors in both bull and bear markets due to their alleged low correlation with bonds and stocks.

When the performance of hedge fund investment styles in an individual and in a portfolio context
is assessed utilizing the classical Markowitz portfolio theory, then the risk-return characteristics
of this alternative investment vehicle seem to be very attractive, thus inferring that hedge funds
are a very sound investment choice for the investment community. Markowitz’ framework,
however, omits three very important aspects regarding the performance of hedge funds: these are
the existence of statistical moments of higher order (skewness and excess kurtosis),
autocorrelation of returns as well as biases. These three factors possess the potential to distort the
return data of hedge funds in a way that leads to exaggeration of their return characteristics, and
underestimation of the inherent level of volatility, hence making the hedge funds appear more
attractive than they are in reality.

The detrimental effects of autocorrelation, fat tails and biases have been studied in isolation, but
the cumulative outcome of the three factors concurrently for the risk-return characteristics of
hedge funds has not been researched yet. Only Eling (2005) has attempted to study the combined
effect of these three aspects, however for a period of strong market rallies during bull markets.

In our thesis we investigate and analyze the performance of hedge funds as standalone assets as
well as portfolio assets during an unexplored yet timeframe, namely the profound global financial
crisis, which started in 2007. Our observations include a period of 41 months, which commence
in January 2007 and finish in May 2010.

The results obtained prove that hedge funds lose a large part of their attractiveness when
considering the combined effects of fat tails, autocorrelation and survivorship bias. Furthermore,
their status of being considered return enhancers during bear markets as standalone assets, and as
risk diversifiers in a portfolio context due to their alleged low correlation with stocks and bonds
is being questioned.

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Table of Contents
Executive Summary ......................................................................................................................... 2
1. Chapter 1: Introduction ................................................................................................................ 6
1.1. Introduction to the field of analysis ....................................................................................... 6
1.2. Contribution of the thesis to the academic research on hedge funds..................................... 7
1.3. Problem statement ................................................................................................................. 9
1.3.1. Sub-questions .................................................................................................................. 9
1.4. Hypotheses........................................................................................................................... 11
1.5. Methodology ........................................................................................................................ 12
1.5.1. Explorative, Descriptive, Explanative and Normative approach .................................. 12
1.5.2. Qualitative and Quantitative Approach ........................................................................ 13
1.5.3. Data and data collection ................................................................................................ 14
1.5.4. Applied theoretical models ........................................................................................... 15
1.5.5. Data validity .................................................................................................................. 16
1.6. Structure of the thesis .......................................................................................................... 17
1.7. Delimitations ....................................................................................................................... 18
2. Chapter 2: The hedge funds’ universe........................................................................................ 19
2.1. History and characteristics of hedge funds .......................................................................... 19
2.1.1. What is a hedge fund? ................................................................................................... 19
2.1.2. History........................................................................................................................... 19
2.1.3. Size of the hedge fund industry .................................................................................... 20
2.1.4. Characteristics of HFs ................................................................................................... 21
2.2. Empirical characteristics of HFs.......................................................................................... 23
2.3. HF investment strategies ..................................................................................................... 25
2.3.1. Hedge funds’ investment styles .................................................................................... 25
2.3.2. The tactical trading investment style ............................................................................ 26
2.3.3. The equity long/short style............................................................................................ 28
2.3.4. The event-driven style................................................................................................... 30
2.3.5. Relative value arbitrage ................................................................................................ 32
2.4. Hedge fund indices .............................................................................................................. 35
2.4.1. Index construction ......................................................................................................... 36
2.4.2. Index providers ............................................................................................................. 38

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2.5. Biases in hedge fund databases ........................................................................................... 41


3. Chapter 3: Theoretical background ............................................................................................ 45
3.1. Introduction to the Markowitz portfolio theory ................................................................... 46
3.1.1. Measurement of return and risk .................................................................................... 47
3.1.2. Efficient Portfolios ........................................................................................................ 50
3.1.3. Assumptions underpinning Markowitz portfolio theory............................................... 61
3.2. Risk-adjusted performance measures: The Sharpe ratio (SR) ............................................. 62
3.3. Normal distribution and statistical moments of higher order .............................................. 64
3.3.1. Normal Distribution ...................................................................................................... 65
3.3.2. Skewness ....................................................................................................................... 66
3.3.3. Kurtosis ......................................................................................................................... 67
3.3.4. Jarque-Bera test for normality of distributions ............................................................. 68
3.3.5. The importance of the 3rd and the 4th moment for hedge fund investors ...................... 69
3.4. Downside risk measures: Value-at-risk (VaR) .................................................................... 71
3.4.1. Markowitz optimization with VaR ............................................................................... 73
3.5. Autocorrelation .................................................................................................................... 75
3.5.1. Defining autocorrelation ............................................................................................... 75
3.5.2. Causes for the existence of autocorrelation .................................................................. 76
3.5.3. Testing for autocorrelation ............................................................................................ 79
3.5.4. Dealing with autocorrelation......................................................................................... 80
4. Chapter 4: Performance evaluation of hedge fund investment strategies as standalone assets . 82
4.1. Traditional approach of performance measurement and evaluation ................................... 82
4.1.1. Risk, return, and return/risk ratio .................................................................................. 82
4.1.2. Equity Market Neutral and Kingate .............................................................................. 85
4.1.3. Sharpe ratio evaluation ................................................................................................. 87
4.1.4. Discrete vs. continuously compounded returns ............................................................ 91
4.2. Drawbacks of the traditional approach ................................................................................ 93
4.2.1. Autocorrelation, survivorship bias and fat tails ............................................................ 93
4.3. Adjustment of results ........................................................................................................... 96
4.3.1 Bias adjustment results .................................................................................................. 96
4.3.2 Autocorrelation adjustment results ................................................................................ 98
4.3.3. Skewness/kurtosis adjustment results ........................................................................... 99

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4.4. Ranking of hedge fund investment styles .......................................................................... 101


5. Chapter 5: Incorporating hedge fund strategies as portfolio assets .......................................... 106
5.1. Pearson’s correlation coefficients ...................................................................................... 106
5.2 Portfolio optimization based on the unadjusted statistics ................................................... 109
5.3 Recalculation of portfolios’ effectiveness based on an adjusted data ................................ 111
6. Chapter 6: Conclusion .............................................................................................................. 114
6.1. Summary of the main findings of the thesis ...................................................................... 114
6.2. Suggestions for future research ......................................................................................... 117
Bibliography ................................................................................................................................. 119
Websites: .................................................................................................................................. 122
Appendices ................................................................................................................................... 123
Appendix 1: Explanation of the abbreviations used in the data calculations ........................... 123
Appendix 2: Individual performance of hedge fund investment styles .................................... 124

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1. Chapter 1: Introduction

1.1. Introduction to the field of analysis

Hedge funds are loosely regulated active investment vehicles with big trading flexibility. Their
primary objective is to execute highly sophisticated investment strategies in order to deliver
absolute returns to their investors regardless of the conditions and fluctuations of the financial
markets.

The hedge fund industry has been veiled in secrecy within the asset management realm until the
beginning of the 1990s as neither qualitative nor quantitative information about their investment
strategies was made easily available to the wider community. In the past years, hedge funds have
become better known, mostly due to a number of academic studies and research initiated and
conducted by e.g. among many others Fung and Hsieh (1999), Amin and Kat (2003), Capocci
and Hubner (2003), Ackermann, McEnally, and Ravenscraft (1999), Lhabitant (2002, 2004,
2006). As a result of that a large part of the academic and the financial world has formed the
opinion that hedge funds can be deemed a sound investment choice as their flexible investment
strategies can improve the risk-return properties and thus exert a positive diversification effect on
portfolios due to their low correlation with traditional asset classes.

The hedge fund industry has experienced significant growth over the last 2 decades for a number
of reasons. Firstly, despite few notorious cases such as e.g. the failure of Long-Term Capital
management (LTCM), George Soros’ Quantum Fund, Julian Robertson’s Tiger Management
fund and more recently Bernard L. Madoff Investment Securities LLC’s fraud case, the hedge
funds in general have been able to convince the investment world that they can live up to the
expectations to deliver absolute returns. This alleged ability to generate superior returns, and thus
alpha, due to their unique dynamic trading strategies, the low correlation with returns on bonds
and equities, and the perceived beneficial diversification effect to traditional portfolios has led to
significant cash inflows in the last years from institutional investors into hedge funds.

Secondly, although primarily aimed at institutional investors and high net worth individuals,
hedge funds have already become more widely accessible through the emergence of ‘funds of
funds’ (FOF), which are mutual funds that hold portfolios of hedge fund investments that are sold
to a wider investor community. These funds’ popularity has grown significantly in recent times as

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they provide a broad exposure to the hedge fund sector and diversify away the risks associated
with an investment in individual funds.

Thirdly, after the burst of the Internet bubble in the beginning of the 21st century, many
institutional investors tried to make up for the losses incurred by them due to the poor
performance of the global equity markets by increasing their allocations to hedge funds. This has
led to an increased interest of institutional investors such as pension funds, endowments and
foundations who were looking for a grater diversification of their portfolios with alternative
investments in vehicles that feature absolute return strategies and positive returns in both
declining and rising securities markets, while attempting to protect the investment principal.

As a result of all these factors, the assets under management (AUM) by the hedge fund industry
have grown exponentially, as well as the number of hedge funds, which have increased
significantly their number: from as few as 300 funds in 1990 to more than 9,000 at present. These
funds allegedly manage assets of more than 2.5 trillion USD (Ineichen and Silberstein, 2008).
Although the average hedge fund size is typically less than US $100 million, with nearly half
under US $25 million (Garbaravicius and Dierick, 2005) and despite representing a small fraction
of the total asset management industry, hedge funds are believed to exercise a disproportionately
substantial influence on the financial and economic sector in relation to their size due to dynamic
and leveraged trading strategies, which is in contrast to traditional asset classes that typically
engage in buy-and-hold strategies (Fung and Hsieh, 1999).

Lastly, an important reason for hedge funds to gain in popularity is due to the increased level of
trust in the way hedge funds operate prompted by some regulatory changes, which contributed to
among others increased transparency, better compliance, and higher operational standards. This
change referred to as the ‘institutionalization’ of the hedge fund industry, is a valid reason why
hedge funds have become more trusted and popular investment vehicle among investors.

1.2. Contribution of the thesis to the academic research on hedge funds

Despite the apparent influence that hedge funds exert on financial markets, we believe that the
knowledge about them is still relatively limited. We deem that it would be beneficial to the
academic world and the financial community to conduct a comprehensive study on hedge funds
revealing their nature, factors that influence the performance of their investment strategies, risk

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models. More specifically, we opt to measure and analyze the hedge funds’ risk-adjusted
performance during the recent economic turmoil , namely the period between January 2007 and
May 2010, in order to investigate whether they have been able to generate absolute returns as
alleged by them. This will be done by analyzing the Dow Jones Credit Suisse (DJCS) Hedge
Fund Index and comparing it to 2 stock indices and 1 bond index, namely Standard & Poor’s
(S&P) 500 and Morgan Stanley Capital International (MSCI) Emerging Markets Index, and
Barclay’s Bond Index. Numerous studies have been conducted on hedge fund performance
during strong market rallies, yet very limited research is available on what was the effect of the
recent global financial crisis on the hedge fund performance.

Further, in terms of positive diversification effect have hedge funds been generally considered a
rock-solid investment tool due to the low correlation with stocks and bond. Most of the
performance measurement and evaluation, however, is being done utilizing Markowitz’s modern
portfolio theory (MPT). MPT is based on two fundaments, with one of them being considered a
sufficient condition: 1) a quadratic utility of the investors; 2) normality of the return distributions
of the assets in a portfolio context. The former condition is empirically proven as impractical; the
latter is a valid assumption in the case of measuring the return on traditional asset classes, such as
e.g. mutual funds, but not a legitimate argument when measuring the return distributions of hedge
funds.

Hence, MPT has the disadvantage of omitting three very significant characteristics of the return
distributions of hedge funds, namely the existence of (i) autocorrelation (also referred to as serial
correlation), (ii) systemic estimation problem (biases problem), and (iii) deviation from normal
distribution of returns due to the existence of statistical moments of higher order, namely
skewness and excess kurtosis (the fat-tail problem).

These three issues have been considered in isolation in academic studies, and with the exception
of Eling (2005) have researchers not taken into account all 3 aspects at the same time and have
not evaluated hedge fund performance with adjusted and unsmoothed data. What is more, this has
been done by Eling (2005) only for a period before the profound financial crisis of 2007, but not
during distressed and turbulent times for the global financial system. Our main contribution is
that we analyze this particular unexplored timeframe of financial distress and that we consider
and incorporate the combined effect of the data corrected for autocorrelation, biases and fat tails

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when we evaluate the performance of hedge fund investment strategies, and when we construct
optimized portfolios. We do expect that our findings would greatly differ from these of Eling.

We draw the main conclusions in our thesis based on a thorough two-tier analysis: we firstly
analyze the attractiveness of hedge fund investment strategies as standalone individual assets for
the cases of unadjusted and adjusted for autocorrelation, survivorship bias, skewness and excess
kurtosis risk-return data; and secondly we scrutinize if inclusion of hedge fund strategies to
portfolio of traditional assets would result in optimized efficient portfolios.

Although the evaluation of investment strategies as well as the construction of optimized


portfolios is conducted in a professional manner based on a quantitative approach, the findings
outlined in our thesis should not be regarded as investment recommendations for investors.

1.3. Problem statement

As previously mentioned, we endeavor to investigate the issue of risk-adjusted performance of


individual hedge fund investment strategies and the effect of portfolio diversification by inclusion
of hedge funds into traditional asset classes while focusing on a very recent and yet unexplored
timeframe of a global recession and financial crisis. We examine a sample period between
January 2007 and May 2010, as we would like to investigate whether this period has had a
negative impact on hedge funds with regards to their performance or whether hedge funds lived
up to the expectations to deliver absolute returns regardless of the market conditions.

All above mentioned considerations lead us to the following formal problem statement:

Have hedge funds been a reasonable investment choice during the period of financial distress
between 2007-2010 provided that their returns are corrected for autocorrelation, systematic
estimation errors and statistical moments of higher order - skewness and excess kurtosis? Would
the inclusion of conservatively evaluated hedge funds into traditional portfolios have any
beneficial effect for the characteristics of the portfolios?

1.3.1. Sub-questions

In our thesis we will break down the problem statement into several sub-questions relating to the
two steps of our analysis:

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With regard to the evaluation of individual hedge fund strategies:

o Are the first two moments of a return distribution, namely mean and standard deviation,
sufficient to evaluate and analyze the statistical properties of the return distribution of
individual hedge fund investment strategies? Our expectations, based on a thorough
review of research literature, are that hedge fund returns would not display normal
distribution, and we will check this hypothesis by conducting a numerical Jarque-Bera
test.
o Is the unadjusted Sharpe Ratio (SR) an adequate measure of hedge fund performance for
the investigated period? Our hypothesis is that there is a high probability to witness
distortion of the data points observed due to eventual existence of autocorrelation,
survivorship bias, and fat tails. If the hypothesis is empirically verified then we intend to
compare the data with a SR adjusted for autocorrelation only, SR adjusted for biases only,
SR adjusted for both biases and autocorrelation, and a Modified Sharpe Ratio, which also
takes into account higher order moments, namely skewness and excess kurtosis.
o Have all hedge fund investment strategies displayed positive returns for this period of
market fluctuations? Our hypothesis is that the majority of the 14 investigated strategies
would display a positive Sharpe ratio even after adjusting for autocorrelation, biases, and
fat tails.
o Have hedge fund investment strategies outperformed both stocks and bonds when
comparing Dow Jones Credit Suisse index adjusted data with S&P500, MSCI Emerging
Markets, and Barclays Bond indices? Based on the rule of thumb that in turbulent times
bonds traditionally do better than equities, we expect that the majority of the individual
DJCS investment strategies would have outperformed both S&P 500 and MSCI Emerging
Markets, but could certainly not match the returns displayed by Barclay’s Bond Index.

With regard to constructing a portfolio:

o Do hedge funds live up to the expectations to display low or negative correlations with
traditional assets, thus yielding a beneficial effect of diversification? Our ex ante
expectations based on research literature are that hedge funds will exhibit low correlation
with traditional asset classes, thus benefiting the portfolio characteristics.

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o Would a traditional portfolio consisting of a mix of stock indices and a bond index have
better return/risk characteristics as compared to a traditional portfolio comprised of a
bond index solely? We expect that the inclusion of stock indices will have a minimal or
no beneficial effect to the characteristics of a traditional portfolio because of a superior
performance of the bonds during the analyzed by us period and unfavorable correlation
coefficients.
o Would the inclusion of individual hedge fund investment strategies play a beneficial
effect for a portfolio consisting of traditional assets? Would the results differ for the cases
of unadjusted and adjusted data? Our ex ante expectations are that in both cases hedge
funds would yield a beneficial effect for the portfolio characteristics due to the expected
low correlations with traditional assets as well as the effect of diversification obtained.
We do expect, however, that in the latter case with adjusted data, the beneficial effect
would be significantly smaller than in the former case with smoothed data.

1.4. Hypotheses

In our thesis we will investigate to what extent our two principal hypotheses hold true:

• The first main hypothesis is that hedge funds investment strategies, when considered
individually, would prove to be an attractive investment asset class, also after the data
points of the return distribution are being corrected for the effects of autocorrelation,
survivorship bias and fat tails.
• The second main hypothesis is that adding a carefully selected hedge fund investment
strategy to a traditional portfolio comprising equities and bonds, would improve the risk-
return characteristics of the newly formed portfolio due to the diversification effect
caused by the low or negative correlation between hedge funds and traditional asset
classes.

In the two-tier analysis we intend to investigate to what degree these two main hypotheses hold
true. Chapter 4 will give answer to hypothesis one, whereas Chapter 5 will demonstrate what
combination of hedge funds, stocks and bonds would result in optimized portfolios.

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1.5. Methodology

The main objective of this thesis is to thoroughly research and analyze hedge funds in order to
evaluate whether or not they can be considered a sound investment vehicle in times of a profound
crisis such as the global economic and financial turmoil, which started in the autumn of 2007, and
whose detrimental consequences can be witnessed even at present, although most economies and
fiscal systems throughout the world have started to gradually recover. In order to investigate
these issues in a professional way, so that we achieve the desired academic purpose of the study,
we apply a formal methodological framework. We firstly outline what types of studies exist, what
data can be used, what approach can be applied and then we classify our thesis according to this
formalized scientific way.

1.5.1. Explorative, Descriptive, Explanative and Normative approach

The amount of existing knowledge within a research area can be of importance when choosing a
study method. The four most common methods are presented below.

• Explorative studies are often preferred when there is little existing knowledge within the
area and the objective is to find fundamental understandings and formulate hypothesis.
• Descriptive studies are used when basic knowledge exists within the research area and the
study’s objective is to describe, but not explain, relations. Descriptive studies answer
questions such as: ‘How many?’, ‘When?’, ‘Where?’, ‘How often?’
• Explanative studies are used when deeper knowledge and understandings are sought and
when the author both wants to describe and explain. The explanative study tries to
describe causal relations among different concepts and answer the question ‘Why?’
• Normative studies are used when there exists apprehension within the research area and
the objective is to give guidance and suggest improvement.

The approach of this master thesis

The purpose of this master thesis is to investigate the risk-adjusted performance measurement of
hedge fund investment strategies during a predefined period of profound financial crisis, which is
an area that is not researched sufficiently today. Because knowledge within the research area does
to certain degree exist, the study method will be a combination of explanative and normative

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study. We intend to seek deeper knowledge within the specific area of interest and, in the end, be
able to present suggestions to the financial community about constructing optimal portfolios.

1.5.2. Qualitative and Quantitative Approach

Qualitative and quantitative approach refers to the way in which the collected data points can be
evaluated.

Quantitative studies cover information that can be measured and evaluated numerically. The
result is often presented as structures or trends in collected data that may lead to verification or
refutation of the hypotheses formulated in the beginning of the study. This method is appropriate
to use when the purpose is to draw high-level conclusions on a broad set of research areas.

Qualitative methods are used when the objective of the study is to create deeper knowledge
within a specific domain. Compared to the quantitative approach, the possibility of generalizing
here is inferior. The use of non-structured and unsystematic observations is common in the
qualitative method.

The qualitative analysis with regards to hedge funds would focus on selecting the strategies,
which will perform well in the near future. A qualitative analysis on hedge funds would try to
find the answer to the following questions:

• Who are the hedge fund’s manager and the traders?


• How do they react to changing market conditions?
• Are they still opened to new investments?
• What is the hedge fund’s leverage?
• Do they use options to hedge?
• Do the returns reflect the strategy that the hedge fund adopts?
• What is the hedge fund’s extreme risk hedge?
• What is the general degree of transparency of the hedge fund?
• What are the used strategies?
• Does the hedge fund follow consistently its investment style?

A qualitative analysis would try to find the answer to the above listed questions. In fact
institutional investors, who opt for allocating assets in hedge funds, would typically have a
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qualitative analyst team as they would add in their decision criteria the past returns of the funds,
the past standard deviation, the past semi-standard deviation, the past linear correlation, the
drawdown, the max loss, the behavior of the hedge funds during the equity/bond market crashes,
the maximum time to recover from a loss, etc.

A quantitative analysis would focus instead on scrutinizing issues such as e.g. extreme risk
analysis, investment style analysis, hedge fund portfolio optimization and hedge fund portfolio
simulation. This would include analyzing the hedge fund risk, the volatility of this asset class, the
biases, autocorrelation, non-normality of returns related to it. Further, it implies making a
comparison of the hedge fund performance (or at least some hedge fund investment strategies)
with the returns offered for the same period by equity and bond indexes.

The quantitative analysis would also be interested in constructing an optimal portfolio by


adopting some optimization techniques such as i.e. local negative correlation minimization,
shortfall risk minimization, Modified Value at Risk minimization, Omega minimization, etc. In
general, this kind of analysis would use optimization techniques which account at least for mean,
variance, skewness and kurtosis. Generally, the different techniques listed above would give
different optimal weights. If the optimal weights are almost similar across different investment
techniques, then the chosen portfolio is the best among all. If not, the quantitative analysis needs
to check what the differences in weights should be.

Clearly, our thesis uses the quantitative approach as the analysis performed by us in terms of
identifying and selecting individual hedge fund investment strategies and building eventually
optimized portfolios relies on the numerical evaluation of performance measures such as e.g. the
return/risk ratio, Sharpe Ratio (SR), Value at Risk (VaR), Modified Value at Risk (MVaR),
Modified Sharpe Ratio (MSR).

1.5.3. Data and data collection

Data that is collected for this kind of study can be of two different types: primary or secondary.
Primary data is collected through interviews, experiments and observations specifically designed
for the study.

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Secondary data is printed data not specific for the study such as written literature, lectures and
web-based sources. An advantage with existing printed data is that it can broaden the knowledge
base within the research area. At the same time, however, it may not give enough in-depth
knowledge within the area of the study. By knowing this, it is very important to have in mind and
be critical towards data and its reliability and applicability in the conducted study.

Data used in this master thesis

The materials used in this thesis are solely based on secondary sources of information, such as
literature and previous research on hedge funds such as e.g. books, academic papers and articles,
accessed primarily through the CBS library and databases. Using them allows us to build up the
theoretical foundation for the thesis, and be able to analyze the empirical data collected.

Furthermore, with respect to the methodology we take into consideration two main aspects,
namely the theoretical models applied and data validity as they give justification for the validity
of the thesis.

1.5.4. Applied theoretical models

The thesis makes use of different theoretical models. In the first part of the analysis, we use:

• The classical risk-return framework, taking into consideration the mean, the standard
deviation, and the return/risk ratio.
• We conduct a Jarque-Bera test that examines the (non-)normality of the return
distributions.
• The concept of risk-adjusted performance measurement suggests that return is related to a
suitable risk measure. We have chosen to work with the SR as an appropriate performance
measure for the hedge fund investment strategies. In the thesis we estimate the unadjusted
SR for each hedge fund strategy as well as the SR adjusted for autocorrelation only, the
SR adjusted for biases only, the SR adjusted for both autocorrelation and biases, and the
Modified SR, where the standard deviation is replaced by the Modified VaR. All these
adjusted SRs are taken into account to compare the observed data points; because if we
performed the analysis on a SR basis only, then hedge funds would undoubtedly appear as
very attractive investment asset classes, ones however which would underestimate the

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underlying risk and overestimate the performance due to the omission of autocorrelation,
biases and fat tails. For estimating the SR we use as risk-free rate the average monthly 3-
month Treasury Bill rate during the sample period January 2007-May 2010.
• Furthermore, as alternative metrics for volatility, instead of standard deviation we use the
Value at Risk (VaR) formula.
• As VaR assumes normal distribution, and hedge funds display skewness and excess
kurtosis, we apply the Cornish-Fisher expansion to account for the statistical moments of
higher order. In such way the MVaR is being calculated, and it is being used by us for
calculating the MSR.

In the second part of the thesis we add a 3rd dimension, namely the correlation coefficients, which
result in 14 optimized portfolios of the hedge fund investment strategies picked from the DJCS
Hedge Fund Index, and traditional asset classes such as bonds and equities. We apply
predominantly the classical Markowitz mean-variance portfolio optimization theory. Given a set
of assets, and a risk preference, the mean-variance analysis seeks the best allocation of wealth,
e.g. portfolios that maximize the expected return for a known risk level or equivalently choosing
portfolios that minimize the risk given a specific level of expected return.

As the returns of the hedge funds are autocorrelated, systematically distorted, and deviate from a
Gaussian (normal) distribution, we construct the optimized portfolios using the unsmoothed and
corrected data obtained in the first part of the analysis.

1.5.5. Data validity

In the empirical investigation we use 41 monthly returns from the DJCS index during the sample
period January 2007 – May 2010. 13 hedge fund strategies are reflected in the analysis. In
addition to the 13 strategies, an aggregated index (DJCS Hedge Fund Index) comprising the
performance of all the strategies is considered. This broadly diversified index is treated as a 14th
strategy. The hedge fund indices are compared with 3 market indices: two of them measure
equity performance, the other one measure bond performance. S&P 500 and MSCI Emerging
Markets Index are used as equity indices and Barclay’s Bond Index is the bond index. We
included indices that focus on both the U.S. and the world capital market.

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1.6. Structure of the thesis

The thesis has been subdivided into the following chapters: Chapter 2 paints a broad picture of
the evolution and growth of hedge funds, and describes the history of this alternative investment
vehicle as well as the characteristic traits. Further, this chapter introduces the most common
empirical risk-return characteristics of hedge funds: return (mean), volatility of the returns
(standard deviation), statistical moments of higher order (skewness and kurtosis). Chapter 2
concludes with the presentation of the different hedge fund indices and the biases that our
analysis needs to correct for.

Chapter 3 lays down the foundation for the analytical part of the thesis by introducing the
relevant theoretical models. We start with Markowitz’ classical portfolio theory, and then we
introduce a relevant risk-adjusted performance measure, namely the Sharpe Ratio. As both
theoretical frameworks assume normal distribution, we present in detail the fundaments of the
Gaussian distribution as well as the statistical moments up the fourth moment. We also explain
what the importance of skewness and kurtosis for the rational investors is. We finish this chapter
by introducing the concept of autocorrelation, its effect on the risk-return profile of a portfolio,
and the way to unsmooth the data points in order to avoid underestimating the risk and
overestimating the returns.

Chapter 4 scrutinizes the risk-adjusted performance of individual hedge fund investment


strategies as standalone assets. Since hedge fund returns are skewed and fat-tailed we can use
neither the standard deviation nor a VaR formula, which assumes a normal distribution. Instead
we first calculate the VaR using the normal distribution formula and then use the Cornish-Fisher
expansion to adjust the VaR for the estimated skewness and kurtosis. We analyze and rank the
different strategies by considering the unadjusted and the adjusted data. In such way we make
sure that all factors that can distort the actual data on hedge funds’ returns are corrected for.

Chapter 5 investigates if hedge fund allocations to traditional portfolio would result in optimized
portfolios. This is done by adding up a 3rd dimension to the return/risk analysis conducted in
Chapter 4, and namely the correlations coefficients, which result in 14 optimizations that allow us
to test how useful are hedge funds for improving the characteristics of the portfolios.

Finally, Chapter 6 will conclude with the summarized main findings of this thesis.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

1.7. Delimitations

It is important to note that knowledge and performance of the hedge fund industry is guarded
with substantial degree of secrecy. Therefore, the quality of information used in any hedge fund
study, including this thesis, can never be as complete as the information available with regard to
traditional asset classes such as e.g. mutual funds.

We relied completely on secondary sources of information to perform our analysis, and these are
primarily academic research on the hedge fund industry accessed via the CBS library. On one
hand it turned out to be a formidable challenge to schedule a meeting with a hedge fund manager
who would talk to us, and share with us details and insights about how hedge funds function,
what lies behind each of their investment strategies, performance of particular hedge funds, etc. A
major reason for this obstacle is the fact that hedge funds operate in general in highly secretive
way with regards to information and performance disclosure. On the other hand, however, this
hindrance presented us with the opportunity to analyze the performance of hedge fund indices. In
such way we kept our research focused on the big picture, namely on a hedge fund index level,
while preserving the validity of the data. Thus, the data obtained is collected via publicly
available sources, in our case the DJCS index results, which were benchmarked against the S&P
500, MSCI Emerging Markets stock indices, and Barclay’s Bond index.

Optimizing a portfolio requires assessing also among many others the investor’s tax status, the
type of investment vehicle, his/her resources and liquidity needs of the investment. All these
requirements and special circumstances that may exert influence on the investment universe of
any investor have not been taken into account in this thesis and are omitted for practical reasons.

CAPM is an important model from modern financial theory. As it falls, however, beyond the
scope of the current paper and is not being used in the upcoming analytical chapters 4 and 5, it
will not be scrutinized and presented in detail in this thesis.

Further, the only alternative risk measure presented in this study, which considers all statistical
properties of the return distribution, is the Modified Value at Risk as proposed by Signer and
Favre (2002). Additional alternative risk measures such as e.g. the Omega measure, Conditional
Value at Risk and the Expected Shortfall from the Extreme Value Theory were not scrutinized in
this paper.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

2. Chapter 2: The hedge funds’ universe

2.1. History and characteristics of hedge funds

2.1.1. What is a hedge fund?

"There is no common definition of what constitutes a Hedge Fund; it can be described as an


unregulated or loosely regulated fund which can freely use various active investment strategies to
achieve positive absolute returns" (Garbaravicius and Dierick, 2005).

The quotation mentioned above indicates that there is no legal or even generally accepted
definition of a hedge fund. The US President’s Working Group on Financial Markets (1999)
characterized such entities as “any pooled investment vehicle that is privately organized,
administered by professional investment managers, and not widely available to the public”.

Brentani (2004) points out that hedge funds feature two important aspects: firstly, their main
objective is to generate positive absolute returns by taking risk and not returns relative to a
predetermined index. Secondly, hedge funds try to control losses and avoid negative
compounding of capital.

Bookstaber (1997) states that hedge funds are difficult to describe and define as they encompass
all possible investment vehicles and strategies minus the traditional funds and investment
strategies.

All definitions, which were already mentioned above indicate that the term hedge fund is
generally used to describe a variety of different types of investment vehicles that share some
similar characteristics, which will be discussed in this chapter.

2.1.2. History

It is generally reported that A. W. Jones set up the first hedge fund in 1949; however, supposedly
there were others who preceded Jones. Benjamin Graham operated an investment fund that
utilized long and short positions and charged an incentive fee. Graham’s partnership, formed in
1926 together with Jerome Newman, included a number of hedged and unhedged strategies, such
as convertible arbitrage and distressed securities. Gradually it became widely accepted that

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Jones’s partnership should be considered the first hedge fund as it was more dynamic and
versatile in its trading strategies (Longo, 2009).

Jones structured his fund as a limited partnership with fewer than 99 investors to avoid the
regulatory requirements of the US Investment Company Act of 1940. He stipulated that the
general partner or fund manager would take 20% of the profits as compensation. His investment
approach involved using leverage to increase the fund exposure and to magnify returns while at
the same time using short selling of stocks to reduce market risk. His aim was to hedge out
market risk by taking as many short positions as long positions so that his fund was market
neutral. In other words, returns would depend not on whether the stock market went up or down
in a specific period, but rather on whether he picked the right stocks.

In its early years, the hedge fund industry remained relatively small and attracted little publicity.
But the number of hedge funds, and the total assets under management began to increase
significantly during the 1990s and the rate of growth has accelerated considerably in the last few
years.

There have been two reasons for this growth. Firstly, the attractiveness of the hedge fund
remuneration structure has been a big incentive to talented traders to leave investment banks and
to asset managers to set up investment funds on their own. Secondly, the freedom of investing in
a hedge fund that is not being constrained by any regulations has proved attractive to investors to
get involved in the hedge fund world.

2.1.3. Size of the hedge fund industry

The hedge fund industry comprises in total more than 9,000 funds at present, with alleged AUM
of more than US $2.5 trillion (Ineichen and Silberstein, 2008).

The early investors in hedge funds have been high net worth individuals, often family or friends
of the fund managers, thus trying to keep a private investment partnership approach. US
endowments such as Ivy League universities have been among the first institutional investors to
start investing in hedge funds, followed by a broad array of other institutional investors such as
i.e. large pension funds.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

This involvement of large investors has contributed to the institutionalization of the hedge fund
industry as institutional investors tend to favor bigger funds with well-developed compliance and
risk management functions. The result has been the concentration of a significant proportion of
hedge fund assets among a small number of big managers.

2.1.4. Characteristics of HFs

Today the term hedge fund infers a very broad connotation, because nowadays hedge funds
control risk by applying various sophisticated investment techniques, which exceed the classic
concept of hedging out the risk. Although short selling and leverage are still widely used
investment techniques for generating absolute returns, hedge funds also make use of complex
derivatives such as e.g. options, futures, forwards, swaps, foreign exchange derivatives, interest
rate derivatives, commodity derivatives, etc.

In general hedge funds are an asset class that shares the following common characteristics:

Return objective: Hedge funds’ main objective is to produce positive absolute returns in both bear
and bull markets, without regard to a particular benchmark. Typically, managers of hedge funds
commit their own capital to ensure that investment decisions are sound and aligned with what has
been promised to the investors. In such way, the preservation of capital becomes a primary
objective.

Investment strategies: Hedge funds take position in a wide range of markets. Dependant on the
different market conditions they are free to choose among various complex and sophisticated
investment techniques, such as e.g. short-selling, leverage, usage of derivatives.

Incentive structure and life expectancy: Hedge funds typically usually charge 1-2% management
fee and up to 20% performance fee. The average lifespan of a hedge fund is around 3.5 years
(Koh, Lee and Phoon, 2001). This often comes as a result from the hedge fund return target,
which is set up with a high watermark clause, which is used as a performance measurement tool.
Only if hedge fund managers exceed the target preset, can they get the performance
compensation fee. In underperforming funds that cannot meet the target, the management would
have lower incentives to sustain this particular hedge fund as it would be more difficult to reach

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

the target for the forthcoming period. In such case, it is preferred to close down the hedge fund
and introduce a new one, with the hope of attracting new investors.

Subscription and withdrawal: Hedge funds have lock-up periods up to a year until first
redemption. This is done in order to preserve the financial stability of the funds if they decide to
invest in illiquid assets. After the initial lock-up period, a prearranged schedule with quarterly or
monthly subscription and redemption may apply. Many hedge funds retain the right to suspend
redemptions under exceptional circumstances if large capital withdrawals can endanger the
financial stability and existence of the fund.

Investors: Hedge funds are not widely available to the public. There are high minimum
investment levels, thus their investors are predominantly high net worth individuals and
institutional investors.

Regulation: Hedge funds are loosely or not regulated depending on their onshore or offshore
residence, although Europe applies at present an increased level of regulation and higher degree
of transparency.

Disclosure: Hedge funds adhere to voluntary disclosure requirements unlike traditional


investment funds.

Domicile: Hedge funds can be domiciled in onshore or offshore locations. Around half of the
number of hedge funds was registered offshore at the end of 2007 according to IFSL Research 1.
The most popular offshore location has been the Cayman Islands (57% of offshore funds),
followed by British Virgin Islands (16%) and Bermuda (11%). The US was the most popular
onshore location, accounting for nearly two-thirds of the number of onshore funds, with
European countries accounting for most of the remainder.

There are certain similarities that hedge funds share with traditional asset classes. These are as
follows:

• Both types of funds are funded by capital from investors, rather than bank loans.

• They both invest in publicly traded securities e.g. equities and bonds.

1
“Hedge Funds 2008”, IFSL Research, July 2008.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

• The capital of hedge funds and mutual funds is invested by expert fund managers.

The key difference between a hedge fund and traditional asset classes lies in the degree of
regulation as well as the level and variety of risky investment strategies. Whereas mutual funds
are required to adhere to strict financial regulations, including the types and levels of risks, the
hedge funds are free to pursue practically any investment strategy with any level of risk.

Another key difference is the fund portfolio composition. The majority of mutual funds are
composed of equities and bonds whereas hedge fund portfolio compositions are far more varied,
with possibly a significant weighting in non-equity and non-bond assets such as i.e. derivatives.

A major difference is also that the historical return characteristics and distribution of hedge funds
tend to differ significantly from these of traditional asset classes. It will be shown in the next
sections that unlike mutual funds, hedge funds returns are not normally distributed; they tend to
exhibit not only fat tails but also serial correlation and are subject to various biases.

2.2. Empirical characteristics of HFs

Hedge fund proponents emphasize the funds’ attractive reward-to-variability characteristics, as


well as their low correlations with traditional assets. Most practitioners, however, evaluate
investment opportunities by applying the mean-variance framework of Markowitz, and/or the
Sharpe Ratio, which both will be presented in detail in Chapter 3. Although these models hold
true for measuring the performance characteristics of traditional investment funds, they are not
directly applicable to hedge funds. This is due to the fact that both theoretical frameworks assume
returns with normal (Gaussian) distribution, which would be defined by its first two moments -
the mean return and variance/standard deviation. Empirical evidence, however, indicates that
hedge fund returns are not normally distributed, but exhibit skewness and excess kurtosis, which
are the third and fourth moment of a return distribution. Hence, if directly applied to hedge funds,
without any modifications, the Markowitz mean-variance analysis and the Sharpe Ratio would
skip over properties that would not be minor or favorable to investors as often the more attractive
attributes of the mean-variance framework would go hand in hand with the less attractive
properties of the higher order statistical moments.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

As already mentioned above, hedge fund investment strategies exhibit excess kurtosis also
referred to as leptokurtosis, which is the fatness of the tails of the distribution. Very often excess
kurtosis goes along with negative skewness, which is an asymmetry in the size of negative
returns versus the size of positive returns. The tail risk as well as the negative skew are of major
concern to investors and remain unrecorded if only standard deviations are used for hedge fund
risk quantification.

The next section gives a brief overview of the characteristics of the return distribution of hedge
funds and their implication for the investors. These properties are being discussed in detail in
Chapter 3.

Mean is the first moment of a return distribution, one that is a measure of the expected return.
Investors expect investment managers to deliver hedge fund returns exceeding the returns of a
benchmark index over a certain time horizon. Hence, a positive mean is important as it displays
the central tendency of a hedge fund manager’s performance. Investors assume that capital
markets have imperfections, which can and should be exploited by fund managers through the
accumulation and usage of relevant information. Investment managers earning positive active
returns satisfy the first essential condition for achieving a satisfactory performance.

Standard Deviation is the second moment of a return distribution and it is a measure of volatility.
Risk-averse investors are expected to be ready to trade-off higher expected return against
increased volatility. This assumption is underpinning in the Sharpe reward-to-variability ratio. In
other words, investors are assumed to dislike risk and they require risk premium from these fund
managers who deliver highly volatile performance.

Skewness is the third central moment of a distribution, one that measures the degree of symmetry
of the return distribution around its mean. In a Gaussian distribution, the value of the skewness is
equal to zero. However, empirical evidence demonstrates that hedge fund returns exhibit
skewness, which is different from zero.

Return maximizing investors have been proven to strongly prefer positive skewness while
disliking negative one (Kraus and Litzenberger, 1976). This is due to the fact that positive
skewness reflects a small probability of experiencing rather small losses but extremely high
returns, whereas in the case of negative skewness there is a probability of achieving many small

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

gains, but also extremely large losses (Lhabitant, 2004). In a positively skewed distribution, the
majority of the observations should be skewed to the left-hand side of the distribution, which
results in the mean active return being larger than the median active return. An actual problem
with determining the ability of a hedge fund manager to deliver positive skewness to the investors
would be that the average life expectancy of a typical hedge fund is relatively short, and hence
the evaluation will be based on a limited number of observations.

Kurtosis, the fourth central moment of a distribution, is a measure of the peakedness and
heaviness of the tails of the return distribution. A distribution that exhibits positive kurtosis is
referred to as platykurtic; the one that displays negative kurtosis is called letokurtic, where as the
Gaussian distribution is mesokurtic. The higher the distribution’s peak, the greater the proportion
of returns around the mean is and hence the greater also the predictability of performance. The
opposite is also true: the lower the peak, the lower the proportion of returns around the mean and
thus the smaller the predictability of performance will be.

Kurtosis is also considered a measure of the influence of extreme returns on the distribution’s
shape. Higher kurtosis suggests fat-tails, or more observations falling in the extremes of the
distribution. Risk-averse investors prefer less risk to more risk, for any given levels of utility.
Therefore, investors view kurtosis as an indication of risk intrinsic in the manager’s performance,
where high kurtosis suggests a high probability of fat-tails. Kurtosis, however, should not be
evaluated in isolation from the other statistical moments, but also be considered with respect to
the mean, standard deviation and skewness of the return distribution.

2.3. HF investment strategies

2.3.1. Hedge funds’ investment styles

Though possessing certain characteristics distinguishing them from other traditional investment
vehicles such as e.g. mutual funds, hedge funds are not coherent entities. The magnitude of
investment tools available to hedge funds managers, resulting from them being privately
organized and loosely regulated, allows for different styles to be employed. It is important to
recognize that while performing an analysis, hedge funds might differ in all the major factors that
influence the investment decisions.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Managerial styles that prevail in a given case are an expression of an undertaken strategy; the
strategy determines i) the goals of a given fund, ii) the ways to achieve them, and iii) from
investors’ perspective the opportunities offered. These 3 factors cause the returns and volatilities
to differ significantly among the types. Further, it is necessary to segregate the hedge funds
accordingly as to have a practical framework to refer to. No general classification norm exists,
though compatibility between different methodologies serves as their justification. For the
purpose of this paper, the classification that we use consists of five main categories, which are
displayed in Figure 1.

Hedge fund
strategies

Relative value
Tactical trading Equity long/short Event-driven Others
arbitrage

Global macro -Global - Distressed securities - Convertible - Multi-strategy

- Managed futures/ - Regional - Risk arbitrage arbitrage funds

CTA - Sectoral - Event-driven - Fixed income - Funds of funds

- Emerging multi-strategy arbitrage

- Dedicated short bias - Equity market neutral

Figure 1: Hedge Fund Strategies (Authors’ own creation)

2.3.2. The tactical trading investment style

The hedge funds exercising the tactical trading investment style are arguably the largest funds in
terms of AUM. Further, they are the most performance oriented entities, and they attract most of
the media attention and coverage. A typical example of a hedge fund representing this particular
trading investment style would be the Quantum Fund and its well known co-founder George
Soros.

Tactical trading seeks for benefits from speculating on the fluctuations of currencies,
commodities, equities and bonds. Managers work on systematic basis, focusing on trends and

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

computer models derived from in-depth technical analysis, as well as discretionary basis with
more fundamental analysis in use.

Styles to be distinguished within this group are global macro investing and commodity trading
advisors (CTAs).

Global macro investing utilizes the macroeconomic principles in a search for any mispricing or
profit opportunities in the global markets. With the top-down approach, managers seek to profit
from the fundamental economic, political and market factors analysis. Once a promising area is
specified, an opportunistic, directional investment is made; high leverage is used as a profit
maximizing tool. Global macro managers assemble big, though concentrated portfolios relying
strongly on derivatives.

The discretionary character of decision making further increases the importance of the managers’
qualifications and experience for the successful performance of the global macro funds.

Managed futures, commodity trading advisors and even trading funds are the interchangeable
names used to describe the same investment vehicle. As it is suggested by all the three names,
this investment style uses the listed commodity and financial futures, trading them on behalf of
clients.

It is important to note that commodity futures were among the first derivatives used to hedge
against commodities’ price movements as well as for purely speculative purpose. Regulations
imposed later lead to yet another strategy, and commodity futures started to be used as
investment tools. Once their potential was realized, investors became eager to gain from them,
and as a result CTAs grew as a sector worth over US $130 billion as of 2005 (Lhabitant, 2006).

In the 80s ca. 61% of the CTAs activity was in trading the agricultural futures, distinct difference
from present times when financial futures for currencies, interest rates and stock indices account
for the vast majority of the traded volume.

Managed futures perform their activities based on different sub-strategies. The main split is
between the systematic and discretionary approach.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The systematic approach was the one that gained more manager appraisal and that currently
dominates the picture with about 80% of the funds preferring it. Systematic traders master
quantitative historical performance analysis, and with the help of ever developing computer tools
define the trading signals. It is the market trend as perceived by managers that decides the buy-
sell decisions. Most of the systemic funds focus on the much debated momentum trading
analysis.

Discretionary funds, in that manner close to the global macro funds, view the fundamental
analysis as the key. It is the fund manager’s experience and trading skills that decide the actions
and as a consequence condition success.

Regardless of what exact style within the tactical trading group is preferred, the common
principle is that markets do not move randomly, which for some might be iconoclastic.

2.3.3. The equity long/short style

“Academic researchers and investment practitioners now recognize that loosening the long-only
constraint that applies in traditional asset management is one of the most effective ways of
increasing portfolio efficiency, maximizing a manager’s investment insights and potentially
increasing alpha generation” (Lhabitant, 2004).

This is a primary strategy taking advantage of what is often perceived to be an element


distinguishing hedge funds from traditional investments, namely, short selling.

As it can be deduced form the name, investments in equities are made, with a composition of
long and short positions that in the broadest sense serve the purpose of decreasing market
exposure. This does not implicate market neutrality, which is aimed at, but never really achieved.
In reality, most of the funds are characterized by a net long exposure, being the result of more
gross long exposure than gross short exposure as opposed to the equity market neutral strategy. It
results in a higher, compared to the other strategies, correlation with traditional markets. Only
small portion of the managers take upon extensive efforts to create net short exposed funds.

The equity long/short style is referred to as a new portfolio creation technique. It is based on a
traditional, fundamental analysis of the market, but the addition of short selling creates an
opportunity for managers to generate profits even in the situations of market decline.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Beside the advantages coming with the availability of short selling, just to mention betting on the
overvalued assets and hedging against the market risk of long positions, certain drawbacks have
to be considered. Short selling imposes higher trading costs as a result of high leverage, higher
turnover, moving asset prices require more monitoring and portfolio rebalancing, delays in
execution and negative effects during bull markets.

As an advantage over the traditional funds, equity long/short funds have a potential of generating
profits from the following four sources:

• Spread in performance of possessed long and short positions versus gains from long
position appreciating only. Such investment is often defined as a double alpha strategy,
because outperformance of an investment is being achieved from both the long position as
the asset appreciates and the short position with its drop in value.
• Interest rebate on the returns realized with the short sale being used as collateral.
• Interest paid on the liquidity buffer deposited at the broker.
• Spread in dividends between long and short positions.

Several sub-strategies can be defined within the equity long-short style:

Region or industry focused managers constitute the first sub-group. Whether it is a continent,
country, single stock exchange or a specific industry, all managers explore the long-short
opportunities presenting themselves in the area.

Dedicated short managers are the opposite of the long only followers. Even with the highest
level of expertise, this group is expected to underperform during the bull periods and do
extremely well when markets decline.

Emerging market funds concentrate on securities available in emerging countries. These exact
business environments are often of little transparency, weak regulation and significant political or
economic risk, but at the same time are often under-researched, resulting in attractive investment
opportunities. Managers have to account for higher volatility and short-selling limitations under
this strategy.

Market timers are short period investors with a dynamic approach to their long-short exposures.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

2.3.4. The event-driven style

Managers of the event-driven style hedge funds place their interest in debt, equity and trade
claims of companies going through specific phases of their life cycles. The underlying
assumption is that, contrary to the regular market functioning periods, companies undergoing
ownership changes, restructuring or market trouble are harder to analyze, impending events are
expected to affect their share price, and as a result undetected, undervalued securities can be
found.

Typical stages of corporate life cycles in which event-driven strategies take positions are spin-
offs, mergers and acquisitions, bankruptcy, reorganization, re-capitalization and share buybacks.

The dominant styles in the category are distressed securities and risk arbitrage.

Distressed securities funds seek to profit from trading debt or equity of entities that are, or
according to managers’ predictions are about to be in operational, legal or financial difficulties.

Looking for good investment opportunities in troubled assets dates back to the times of rapid
development of railways in England and many bankruptcies related with that activity. More
recent similar market situation came with the creation of the junk bond trading market.

For many individual or traditional investors such securities are only to be avoided, while hedge
fund managers see them as an ideal direction to look for ‘discounts’. Market practitioners prove
these discounts to be existing, which is explained by several factors resulting from the specific
stage these companies are in.

One of the reasons is that significant selling pressure is often present with such assets. Either in
an actual distress or in an anticipation of some sort of troubles, price tends to drop in some cases
leading to undervaluation. Discounts stem also from the need of restructuring or cessation, when
sale is required, hedge funds act as liquidity providers, anticipating future surge in assets value.
In some countries it is possible to only pick the desired parts of the troubled business, leaving
aside the over-leveraged or unwanted ones.

The advantage hedge fund managers posses over traditional investors in this sector comes mainly
from the level of analysis performed and expertise possessed, but not only. For example, for most

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

institutional investors buying such untradeable assets would be against their charts, fiduciary
responsibilities and simply regulatory rules. Banks are discouraged by a high level of regulatory
capital that would need to be held with such assets. Individuals expose often unreasonable fear,
strengthened further by lack of analysts’ coverage on such securities. Low liquidity and long
redemption periods are a concern too.

Having this market imbalance of more market knowledge and limited interest from other
investors, managers invest in distressed securities hoping for the future value appreciation.

Some investments of this type are hedged by holding put options in the respective markets, while
more often fund managers get involved in the restructuring efforts and ongoing functioning of the
firm to support higher and faster returns. This is the active investment style, as opposed to the
passive, opportunistic, value oriented trading.

The valuation process does not come easy though. Valuing distressed companies’ assets is a
complicated process, requires in-depth knowledge of valuation, law and company’s business.

Several risks are taken up in the distressed securities investment, financial risk up to recovery rate
considerations, title risk dealing with recognition of ownership, liquidation risk given the
company goes bankrupt, as well as long bias and liquidity risk, capturing the long time period
when assets are being held and lack of real possibility to hedge with short sales.

Risk arbitrage (merger arbitrage) is an event-driven strategy taking advantage of opportunities


deriving from companies going through the corporate control changes e.g. mergers and
acquisitions. Leveraged buyouts, mergers and hostile takeovers are of major interest to risk
arbitrage hedge funds.

The type of operations to be conducted in relation to the announced merger depends on the type
of the acquirer-acquired company agreement.

When the planned deal is specified as a pure cash offer, what is the potential profit for a hedge
fund is the arbitrage spread. The acquiring company makes an offer to purchase the acquired
company’s stock at a given bid price, above the current market price. If an agreement is reached
and the merger is announced to be pending, merger arbitrage manager buys the stock of the

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

acquired company, hoping the merger will end up a success and after the regulatory acceptance
the market price of the stock will appreciate, optimally up to the bid price levels.

In the situation when merger is agreed to be on a stock-for-stock basis, picking short and long
positions is required. Similarly to the previous case, the investor buys shares of the acquired
entity, going short in the acquiring firm’s stock. Although the deal is public, some spread is there
to be realized given the merger ends up a success, shares of the acquired company are expected to
gain in value and the opposite for the buyer’s shares.

The major risk associated with the merger arbitrage is the deal breaking. The main concern is not
the range of profits, but the transaction risk and the calendar risk indicating the exact timing of
the deal. Merger arbitrage is therefore a bet on whether the merger will be successful or not.

2.3.5. Relative value arbitrage

Managers pursuing this strategy, trade in a broad range of securities, equity, debt options and
futures. The underlying trade assumption is that there are pricing discrepancies between the
related, similar instruments available in the market. Having that in mind, the prediction is that
such ‘pairs’ of securities or market prices will converge over time to reflect the theoretical or fair
value of the respective assets. Mathematical, fundamental and technical analyses are being used
to trace the sets of mispricing and implement the double-sided strategy; asset determined as
undervalued is purchased, and the related overpriced security is sold short.

Convertible bonds and their underlying equity are a primary subject of interest for the convertible
arbitrage style managers. It is a common opinion that such bonds are often undervalued,
although popular explanations of this fact fail to be satisfactory. The market mechanism assures
that at the maturity date such securities will be fairly valued, either in a form of a bond maturity
price or a value of the converted shares; fair market value should be present at any time before
the maturity, otherwise an arbitrage opportunity exists. When arbitrage opportunities are spotted
then hedge funds come into play. The intended investment is not limited to a simple purchase of
an undervalued convertible bond, which would be an unhedged, traditional position vulnerable to
different risks such as interest risk, equity and credit risks. The three mentioned risks, their
interaction and additionally optional clauses (put, call clauses) make the valuation of convertible

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

bonds a sophisticated and hard task in many cases resulting with a mispricing. It is the task of a
hedge fund manager to effectively protect against the mentioned set of risks.

Interest rate risk is dealt with by selling interest rate future contracts or interest rate swaps.

Equity risk is hedged by shorting the equity underlying the possessed bond. The amount of shares
to be sold short is specified as the delta component (value of a unit change in bonds value as a
result of one unit change in the underlying equity value) times the number of shares bond can be
exchanged into, multiplied by the number of bonds in a portfolio. Hedging the equity risk
requires more effort than the interest rate risk, since the delta component, which is the
sensitiveness of the bond price to the equity price, will be changing over time, ergo the amount of
shares held needs to be rebalanced on an ongoing basis.

The attractiveness of the convertible bonds is grasped by the gamma element. High gamma
typical for the convertible bonds means that their price is more sensitive to the related equity’s
price climbing up than decreasing. Based on that, convertible bonds appear as an attractive
investment in the times of crisis.

Credit risk acts as the biggest challenge to the convertible arbitrage managers. Convertible bond
issuers are in most of the cases below the investment grade, moreover such bonds are often
unsecured, subordinated, issued by companies with high volatility of earnings, high leverage. All
these factors strengthen the credit risk. A relevant solution to this problem is the asset swap. The
asset swap allows the bond to be divided into its two core components: the fixed income part
(acquired by the credit buyer) and the equity call option (to be kept by the credit seller). This
process unlocks the theoretical value of convertible bonds allowing hedge funds to profit from
them.

Fixed income arbitrage seeks to find and exploit the pricing anomalies across and within the
fixed income markets. The conformed presence of many anomalies is due to the lack of
agreement on a standard pricing model in the area, investor preference, exogenous shock to
supply and demand or structural features. Several sub-strategies are employed, reflecting the
magnitude of types of fixed income instruments, markets and market situations. These strategies
include, depending on where the anomaly presents itself, yield curve arbitrage, sovereign debt

33
Hedge Funds’ Performance During The Bear Market Of 2007-2010

arbitrage, corporate versus treasury yield spreads, municipal bonds versus treasury yield spread,
cash versus futures and mortgage-backed securities arbitrage.

Equity market neutral

Typical long/short investing, also in the case of the long/short equity hedge fund strategies, is
conducted with buying and selling decisions being made separately with no relation between the
securities being looked into. This leads to a net long or net short exposure and is far from a
precisely hedged position.

Contrary to the above, equity market neutral selling and buying operations are in a close relation,
moreover they are concurrent. Attentively picked long and short positions are aimed at market
neutrality, or as market risk-free portfolio as possible.

Equity market neutral strategy is a highly qualitative portfolio construction technique.

The idea behind such investments is to exploit the market inefficiencies between the related
securities, while eliminating the market timing requirement from investor’s perspective. Returns
come from the selection of shares and bets made on their respective under- and overvaluations,
not the general market conditions. As a consequence, managers can focus on the areas where they
possess the skills, not having to worry about forecasting the market movements.

Key feature of these funds is the low correlation of their returns with the stock index returns,
which makes them being perceived as the ‘quintessential’ hedge funds.

Market neutrality calls for possibly zero beta values and a ‘pure’ alpha to be generated, though
the neutrality can be broken into levels.

The very basic approach is dollar neutrality where long and short positions have to be equal in
the dollar value invested. No correlation with the market is considered, making the dollar
neutrality a weak concept.

Beta neutrality on the other hand includes the beta of the respective securities in the equation and
adjusts the weights accordingly. Another risky area is defined by sector neutrality. Portfolio
neutral from the general market perspective can still suffer significantly if long and short
positions are taken in different sectors, in companies with different capitalization or of different

34
Hedge Funds’ Performance During The Bear Market Of 2007-2010

nature such as e.g. value/growth stocks. If, for example long and short positions are placed in
different sectors, it will often be the case that trends in the respective ones are divergent, and as a
result the portfolio is exposed to a significant risk. Sector neutrality means coherence with respect
to that is established.

The ultimate, most quantitative level is the factor neutrality. Factor models are used to determine
the sources of risk and determinants of performance for a given security. Starting with the market
model, several influencing factors are considered and their impact measured to finally be able to
hedge against them. The downside is that the more risk factors are accounted for, the smaller the
opportunity to add value.

Summing up, in the best of situations, equity market neutral funds eliminate the beta risk, realize
alpha profits from both hedging positions as well as gain from interest earned on the cash un-
invested for liquidity purposes and interest on cash made on short sales and held as a collateral.

Funds of hedge funds (funds of funds) exist as a tool with the use of which diversification benefits
can be achieved through a single investment. The broad spectrum of hedge fund investment styles
results in different risk-return characteristics, and it seems attractive to include a set of hedge
funds into a portfolio to make more efficient, just as it is in the case of traditional investments.
Diversification offered by funds of funds protects against poor performance of single managers
making its impact smaller, offer more stable, long-term investments. Managers can choose to
build fund of funds on several funds using the same strategy (style-specific) or to pick funds
across investment styles (multi-strategy fund of funds).

Some funds do not mention any of the existing styles to be their dominant strategy, freely
switching between them depending on the opportunities presenting themselves. This group is
referred to as multi-strategy funds.

2.4. Hedge fund indices

In the early days of their existence, hedge funds were a highly elitist investment tool. Back in the
late 80s, the exclusivity was the marketing idea for hedge funds, only the right contacts and
sufficient amount of money could guarantee access to this alternative investment. The lack of

35
Hedge Funds’ Performance During The Bear Market Of 2007-2010

transparency and a straight forward strategy of letting only the certain, wealthiest individuals to
be allowed to invest is now over with.

The increasing popularity and acceptance of hedge funds made the market realize the need for a
tool aimed at a broad spectrum of investors, institutional ones being the main driving force, who
could use it to track the historical and current trends in the area as well as to have as a
comparison and evaluation benchmark. Providing hedge fund indices became a competitive
sector that has established them as a real investment alternative on the market. Indices helped the
industry develop into the stage it is in, but were also an answer for the growing need for accurate
and timely measures of valuation, return and risk.

2.4.1. Index construction

Properly constructed, an unbiased index is a valuable tool providing all the basic information
required for the investment decisions. Ideally a hedge fund index informs reliably on the outlooks
of the composition, valuation, performance and risks of the industry over time and its correlations
with other assets. It helps optimize a portfolio and better understand the performance of different
investment styles. Knowing that managers differ in their skills and qualifications, the index
provides a comparison benchmark to assess an individual fund performance. The index is also a
basis for constructing the passive investment product, which enables an easy, single step
investment into a diversified portfolio reflecting the average performance of the whole asset
class.

In reality, hedge fund indices face significant obstacles, thus making the construction process a
hard challenge. The common drawback is that all the biases possessed by the hedge funds
databases underlying the indices are transferred into them. Index providers undertake efforts to
limit the influence of biases, but it is never fully achieved. Another issue is the ambiguity and
arbitrary nature of the hedge fund styles classification, borders between them are unclear which
complicates the construction process too. As a result there is no universal index or guidelines
how to build one and several index providers compete while results presented vary.

The key principles that should be the basis for a proper index construction are as follows
(Lhabitant, 2004):

36
Hedge Funds’ Performance During The Bear Market Of 2007-2010

• Transparency- the list of funds included and the weights assigned to the respective ones
should be accessible. The rules on implementing modifications, adding or removing
funds, changing weights should be defined in advance and should be justifiable. Data used
for index computation ought to be provided for verification purposes.
• Index coverage and representativity- it deals with a tradeoff between indices being
comprehensive versus appropriate. The more funds included, the more representative of
the actual state of an industry the index is. On the other hand, it might be justified to
exclude some funds due to their features, being too small or too young to be invested in or
not following one clear investment style.
• Weighting- reflects the crucial decision on picking the weighting scheme. The choice, as
in the other asset classes, is between the market capitalization adjusted weighting and
equal weighting. Traditional markets chose the capitalization weighted approach as the
one giving more credible picture of the performance, though it is not always how hedge
funds operate.
• Investability- pertains to hedge funds closed for investments after reaching the
capitalization required. Excluding the closed funds from an index will distort the
evaluation of the broad sector performance. If counted in, closed funds will improve the
index returns outperforming the actual entities investable. Methodology pursued has to be
clearly stated.
• No backfilling- index providers should not have a possibility to make an a posteriori
upgrades to the data supplied.
• Risk factor exposure information should be provided.

Limits to the hedge fund indices revisited

Amenc and Goltz (2008) made a research on the limits to the credibility and usefulness of the
hedge fund indices as market perceives them. Their comparative approach was aimed at
answering the question whether the biases and other drawbacks associated with hedge fund
indices are specific to them only, or widely accepted stock indices posses them too. The second
question was whether and to what extent can these limits be overcome. The authors acknowledge
that caution is needed when selecting and interpreting an index. They notice that multitude of
returns for competing indices for the same strategy exist and they explain this with indices not

37
Hedge Funds’ Performance During The Bear Market Of 2007-2010

being fully representative. Sampling problem results from the lack of regulation on performance
disclosure, with only over a half of hedge funds reporting to any of the index databases.

Amenc and Goltz (2008) do not share the opinion of Fung and Hsieh (2004) that hedge fund
indices only provide an estimate of industries’ current development on average and are of little
help in asset allocation and performance measurement. The former researchers show that the
biases troubling the hedge fund indices are present in the widely accepted indices for traditional
asset classes too. As a consequence, consistency calls for accepting them as a valid investment
tool, equally with stock indices. Furthermore, the analysis demonstrates that due diligence in the
construction process limits the level of bias significantly. It is also noticed that regardless of what
index provider we look at, the investable index always reflects the reality better than the non-
investable one. With regard to the global index versus single category or style indices, it is shown
that the latter are always more representative and trustworthy.

The learning point for this project is that it is of great importance to interpret the indices properly
and their returns with a solid dose of conservativeness. It is of great importance which provider is
being selected and which exact index from all the available ones is being used for our analysis.

2.4.2. Index providers

Hedge Fund Research

One of the longest operating and arguably the most popular index among the investors is the
Hedge Fund Research (HFR), which is a Chicago based index and advisory provider established
in 1992. Specializing in indexation and analysis of hedge funds, HFR claims to have the most
detailed classification system 2. Except for details on historical performance and assets, HFR is a
broad basis of information on hedge fund managers. Over 100 indices are supplied, from industry
aggregate levels to specific, limited sub-strategy or region oriented ones. HFR indices are net of
fees and since 1994 free of survivorship bias (Lhabitant, 2006). The construction of indices is
made on an equal-weighted basis; there is no minimum required asset size and no minimum track
record for including a particular fund. Revision of weights is performed monthly, with new funds
added and defunct ones removed. Indices are updated three times a month and a trailing period of

2
http://www.hedgefundresearch.com/index.php?fuse=about&1277727501

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

4 months is treated as estimate and is a subject to corrections. Assigning investment style


categories is based on fund’s offering memoranda.

Database underlying the indices produced consists of over 6500 funds with an almost equal split
between the US and offshore ones 3.

Morningstar Morgan Stanley Capital Indices

Morgan Stanley Capital Indices (MSCI) is a renowned provider of fixed income and global
equity indices worldwide. It has been present in the hedge fund indexing market since 2002, but
in the present form since 2008 when Morningstar purchased the MSCI Hedge Fund Index
Family 4. Current operation is based on the vast hedge fund database of Morningstar, and the most
comprehensive and detailed hedge fund classification framework created by MSCI and known as
the MSCI Hedge Fund Classification Standard. Several dimensions are used to group funds into
different classifications. The main dimensions employed are the investment process used
(directional trading, relative value etc.), asset class invested in to generate returns (equities, fixed
income, commodities, currencies) and the geographic location of investments undertaken. Each
dimension is broken into sub-categories, which together with some secondary characteristics used
in the framework and division based on the size of funds (capitalization) results in a multitude of
indices. The official number of indices available from MSCI as of 2009 was 193. From the
technical perspective, indices provided are equally weighted, mostly non-investable and
rebalanced monthly.

Standard & Poor’s

Yet another high achiever in the general index construction, S&P started their hedge fund indices
in 2002. One main and four sub-indices were constructed covering nine investment strategies in
total. From the beginning S&P’s main index was a managed account-based, investable index. The
very specific construction methodology was selected, with only 40 funds being the basis for the
main index, less than 1% of the known hedge fund universe. Competitors would refer to S&P’s
product as a fund of funds not a real index. S&P would argue that based on their statistical
research, reliable reporting of performance of 30-40 funds can effectively mimic the state of

3
https://www.hedgefundresearch.com/index.php?fuse=database-faq&1277729105
4
http://alternativeinvestments.morningstar.com/pandora/docs/factsheets/Mstar-MSCI-Indexes.pdf

39
Hedge Funds’ Performance During The Bear Market Of 2007-2010

much larger, market performance. This rather risky approach was verified in 2006 when after
over a dozen deletions of the constituent funds S&P announced it will no longer publish its hedge
fund indices 5.

At present, S&P offers investors a hedge fund evaluator, which is a tool that enables creating a
theoretical hedge fund portfolio. The hedge fund evaluator forecasts the performance of the
portfolio by finding an existing, public index having high correlation with the analyzed portfolio
and projecting its potential performance.

Dow Jones Credit Suisse Hedge Fund Indexes (DJCS)

Former Credit Suisse/Tremont Hedge Fund Indexes rebranded after Credit Suisse Index Co.
joined forces with Dow Jones Indexes in June 2010. Methodologies for each of the indexes, as
well as the index rules remained unchanged.

One notable advantage that DJCS Index has over other suppliers is that it was first, and still is
one of only few constructing its index on an asset weighted basis. This guaranties a more accurate
depiction of the market reality.

Indices are constructed from a representative selection of hedge funds from a database consisting
of over 5000 funds. Inclusion in a database is possible after meeting the main requirements, at
least US $50 million under management, one-year track record and current, audited financial
statements.

The main group of indices provided is the Dow Jones Credit Suisse Hedge Fund Index (the
‘Broad index’). It consists of non-investable, broad categories indices that are meant to represent
the state of the industry in as precise as possible manner. From the assumption, each type of an
index from the group is supposed to represent at least 85% of the underlying market. Except from
the composite, inter-style index, ten subcategories are distinguished based on the dominant
investment style (plus additional three within the Event Driven category). Fund weight caps are
in use to increase diversification and limit concentration risk. The index is calculated and
rebalanced monthly, if necessary, whereas fund composition is verified quarterly. Index data runs
back to 1994.

5
http://money.cnn.com/2006/06/30/markets/hedge.fund.index/

40
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Dow Jones Credit Suisse indices deal decently with biases. There is no backfilling bias as the
rules do not allow modifications in the past date index composition. Furthermore, “To minimize
survivorship bias, funds are not removed from the index until they are fully liquidated or fail to
meet the financial reporting requirements.” 6

Alongside the non-investable, broad indices, other products are offered. The Dow Jones Credit
Suisse All Hedge Index is an investable index comprised of all the broad index categories
available. The DJCS Blue Chip Hedge Fund Index is an investable index built from the 60
biggest funds picked across the different investment styles. Finally, the DJCS LEA Hedge Fund
Index is an asset-weighted, composite index focusing on three regions of emerging hedge fund
markets (Latin America, Asia and Emerging Europe with Middle East and Africa).

2.5. Biases in hedge fund databases:

Biases seem to be an important issue when measuring and evaluating hedge funds’ performance
as they can cause distortion in the data points observed, and in this way they may give a false
impression about the attractiveness of this alternative investment vehicle. The main sources of
hedge fund databases biases are two. The first relates to the way each database is constructed, and
they are intrinsic to the data collection process. The second is linked to the problem of stale or
‘managed’ hedge fund prices being reported by the managers directly.

Below are listed the foremost biases that an investor needs to consider when evaluating and
reflecting on the attractiveness of a hedge fund performance:

Self-selection bias: this bias originates from the private nature of the hedge funds. Unlike
traditional investment vehicles, hedge funds are not formally obliged to disclose performance or
asset information to anyone beside their investors. Any reported data to the wider public is done
on a voluntary basis, and the managers themselves have the right to choose what information to
be revealed to the wider public and what not. Therefore, the sample of hedge funds, which are
being observed, will never constitute a true random sample of the hedge funds’ general
population.

6
http://www.hedgeindex.com/hedgeindex/en/indexmethodology.aspx?indexname=HEDG&cy=USD

41
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Further, small and medium-sized hedge funds with persistent positive track record would have a
bigger incentive to report to databases compared to underperforming funds. The former would
like to become more visible to potential investors, whereas the latter would wait until they can
show a good track record of positive returns over a certain investment horizon when they will
also start to report returns. In such way, the databases will usually have a small number of
underperforming funds, and hence they will produce a bias towards the best performing funds.

On the other hand well performing hedge funds may opt out of reporting to databases. The
rationale behind such decision would be that they would typically have a long list of potential
investors who would like to enter the fund, and secondly they may fear that if included in an
index, they may improve the performance characteristics of this index, but their individual
performance would appear less differentiated and would not stand out. In this particular case,
databases will produce a bias towards the average performing hedge funds.

Database/sample selection bias: most of the hedge fund databases cover funds that can meet the
specific criteria required, such as e.g. a certain level of assets under management, track record
over specific time horizon, which proves at least 1 or 2 years of existence. Taking into
considerations all these criteria it gets clear that the database can and probably will produce an
upward bias compared with all existing hedge funds.

Furthermore, some databases may exclude particular investment styles, while others may include
them, thus creating incoherent results. Beside explicit selection biases, there may be also implicit
ones, and this would be the case when managers agree to report to one or two databases, but not
to the rest, thus creating inconsistencies in the statistics calculated by the different databases.

Survivorship bias: this is probably the most important bias of all, and it is being widely
mentioned and analyzed in the literature regarding hedge fund performance. This particular bias
relates to the fact that many hedge funds tend to get excluded from the performance list as they
stop to exist. In such way, historical returns from the databases tend to be overstated whilst the
historical risk tends to be understated. This reasoning is done under 2 assumptions: i) that funds
have disappeared for performance reasons, and ii) that data on funds, which have disappeared for
performance reasons is dropped from the database. Survivorship bias is a natural consequence of

42
Hedge Funds’ Performance During The Bear Market Of 2007-2010

the way the hedge fund industry has evolved. Thus, in the context of analyzing hedge fund data,
survivorship bias cannot be completely mitigated.

A well-known problem concerning the survivorship bias relates to retrieving information on


hedge funds that ceased to exist before database vendors started to collect their data. Due to the
lack of public disclosure, the only information available about hedge funds that ceased operation
prior to the mid-1990s is incomplete. Thus, hedge fund databases are to large extent vulnerable to
survivorship bias, and analysts cannot make a fair assessment of it prior to the mid-1990s.

Another problem arises due to the difference between funds that decided to exit a database, which
a labeled ‘defunct funds’, and these that ceased operation, which are referred to as ‘dead funds’.
The difference is that a dead fund is certainly a defunct fund, but a defunct fund does not
necessarily need to be a dead fund. The reason for a fund to become defunct could be that it
voluntarily stopped reporting information to a database vendor because it has reached the optimal
size for its investment style. The reduced need for new capital, and the preference for privacy,
often means that the fund no longer wants to provide its performance information to database
vendors. Such type of defunct fund would actually have a higher return and lower risk than the
typical hedge fund in the universe or in the database.

Researchers such as e.g. Brooks and Kat (2002) have found that 30% of newly established funds
fail to perform and stop to exist within the first 3 years. Furthermore, Gregoriu (2002) alleges that
the median life of a hedge fund is typically around 5.5 years. To deal with the consequences of
survivorship bias, some data vendors now retain historical data about funds that have ceased to
exist or stopped reporting data due to underperformance. In such way survivorship bias is
believed to gradually disappear with time. Others, however, openly state that about survivorship
bias is not their concern, so they keep on eliminating the data of short-lived hedge funds, thus
reinforcing the survivorship bias.

The seriousness of the survivorship bias is reflected in the studies of many researchers. Fung and
Hsieh (2000b) estimate that survivorship bias amounts to 3%. In this thesis we consider the
annual level of survivorship bias to be 2.1%, and the analyzed by us data is corrected with 2.1%
respectively.

43
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Backfill or instant history bias: Such bias occurs when funds joining a given database are
allowed to backfill their historical returns, therefore creating ‘instant history’, although they have
not been part of the database for the past years. This option given to hedge fund managers to
make a decision of whether to be included in the database with the fund’s full or partial track
record tends to bias the performance of the database significantly upwards.

Infrequent pricing or illiquidity bias: This particular bias occurs when a hedge fund manager
tends to smooth the fund’s returns by systematically understating the volatility of the hedge fund
portfolio and its correlations to traditional indexes. This leads to systematic overstatement of risk-
adjusted returns, and as a consequence the returns will look more lucrative than they are in
reality, and there will be over-allocation to investment styles that make use of less liquid
securities.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

3. Chapter 3: Theoretical background

The purpose of this chapter is to take into consideration the relevant theoretical models that help
to correctly measure the performance of hedge funds. We present firstly Markowitz’ mean-
variance analysis as it is probably the best tool for understanding the risk-return trade-off that
every investor is faced with. This framework is a keystone in modern financial theory as
performance measurement utilizes a whole set of techniques, many of which originate in
Markowitz’ modern portfolio theory (MPT).

Subsequently, we pay attention to models that allow us to analyze effectively the performance of
the different hedge fund investment strategies. We introduce in this section a widely accepted and
utilized risk-adjusted performance measure, the reward-to-variability ratio, widely referred to as
the Sharpe Ratio (SR) because it was developed by William Sharpe.

As both MPT and the SR assume symmetrical Gaussian distribution of returns, we introduce the
concept of normal distribution. The topic of the non-normality of returns is very relevant for our
thesis, and with respect to the fact that hedge fund returns exhibit additional statistical properties,
we need to describe in detail two moments of higher order, that could lead to the underestimation
of risk and the overestimation of the performance characteristics of hedge funds if omitted. With
regard to this, we firstly, we introduce the relevant 3rd and 4th statistical moments as well as the
tool that helps verify whether or not skewness and excess kurtosis exist in the observed data
points, and namely the Jarque-Bera test.

Further, we introduce Value at risk (VaR) as alternative performance measure that tracks the
downside risk. VaR, however, assumes normal distribution too, so to be aligned with the return
characteristics of hedge funds we present the Modified VaR (MVaR), which is computed with the
help of the Cornish-Fischer expansion. MVaR is a very relevant model for the analysis in Chapter
4 and 5 as it enables the incorporation of fat tails.

A step further is the introduction of the serial correlation of returns as this allows us to account
for one additional factor that distorts the data points on the hedge funds’ returns. The tool that
helps to verify the existence of autocorrelation - the Ljung/Box Q-statistics, is also being taken
presented.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

This will conclude Chapter 3, whose main objective is to scrutinize all factors that could cause an
effect of underestimating risk and overestimating the return of hedge funds and to discuss the
various techniques proposed in recent research to combat the impact of data distortion stemming
from the fat tails and the autocorrelation problem.

3.1. Introduction to the Markowitz portfolio theory

The idea about diversifying the assets in a portfolio context seems to be fundamental in financial
and economic theory. The popular expression ‘Do not put all your eggs in one basket’ has been
traditionally understood and discussed by financial theorists before 1952 e.g. Williams (1938),
and Leavens (1945); however, what eluded them was firstly the effect of diversification when
risks are correlated, and secondly the risk/return tradeoff on the portfolio as a whole. The notion
of diversification has become formally devised by Harry Markowitz (1952, 1959), who through
his seminal works founded a new theoretical framework. It proved that when investors add assets
to a given portfolio, then the total risk of that portfolio as measured by the variance of total return
is reduced continuously, and the expected return of the portfolio is the weighted average of the
expected returns of the assets comprising the portfolio. Put differently, diversification is being
achieved by investing in portfolios rather than in individual assets, which leads to the reduction
of the total risk of the investments without giving up return.

Markowitz developed through his research an efficient portfolio-selection technique known


nowadays as modern portfolio theory. Prior to Markowitz, theorists and practitioners used
security-selection models, which focused solely on the returns generated by investment
opportunities. This would mean that the best investment decision at that time would be to
construct a portfolio of these assets that offered the best possible return.

The Markowitz theory retained the emphasis on return; but it steered the attention to the
correlation of the securities and also elevated the risk as factor of equal importance to the
investment choice, and in such way the concept of portfolio risk came into being.

Markowitz’s greatest contribution is that he was the first to explore how the risk of a portfolio as
measured by the variance, can be significantly decreased through diversification. Moreover, he
put emphasis on selecting portfolios based on their overall risk-reward characteristics instead of
constructing portfolios from assets with attractive individual risk-reward characteristics.

46
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Markowitz’s mean-variance analysis is based on the following assumptions with regards to the
behavior of both the investors and the financial markets:

• The investors can estimate a probability distribution of the possible returns over a certain
holding period.
• Investors maximize their utility within the framework of diminishing marginal utility of
wealth.
• Variability of returns is used by the investors to measure risk.
• Investors care only about the first two moments of a return distribution, namely the mean
(expected return) and variance (risk) of the returns of their portfolios over a certain
investment horizon.
• Investors are risk-averse; hence return is sought after; whereas risk must be avoided.
• Financial markets are frictionless, meaning that they constitute a trading environment
where all costs and restraints associated with transactions are non-existent.

3.1.1. Measurement of return and risk

Return

The return according to the MPT is the weighted average return of the assets included in the
portfolio. The general formula of the expected return for n assets is represented mathematically
by:

n
E (rP ) = ∑ wi E ( ri )
i =1

where:

∑ w =1
i =1
i

n= number of assets

wi = proportion invested in security i

ri , rP = return on ith asset and portfolio p

47
Hedge Funds’ Performance During The Bear Market Of 2007-2010

E (ri ) = expectation of the return on ith security

Risk

The general connotation of the term ‘risk’ is pejorative as it is associated with the probability of
sustaining loss. In financial theory, however, risk is referred to as the dispersion of unexpected
outcomes due to movements in financial variables (Jorion, 2007). Hence, not only the negative
deviations, but also the positive ones are considered as sources of risk. Risk is measured by the
standard deviation or the variance of a distribution.

The variance of an individual asset is the expected value of the sum of the squared deviations
from the mean, and the standard deviation is the square root of the variance (Bodie, Kane and
Marcus, 2009). The variance of a portfolio is equal to the weighted average covariance of the
returns on its individual assets:

Var ( r=
p) ∑∑ w w Cov ( r , r )
n n
σ=
2
p i j i j
=i 1 =j 1

Covariance can be expressed as follows:

( ri , rj ) ρ=
Cov= ijσ iσ j σ ij

where:

ρij = correlation coefficient between the rates of return on asset i, ri , and the rates of return on

asset j, rj

σ i , and σ j represent standard deviations of ri and rj respectively.

The correlation is a fundamental novelty in the MPT as it measures how closely two random
variables go up and down together. Its implication for the securities in a portfolio will be
presented in more detail in a subsequent section. Covariance on the other hand is the correlation
multiplied by the standard deviations of the return of the individual securities. High covariance
indicates that if the return rates of an asset increase, then this would result in a rise in the return
rates of the other security as well. Low covariance means the returns of individual securities are

48
Hedge Funds’ Performance During The Bear Market Of 2007-2010

relatively independent, whereas a negative covariance is a sign that an increase in one asset’s
return is likely to correspond to a decrease in the other (Bodie, Kane and Marcus, 2009).

Substituting for the covariance we reach the following formula:

Var ( rp ) = ∑∑ wi w j ρijσ iσ j
n n

=i 1 =j 1

All in all, the estimate of the mean return for each single asset is its average value in the observed
period; the estimate of variance is the average value of the squared deviations around the sample
average; the estimate of the covariance is the average value of the cross-product of deviations
(Elton, 2011).

Utility function and risk preferences of an investor

One of the factors to consider when selecting the optimal portfolio for a particular investor is the
degree of risk aversion, which is the investor’s willingness to trade off risk against expected
return. This level of aversion to risk can be characterized by defining the investor’s indifference
curve, consisting of the risk/return pairs defining the trade-off between the expected return and
the risk. It establishes the increment in return that a particular investor will require in order to
make an increment in risk worthwhile. For a portfolio with expected return E (rp ) and standard

deviation σ p the investor has the following utility function:

U E (rp ) − 0.005 Aσ p2
=

where U is the utility value and A is an index of the investor’s risk aversion. The number 0.005
is a scaling factor that allows for expressing the expected return and standard deviation as
percentages rather than as decimals. The interpretation of this expression is that the utility from a
portfolio increases as the expected rate of return grows, and it diminishes when the variance
increases. The relative magnitude of these changes is governed by the coefficient of risk aversion,
A. For risk-neutral investors A=0. High levels of risk aversion are reflected in larger values for A.

MPT assumes that investors are risk averse. This means that if two securities offer the same
expected return, then the investors would show preference towards the less risky one. Further, an

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

investor would take on additional risk only if he/she is being compensated by higher expected
returns. The other way around is also a valid assumption: an investor who desires higher expected
return must concede to a higher risk.

The exact risk/return trade-off will differ for different investors as it is based on the individual
level of risk aversion. The practical inference here is that a rational investor will not invest in a
portfolio if another portfolio displays more favorable risk-return characteristics. For example if
an alternative portfolio offers higher expected return for the same level of risk as the initial
portfolio, then the investor will always choose the alternative one.

Markowitz classifies the investors into three categories, and namely risk-neutral, risk-averse, and
risk-lover. Risk-neutral investors would not require risk premium for risky investments, because
they would only care about the expected rates of return. Risk-averse investors would opt for
either only risk-free securities such as the T-Bills or speculative investments that offer positive
risk-premium. A risk-lover is an investor who is willing to engage in fair games and gambles as
this investor includes in the value of the expected return the ’pleasure’ of confronting the
investment’s risk.

3.1.2. Efficient Portfolios

Efficient portfolios can be compiled by any number of asset combinations. In the following
section we show how to construct an efficient portfolio by mixing two risky assets, and we
observe the properties of the portfolio. This would give the reader an understanding how a
portfolio of many risky assets could best be formed.

Two-risky-assets portfolio

A major challenge when constructing an efficient portfolio from 2 risky securities is to get an
understanding what is the interdependency of the uncertainties of both asset returns. The key
determinant of portfolio risk would be to find out to what degree the returns of the assets move
together in the same or the opposite direction. The extent to which a portfolio of two risky
securities reduces the variability of returns depends on the degree of correlation between the
expected rates of returns of the assets.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Let us consider the example of a portfolio, where the proportion wA is invested in risky asset A

and the remaining proportion1 − wA , represented by wB , is invested in risky asset B. Then the

expected rate of return on the portfolio is the weighted average of the expected returns on the
risky assets A and B, with the same portfolio proportions as weights.

=
E (rP ) wA E (rA ) + wB E (rB )

The variance of the return on a two risky asset portfolio is mathematically denoted by the
following formula:

σ P2 =( wAσ A + wBσ B ) 2 =wA 2σ A 2 + wB 2σ B 2 + 2wA wB ρ ABσ Aσ B

where ρ AB is the correlation coefficient between the returns on asset A and asset B. As
previously mentioned the correlation is a measure of how closely two random variables move up
and down together. Correlation can be a number between +1 and -1. The former is known as a
perfect positive correlation, and it offers no reduction of portfolio risk. The latter is referred to as
the perfect negative correlation and it means that the portfolio risk has been diversified away.
Logically, investors strive towards achieving a low or negative correlation as this will
significantly diminish portfolio risk.

With ρ AB = 1.0 , which would mean that Asset A and B are perfectly positively correlated, the

previous formula is being simplified to:

σ p 2 =wA 2σ A 2 + wB 2σ B 2 + 2wA wBσ Aσ B =( wAσ A + wBσ B ) 2

or

σ p wAσ A + wBσ B
=

The portfolio standard deviation is a weighted average of the individual security standard
deviations only in the specific case of perfect positive correlation ρ AB = 1.0 . There are no

diversification gains in this case because no matter what the proportions of asset A and asset B
are, both the portfolio mean and the standard deviation are only weighted averages. Figure 2

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

below demonstrates the how correlation coefficients from +1 to -1 influence the opportunity set.
In the case of a perfect positive correlation the opportunity set is a straight line going through the
individual securities A and B. No portfolio in the figure can be labeled as inefficient, and the
investor choice among the different portfolios will be dependant only on the investors’ risk
preference.

E (r )

ρ = −1
B
ρ =0 ρ =1

0 < ρ <1

Figure 2: Correlation coefficients for assets A and B


(Authors’ own creation)

Diversification effect is nonexistent in the case of perfect positive correlation. A correlation


coefficient ρ < 1 indicates that there will be a diversification effect as the portfolio standard
deviation is less than the weighted average of the standard deviations of the individual assets.
Hence, there are benefits stemming from diversification when security returns’ correlation
coefficient is less than 1.

The larger the negative correlation, the greater the diversification benefits to the portfolio risk
will be. With perfect negative correlation, the diversification effect will reduce the portfolio
standard deviation to zero. This is the most desirable outcome from investor’s perspective as all
portfolio risk is being completely wiped out.

All in all, Markowitz’s mean-variance analysis proves that an investor can diminish portfolio risk
by holding instruments which are not perfectly positively correlated. This means that investors

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

can reduce their exposure to individual asset risk by holding a diversified portfolio of securities.
Further, this diversification allows for achieving the same portfolio return with smaller risk, and
this is what makes Markowitz portfolio theory so groundbreaking and fundamental.

Markowitz efficient frontier

In a risk-return diagram all possible portfolios can be schematically represented. The efficient
frontier is the set of all attainable combinations of risk and return offered by portfolios
comprising the same assets in different proportions, for which there is lowest risk for a given
level of expected return. On the other hand, for a given risk level, the portfolio that is on the
efficient frontier will represent the combination that offers the best possible expected return. In
terms of mathematical representation, the efficient frontier is the intersection of minimum
variance portfolios and a set of portfolios with maximum return.

Figure 3 below demonstrates the set of all possible combinations of risk and return of portfolios
compiled of asset A and asset B in different proportions. MPT argues that rational investors
would prefer these portfolios that lie in the northwestern quadrant of the diagram as they have
high expected returns and low variability.

E (r ) B

A’

MVP V

Figure 3: Feasible investment set


(Authors’ own creation)

The curve AVB in Figure 3 is the feasible opportunity set representing all possible portfolio
combinations. Point V represents the minimum variance portfolio (MVP) since no other existing

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

portfolio offers lower volatility. All portfolios that are on the part of the curve that is below the
MVP should be rejected by investors as being inefficient. They do not meet the criteria of
maximizing expected return for a given level of risk. According to the fundamentals of utility
theory, investors would always prefer portfolios offering more return to less for a given risk level.
Hence, the investors can find portfolios on the upward sloping VB frontier that offer higher rate
of expected return for same value of standard deviation as opposed to the downward sloping VA
curve (e.g. portfolio A’ will dominate portfolio A because it offers a higher expected return for
the same level of volatility). Thus, the curve VB represents all possible efficient portfolios and is
called the efficient frontier because it represents the set of portfolios that offers the highest
possible return for each level of portfolio variance.

The choice among the portfolios on the upward sloping efficient frontier will depend on the risk
preferences of the investors. There is a risk/return tradeoff, because in this part of the curve the
higher expected return comes at the cost of higher risk.

E (r )
Efficient frontier

Individual assets
MVP

Figure 4: Markowitz' efficient frontier


(Authors’ own creation)

Short selling

Short selling is an investment technique, which is often employed by hedge funds. It involves
selling assets that an investor does not own, but has borrowed from a broker, expecting an
eventual drop price of the borrowed asset. When the price of a security declines, then the investor

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

buys back an equivalent number of assets at the new lower price and returns to the lender the
borrowed securities. The difference that remains from selling the assets at different price level is
the profit for the short seller.

Short selling constraint in imposed by authorities on traditional investment funds as it involves a


high level of risk. Employing this investment technique by hedge funds, however, is a possible
valid explanation of the alleged claim that these alternative investment vehicles are indeed able to
produce absolute returns regardless of any market conditions.

Having asset A and asset B, and given that E (rA ) ≥ E (rB ) and σ A ≥ σ B , then with short sales

allowed, an investor could sell short asset B and reinvest in A. If the number of short sales is
unrestricted, and the investor constantly sells asset B and reinvests in A, then he/she could
generate an unlimited expected return.

With short sales allowed, the upper limit of the highest-return portfolio would be infinity.
Reversely, an investor could short sell security A and reinvest in security B, and in such way
generate a return less than the return on the lowest-return assets. If short selling is unrestricted,
then an infinitely negative return can be achieved, thereby removing the lower limit on the
efficient frontier. Therefore, short selling could at least in theory increase the range of alternative
investments from the MVP to plus or minus infinity.

Calculating the MVP

The portfolio selection problem in the context of the Markowitz framework can be expressed as
maximizing the expected return E (rp ) in regards with the risk of the investment σ p or

minimizing the risk with respect to a given return.

Mathematically, the portfolio selection problem can be formulated in the following way: for two
risky assets A and B the portfolio consists of the proportions wA , wB , and the weights are chosen
so that the risk is minimized:

Min σ P2 = wA 2σ A 2 + wB 2σ B 2 + 2 wA wB ρ ABσ Aσ B
wA

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

for each chosen return and subject to wA + wB= 1, wA ≥ 0, wB ≥ 0 . The last two constraints infer

that the securities cannot be sold short.

Correlation of two assets weight of asset A weight of asset B

ρ=1 σB σ A − 2σ B
wA = wB =
σ A −σ B σ A −σ B

ρ = -1 σB σA
wA = wB =
σ A +σB σ A +σB

ρ=0 σ2 σ 2 − 2σ 2
wA = 2 B
wB = 2 A B

σ +σ 2 A B
σ +σ 2
A B

Table 1: MVP weights with short sales constraint imposed


The example above represents the case of a two-asset portfolio. For the more general case of
portfolios containing N assets, the minimum portfolio weights can be calculated by minimizing
the Lagrange function C for portfolio variance.

n n
Min σ = ∑∑ wi w j ρijσ iσ j
2
p
=i 1 =j 1

Subject to w1 + w2 + ... + wN =
1

( i j ) 1  ∑Wi 

n n n
=C ∑∑
=i 1 =j 1
w w
i j Cov r r + λ 1 −
 =i 1 

in which λ1 are the Lagrange multipliers, ρij is the correlation coefficient between ri and rj .

In such way, the minimum variance can be calculated for any given level of expected portfolio
return, subject to the constraint that the weights sum to one.

Calculating the weights of optimal risky portfolio

The previous section introduced the approach for calculating the MVP and minimizing the
variance of the portfolio subject to the portfolio weights summing to one. In this section we

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

bring in a target expected rate of return in order to obtain an optimal risky portfolio.
Mathematically this is attained in the following manner:

n n
Min σ p2 = ∑∑ WiW j ρijσ iσ j
=i 1 =j 1

Subject to


i =1
Wi E ( ri ) = E * , where E * is the target expected return and


i=1
Wi = 1.0

The first constraint indicates that the expected return on the portfolio E ( ri ) ought to be equal to

the target return E * determined by the portfolio manager. The second constraint shows that the
weights of the securities invested in the portfolio must sum to one.

The Lagrangian objective function can be written as:

 * n   
( )
n n n
=C ∑∑
=i 1 =j 1
w w
i j Cov r r
i j + λ1

E − ∑
=i 1
wi E ( r )
i 

+ λ2 1 − ∑
 =i 1 
wi 

Calculating the partial derivatives of the equation above with respect to each of the variables,
w1 , w2 ,...., wN , λ1 , λ2 and then setting the resulting equations equal to zero, will achieve the
minimization of the portfolio variance subject to the Lagrangian constraints. Then, one can obtain
the weights of the optimal risky portfolio with the help of matrix algebra.

n n
With short selling allowed, the second constraint, ∑ wi = 1 should be substituted by ∑ wi = 1.0 ,
i =1 i =1

where the absolute value of the weights wi allows for a given wi to be negative (sold short), but

maintains the requirement that the sum of the invested assets equals one. The Lagrangian
function is then:
 * n   
( )
n n n
=C ∑∑
=i 1 =j 1
w w
i j Cov r r
i j + λ1

E − ∑
=i 1
wi E ( r )
i 

+ λ2 1 −
 =i 1
∑ wi 

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The optimal risky portfolio

As previously mentioned, an investor in a portfolio with expected return E (rp ) and standard

deviation σ p has the following utility function:

U E (rp ) − 0.005 Aσ p2
=

where U is the investor’s utility function and A represents the level of an investor’s risk
aversion.

Portfolio selection, then, is determined by plotting investors’ utility functions together with the
efficient-frontier set of available investment opportunities. In Figure 5, utility indifference curves
are displayed together with the efficient frontier. The curve with the steeper slope infers a greater
level of risk aversion, and the investor is indifferent towards any combination of expected return
and risk along this curve. The utility curve with the flatter slope signifies a smaller degree of risk-
aversion, and hence the investor would accept a higher level of volatility in order to obtain higher
return. The optimal portfolio is the one that provides the highest utility, and in Figure 5 these are
points A and B for the investors with different risk-return preferences. Both points are tangent of
the respective utility curve and the efficient frontier, and each of them results in an optimal
portfolio for a given level of risk aversion.

E (r )

B
A Efficient frontier

MVP
σ

Figure 5: Efficient frontier and investors' indifference utility curves


(Authors’ own creation)

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Determining the optimal risky portfolios can be done by using the Capital Allocation Line
(CAL). It denotes all feasible risk-return combinations attainable from different asset allocation
choices.

In the case of two risky assets A and B, and a risk-free asset, the initial objective would be to find
the weights wA and wB that result in the highest slope of the CAL as this would result in defining

the risky portfolio with the highest Sharpe ratio. Hence, the aim is to maximize the slope of the
CAL (denoted by CALS ) for any possible portfolio (P). The formula for the slope of CAL is given

by:

E (rp ) − rf
CALS =
σp

For the portfolio with two risky assets, the expected return and standard deviation are:

=
E (rP ) wA E (rA ) + wB E (rB )

σ P = ( wA 2σ A 2 + wB 2σ B 2 + 2wA wB ρ ABσ Aσ B )1/ 2

When maximizing CALS , one ought to fulfill the constraint that the portfolio weights should sum
to 1. Mathematically, the formula is written as:

E (rp ) − rf
max CAL =
wi
S
σp

subject to. ∑w i =1

In this case of two risky assets, the weights of the optimal risky portfolio are computed as
follows:

[ E (rA ) − rf ]σ B2 − [ E (rB ) − rf ]ρ ABσ Aσ B


wA =
[ E (rA ) − rf ]σ B2 + [ E (rB ) − rf ]σ A2 − [ E (rA ) − rf + E (rB ) − rf ]ρ ABσ Aσ B
wB = 1 − wA

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Then, an optimal complete portfolio can be formed from an optimal risky portfolio and the CAL.
The individual investor’s degree of risk aversion, A, should be used to calculate the optimal
proportion of the complete portfolio which to invest in the risky component.

Given a risk-free rate, denoted by rf , and a risky portfolio with expected return E (rp ) and

standard deviation σ p , for any choice of y the expected return of the complete portfolio will be:

E (rC ) =
rf + y[ E (rp ) − rf ]

And the variance of the overall portfolio is given by:

σ C2 = y 2σ p2

The investor ties to maximize his/her utility, U, by choosing the best allocation to the risky asset
y . The utility maximization problem can be written more generally as:

max U=E (r ) − 0.005 Aσ =rf + y[ E (rp ) − rf ] − 0.005 Ay 2σ p2


2
C C
y

When the derivative of the expression is set to zero, then the optimal allocation for risk-averse
investors in the risky asset, y* , is found by:

E (rp ) − rf
y* =
0.01Aσ p2

This solution indicates that the optimal allocation in the risky asset is directly proportional to the
risk premium and inversely proportional to the level of risk aversion and the level of risk. Figure
6 below demonstrates how an optimal portfolio is being determined.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

CAL
E (r )

Indifference Curve

Opportunity Set of Risky


Assets

Optimal Risky Portfolio

rf Optimal MVP
Complete
Portfolio
σ

Figure 6: Determining an optimal risky portfolio and optimal complete portfolio

(Authors’ own creation)

3.1.3. Assumptions underpinning Markowitz portfolio theory

This classical mean-variance analysis developed by Markowitz relies decisively on two


assumptions: (1) either the investors have quadratic utility or (2) the returns of the securities are
jointly normally, symmetrically distributed. It is important to note that both assumptions are not
required at the same time, one is considered sufficient.

Assumption 1: quadratic utility

If investors have quadratic preferences represented as below, then the mean-variance


optimization is appropriate:

U (W
= ) aW − bW 2
The formula above indicates that if an investor has quadratic preferences, he/she only cares about
the first two moments of a return distribution, namely the mean and variance of returns; higher
statistical moments such as skewness and kurtosis according to the MPT have no effect on the
expected utility, which means that the investor would be indifferent in the case of extreme losses,
which is contradicting with rational investment behavior. Hence, quadratic utility has been
proven to be inconsistent with rational investor decision making with respect to avoiding risk.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Assumption 2: normal distribution

Markowitz’ mean-variance analysis relies predominantly on the assumption that the returns of the
assets in a portfolio context are jointly normally distributed, which infers that the mean and the
variance would completely describe the return distribution. The normal distribution is symmetric,
thus its 3rd moment referred to as skewness would be 0. The 4th moment, which is called kurtosis,
in the case of a normal distribution has a value of 3. It has been proven that returns of hedge
funds do exhibit higher moments, and that the assumption of normality does not apply to them.
For this reason the concept about normality of the return distribution as well as statistical
moments of higher order are being presented in more detail in an upcoming section.

3.2. Risk-adjusted performance measures: The Sharpe ratio (SR)

The ‘reward-to-variability’ ratio, more commonly known as the Sharpe ratio, is a measure of
risk-adjusted performance, proposed by William Sharpe in 1966. This ratio, which is relatively
simple, measures the amount of excess return per unit of volatility (Lhabitant, 2004). The SR is
intended to provide a convenient summary of these two important aspects for any investment
strategy involving the difference between the return of a fund and that of a relevant benchmark,
and when properly utilized, the SR can improve the process of making sound investment
decisions.

The Sharpe Ratio is mathematically represented with the following formula:

RP − RF
Sharpe Ratio P =
σP

Where:

RP is the expected return on portfolio P, normally annualized

RF is the risk-free rate, which is annualized if the portfolio return is annualized

σ P stands for the portfolio return’s standard deviation, which is also annualized, provided that
the portfolio return is annualized.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The Sharpe ratio has important implications for investors and their preference of risk level. The
Sharpe ratio simply measures the slope of the line from the risk free rate, which is the starting
point for any investor, to the combined return and risk of each portfolio. The steeper the slope is,
the higher the Sharpe ratio, and hence the better the combined performance of risk and return.

The SR builds upon Markowitz' MPT, which assumes that the first two moments of the
distribution of returns are sufficient statistics for evaluating the forecasted characteristics of an
investment portfolio. The evaluation based on the mean and the standard deviation of a
distribution do not take into account possible differences among portfolios in other moments or in
distributions of outcomes that may be associated with different levels of investor utility, and this
is considered a potential pitfall when measuring the performance of hedge fund investment
strategies.

It is worth noting that any measure, including the SR, which tries to make an unbiased prediction
of the performance of investment funds, requires an extensive set of assumptions for justification.
In reality, these assumptions are at best likely to hold only approximately. With respect to this,
the use of unadjusted ex post SRs as inputs for unbiased predictions of ex ante SRs is subject to
serious question. Despite this potential drawback, however, the SR is considered a very useful
performance measure as it takes into account both risk and expected return unlike alternatives
that focus only on the latter.

With regards to investment decisions, ex ante SRs can endow with important inputs. When
selecting a fund among a set of funds to provide representation in a particular market, it is
reasonable to include the one with the greatest predicted SR. When allocating assets among
several funds, it is practical and prudent to allocate them such that the residual risk levels are
proportional to the ex ante SRs for the residual returns (Sharpe, 1994).

It is vital to keep in mind that the SR does not consider correlations, and when an investment
decision may affect correlations with other assets in an investor's portfolio, such information
should be used to supplement comparisons based on SRs.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

3.3. Normal distribution and statistical moments of higher order

As previously mentioned, the foundation of modern portfolio theory is centered on the


relationship and the tradeoff between risk and return. The models of Markowitz (1952) extended
by these of Sharpe (1964) and Lintner (1965) with the Capital Asset Pricing Model (CAPM) have
contributed to our understanding as to how risky assets are priced in the market. However, these
theoretical frameworks have proven to be constrained when evaluating the performance of hedge
funds because of the specific assumptions that they make.

The ground-breaking portfolio evaluation techniques of Sharpe (1966), Jensen (1968, 1969) and
Treynor (1965) are all firmly grounded in MPT. The first and foremost assumption shared by all
of them is a reliance on only the first and second moments of the return distribution. Secondly,
from a performance evaluation perspective, the models assume that investors only price securities
in terms of mean and variance of returns, thus assuming that accounting for the higher moments
of a return distribution such as skewness and kurtosis is redundant and irrelevant.

However, empirical studies e.g. Leland (1999), Cotton (2000), have confirmed that the
distributional properties of asset returns with respect to hedge funds are inconsistent with a
normal distribution. Academics and practitioners advocate the use of additional risk measures
embodied in the higher moments of return distributions in order to capture additional elements of
portfolio risk as well as more accurate information content to be able to analyze the active
management ability of professional investors. If the models do not accurately measure portfolio
risk (β), then the risk-adjusted performance measure (α) will provide the investment analysts with
incorrect presumptions concerning investment performance. Thus, the 3rd and 4th moment of a
return distribution are of great significance when evaluating the performance of hedge fund
investment strategies, and they should not be omitted, but presented and discussed in detail.

This specific section of the thesis will scrutinize the fundaments of return distributions in a
manner that accounts for non-symmetries, such that improved inferences can be made concerning
the performance and risk attributes of hedge fund investment managers.

We start with presentation of the concept of normal distribution, and continue with discussion on
the statistical moments of higher order which are proven to affect the performance of hedge funds
investment strategies.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

3.3.1. Normal Distribution

The normal distribution, also referred to as Gaussian distribution, resembles a bell-shaped curve.
It is the most widely studied probability distribution in statistics, and it plays a central role in
finance. Perfect symmetry is consistent with a normal distribution, where the mean, median and
mode all exhibit the same value.

The concept of normal distribution can be essential in explaining the portfolio characteristics as it
displays some convenient properties. In essence, the whole distribution can be characterized by
its two first moments, namely its mean return and its variance:

(
N µ ,σ 2 )
The mean return represents the location, whereas the variance characterizes the dispersion. The
distribution function is represented by the following expression:


( x − µ )2
1
f ( x) =
Φ ( x) = e 2σ 2

2πσ 2

The Greek letter µ stands for the mean, which is the location of the peak; σ 2 on the other hand
signifies the variance and measures the width of the distribution. The normal distribution has a µ

=0 and σ 2 =1. A very important characteristic for a normally distributed variable is that it has
symmetric distribution around its mean.

The characteristics of the normal distribution can be very useful as there is a strong connection
between the size of the sample N and the extent to which a sampling distribution approaches the
normal form. Many sampling distributions based on large N can be approximated by the normal
distribution even though the population distribution itself is not normal.

Often, as a measure for volatility we take the square root of the variance, which is referred to as
standard deviation, and is denoted by σ . It measures to what extent a portfolio fluctuates with
respect to its mean return over time. It is mathematically represented with the following formula:

1 T
∑ ( Rt −1,t − R )
2

T − 1 t =1

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Normal distribution is assumed by many performance measurement models, including the


Markowitz mean-variance analysis and the Sharpe ratio. The latter two are perfectly applicable to
measuring the return characteristics of traditional asset classes. Hedge funds, however, do not
conform to the presumption for normality of distribution of their returns, and beside the mean and
variance, one needs to consider two higher order statistical moments to describe the active return
distribution of this alternative asset class. These are the 3rd and the 4th moments, skewness and
excess kurtosis, and they account for the non-symmetries of the return distributions. The former
describes departures from symmetry; whereas the latter depicts the degree of flatness of a
distribution. The subsequent paragraphs outline the characteristics of these 2 statistical moments
of higher order in a return distribution.

3.3.2. Skewness

Skewness is the third central moment of a distribution, and it is a measure of the asymmetry of
the distribution around the mean. Statistically, skewness uses the ratio of the average cubed
deviations from the mean, called the third moment. Skewness is formally represented by the
following formula:

3
T  R
T t −1,t − R 
Skewness = ∑ 
(T − 1)(T − 2) t =1  σ

where T is the number of observations (Lhabitant, 2004). The measure preserves the sign of the
cubic deviation from the mean. Thus, if the distribution is skewed to the right, the extreme
positive values will dominate the third moment, resulting in a positive measure of the skew.
However, if the distribution is skewed to the left, then the cubed extreme negative values will
dominate, and the skew will be negative in value. Not surprisingly, investors prefer positive to
negative skewness. In the case of normal distribution the curve is symmetrical and has a
skewness coefficient equal to zero.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Figure 7: Skewness (Source: Gujarati, 1995)

If the distribution is positively skewed, the standard deviation is deemed to overestimate the risk
as extreme positive deviations from expectation nevertheless increase the degree of volatility
(Bodie, Kane and Marcus, 2009). On the other hand, and more importantly, when the distribution
is negatively skewed, the standard deviation will underestimate risk.

3.3.3. Kurtosis

Kurtosis is the fourth central moment of a distribution, and it measures the peakedness and
heaviness of the tails of a distribution (Lhabitant, 2004). It is another important deviation from
normality, which is highly applicable to hedge funds. It concerns the likelihood of extreme values
on either side of the mean at the expense of a smaller fraction of moderate deviations. Put
otherwise, when the tails of a distribution are fat, then there is more mass in the tails then
predicted by the normal distribution, which is at the expense of a mass near the center of a
distribution. In the case of a preserved symmetrical fat-tailed distribution, the standard deviation
will underestimate the likelihood of extreme events such as large gains and large losses.
Distributions are defined to be platykurtic, when they display positive kurtosis. Graphically they
would display a distinct peak near the mean, decline rapidly, and have heavy tails. When
distributions are clustered near the mean, they are identified as leptokurtic and have negative
kurtosis. Again, graphically they display a flat peak near the mean, and a uniform distribution is
an extreme case. A normal distribution is labeled mesokurtic with a kurtosis of three 7.

7
The measure of kurtosis has often a value of 3, which however is being subtracted as displayed by the equation in
the main text of the thesis, which follows Lhabitant (2004). In such cases, distributions satisfying the normality
assumptions would be expected to generate kurtosis values equal to 0.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Figure 8: Kurtosis (Source: Gujarati, 1995)

Formally, kurtosis is defined as:

T (T + 1) 3 (T − 1)
4
 Rt −1,t − R 
2
T
Kurtosis = ∑   −
(T − 1)(T − 2 )(T − 3) t =1  σ  (T − 2 )(T − 3)

where T is the number of observations (Lhabitant, 2004). The measure is always positive
regardless of the sign of the deviation of the observation from the mean.

3.3.4. Jarque-Bera test for normality of distributions

The Jarque-Bera (JB) test, which is also employed by us in this thesis, measures the departure
from normality in return distributions based on skewness and kurtosis. The general formula for
JB is defined as:

 S 2 ( K − 3)2 
JB n  +
= 
 6 24 
 

where

n is the number of observations or degrees of freedom,

S is skewness,

and K is kurtosis.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

For the case of perfectly normal distribution we have S = 0, K = 3 and JB = 0. JB has in fact the
distribution of χ 22 ( χ 2 with two degrees of freedom); thus, we accept the null hypothesis

H 0 : S = 0 and K = 3 with error term ε if and only if JB < χ 2;2 ε .

3.3.5. The importance of the 3rd and the 4th moment for hedge fund investors

For a hedge fund manager it is vital to choose for his/her investors an investment strategy, which
corresponds best with the preferences and the expected risk-return profile of the investor, i.e. the
expectations towards portfolio diversification, risk-return characteristics, and yield enhancement.
Many investors, however, may have distinguishable investment goals that go beyond quadratic
utility, and implicitly or explicitly include preferences towards the higher moment return
characteristics of their investments. For example there would be investors who would care about
extreme losses; therefore the absence of leptokurtosis in the return distributions of their
investments would be very important to them. For this reason a classical mean variance
optimization will not meet the preferences and expectations of this kind of investors, because the
variance as a risk measure firstly fails to grasp the risk correctly, and secondly does not take into
account more complex investor preferences. Hence, we believe that a diligent hedge fund
manager will have to consider the existing skewness and kurtosis, not only to be able to account
for the specific return characteristics of the single hedge fund investment strategies, but at the
same time to consider the preferences of the investors in his/her optimization model.

Skewness and excess kurtosis are of big importance for investors in hedge funds since they
considerably influence the probability of certain outcomes and returns. For example the
symmetric Gaussian distribution exhibits more returns on the left tail than a positively, right-
skewed distribution. The opposite holds also true: the normal distribution displays fewer returns
on the left tail than a negatively, left-skewed distribution.

In addition, a positive skewed distribution has more returns below the mean than a normal
distribution, meaning that investors would earn on average smaller returns. Negative skewed
distribution displays more returns above the mean as compared to Gaussian distribution, which
indicates higher returns on average. However, the average smaller returns are being offset by the
probability of earning very large positive returns as it is in the case of a positively skewed return
distribution, and these positive returns are far larger than those typical for a comparable

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

symmetric distribution. On the other hand, negative skewness would imply there is a probability
of achieving many small gains, but also extremely large losses (Lhabitant, 2004). It is not
surprising that investors care a great deal about skewness and achieving positive skewness is
preferred by them as witnessed by Kraus and Litzenberger (1976).

Return distributions with excess kurtosis commonly display higher and more frequent extreme
events in comparison to a symmetrical Gaussian distribution. Thus, the mean average loss for
distributions with leptokurtosis is considerably higher. This comes as a result from the increased
probability that these distributions will show a higher or more acute peak compared to a normal
distribution. As a consequence, most returns would lie in a very close range to the mean. Risk-
averse investors, who by definition care a great deal about extreme losses, may avoid them by
investing in asset classes with return distribution without leptokurtosis. This, however, would
come together with a more volatile and unpredictable payoff around the mean.

The importance of skewness and kurtosis is a thoroughly researched topic in the financial
literature. Friedman and Savage (1948) were among the first to investigate on the importance of
skewness in decision making in gambling such as lottery game. Amenc et al. (2004) assert that
investors of alternative asset classes such as e.g. hedge funds would be knowledgeable about the
existence of higher moments in their return distribution. Consequently, they would be concerned
about the shape of the return distribution because it considerably influences the probability for
them to earn certain returns. Fang and Lai (1997) found arguments that investors distinguish
differences in kurtosis.

A very important characteristic of the 3rd and the 4th moments is that they are not independent of
each other. Furthermore, they cannot be diversified away by increasing the number of assets in a
hedge fund portfolio. These 2 very essential aspects of skewness and kurtosis for a hedge fund
manager have been researched by i.e. Brockett and Garven (1998), Harvey et al. (2003). These
findings come as a confirmation that higher statistical moments up to the fourth are of big
importance for hedge fund managers, and they need to be taken into consideration when choosing
an asset allocation model in order to reflect the investors’ needs and preferences in a correct
manner.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

When the return distribution of a certain asset class displays significant skewness and kurtosis,
then using variance as a risk measure becomes impractical for measuring and evaluating the risk
characteristics of the investments. As a result of this, the classical Markowitz portfolio theory
along with the Sharpe ratio does not display accurate and efficient results. Scott and Horvath
(1980b) were among the first to witness this discrepancy.

Cvitanic et al. (2007) argue that if higher moments are not taken into account, then a hedge fund
manager will surely underestimate the riskiness of the investments made, and the portfolio
optimization may lead to a significant overinvestment in risky assets, especially in the presence
of high volatility. Jondeau and Rockinger (2005) also claim that non-normality can lead a mean-
variance optimization to large opportunity costs. Thus, in order to account for the preferences of
investors correctly as well as for the desired return characteristics, we need in our thesis to
present a model which allows for the incorporation of the third and fourth moments. In the
subsequent section we will introduce an alternative measure of risk, and namely such that
includes the presence of skewness and kurtosis.

3.4. Downside risk measures: Value-at-risk (VaR)

In the previous sections we introduced the MPT and the SR as traditional models for measuring
the performance of investment funds. However, the difficulty with respect to them is that when
the requirement of a normal distribution of the returns is not satisfied, then the volatility as a risk
measure seems to be insufficient, and omitting important statistical characteristics may result in
overestimation of the performance of a fund while underestimating the risk level. This comes as a
result from the fact that hedge funds’ returns depart from normality and exhibit negative
skewness and positive kurtosis, especially in the case of convertible arbitrage, risk arbitrage and
distressed securities (Brooks and Kat, 2002).

The reason why VaR is being introduced in this thesis is because it is measure that summarizes a
portfolio exposure to market risk as well as it detects the probability of an unfavorable move.

VaR is a quantitative measurement tool for risk management. It measures the worst possible loss
that can occur under normal market conditions over a specific time horizon at a predefined
confidence level. Further, VaR can be regarded as the lowest quantile of the potential loss that
can occur with χ % probability within a given portfolio during a specified time period (Jorion,

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

2007). The basic time period T and the confidence level (the quantile) q are the two major
parameters in the VaR model. T can differ from a few hours for an active trading desk to a year
for a pension fund, while q is typically set at 95% or 99%.

VaR has the following advantages as a measure of risk:

• VaR can better reflect the risk preferences of investors.


• It has become an industry standard for measuring risk.
• It has been extensively researched and analyzed.
• It can be easily modified and extended to non-normally distributed returns.

As we know risk is measured by the dispersion of the possible outcomes, and a flatter distribution
signifies a higher risk, whereas a tighter distribution means lower risk. VaR as a model allows to
measure the downside risk by the quantiles, which are the cutoff values q such that the area to the
left or right represents a given probability c:

+∞
c =prob ( X ≥ q ) =∫ f ( x ) dx =−
1 F (q)
−α

VaR’s biggest advantage is the fact that it can summarize in a single number the downside risk of
an investment fund due to financial market variables (Jorion, 2007). VaR can be derived from
probability distributions in two ways: either from taking into account the actual empirical
distribution or by using a parametric approximation of the distribution.

There are few inputs that are needed to calculate VaR:

• Size of the portfolio


• Measure of the variability of the risk factors
• Time horizon
• Confidence level

Following Favre and Galéano (2002), VaR can be mathematically expressed as:

= W ( µ − zα σ )
VaR

Where:

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

W is the initial investment;

µ and σ as parameters are expressed on an annual basis;

zα is the alpha-quantile of a standard normal distribution.

Hedge fund returns as already discussed are skewed and fat-tailed; hence the VaR formula, which
assumes a normal distribution, is not particularly useful and applicable for hedge fund return
distributions. VaR, however, has one very important characteristic, and namely it can be easily
modified, so that it can take into account the impact of the third and the fourth moments. In this
thesis the modification is done with the help of the Cornish-Fisher expansion, which allows
adjusting VaR for the estimated skewness and kurtosis.

The VaR formula is being replaced by the MVaR formula:

= W ( µ − zCF σ )
MVaR

Where the Cornish-Fisher expansion is represented by the following formula:

zCF =zc +
6
(
1 2
)
zc − 1 S +
1 3
24
( )
zc − 3 zc K −
1
36
( )
2 zc3 − 5 zc S 2

zc is the critical value for probability (1-α);

S stands for skewness;

K stands for excess kurtosis.

zc in the formula is equal to –2.33 for a 99% probability or to –1.96 for a 95% probability. The
modified VaR allows computing the Value-at-Risk for distributions with asymmetry (positive or
negative skewness) and fat tails (positive excess kurtosis). If the distribution is Gaussian, then
zCF is equal to zc , and hence the risk is measured only with volatility.

3.4.1. Markowitz optimization with VaR

In order to show the impact of data adjustments on the calculated portfolios, certain steps need to
be taken. The standard portfolios, calculated on the basis of Markowitz framework inform us

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

what exact fractions are to be invested in a given asset, to meet the requirement of achieving the
highest return/risk ratio. Having the weights, we can calculate the monthly returns of an
optimized portfolio, based on the monthly returns of respective assets, and with that the exact
mean and standard deviation of the portfolios. These calculations do not take yet into account the
data adjustments.

Further, incorporation of data adjustments into the portfolio effectiveness ratio requires
introduction of a new risk measure. The comparability between the optimization results of the
classical approach, and the adjusted approach is possible having the unadjusted data portfolio’s
risk expressed in the form of Value at Risk replacing the standard deviation, while the adjusted
portfolio uses a related Modified Value at Risk.

Value at Risk for each portfolio can be calculated straight from the values of their mean and
standard deviation. Effecting return/risk ratio is calculated by dividing the portfolio mean by its
Value at Risk.

Calculating portfolio’s MVaR requires more effort. Portfolio’s expected return is calculated as a
weighted average (weights according to the initial optimization) of respective assets’, bias
adjusted (bias applied to hedge fund mean return only) mean returns.

Standard deviations of included assets adjusted for autocorrelation are used, together with
portfolio weights and correlation coefficients between the assets, to calculate the new, partially
adjusted standard deviation of a portfolio (formula used calculates variance, standard deviation is
easily derived from it).

Based on the portfolio returns for each point in time, skewness and kurtosis are calculated (for
each standard portfolio), and then used to determine the Cornish-Fisher expansion value. With
the above three, adjusted portfolio expected return, standard deviation and Cornish-Fisher
expansion, the numerical value of MVaR is calculated according to the formula.

The described procedure is repeated for each portfolio and in each case it results in two, directly
comparable portfolio efficiency ratios, return/VaR (unadjusted data) and bias adjusted
return/MVaR (all adjustments considered).

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

By comparing the two ratios the impact of hidden data deficiencies on the attractiveness of
calculated portfolio can be shown. Keeping the same weights before and after adjustment, instead
of calculating the new fractions based on the adjusted data, displays and stresses the level of
underestimation of portfolios risk and overestimation of its expected return when the same
portfolio is analyzed traditionally and in a more in depth manner.

3.5. Autocorrelation

In this section of the thesis we present a very important issue with respect to the return profile of
hedge funds and namely the existence of serial correlation, also referred to as autocorrelation.
Hedge fund returns cannot be assessed solely with the help of the Markowitz portfolio theory,
and the Sharpe ratio as these models fail to capture the autocorrelation, which creates a distortion
in the data points of the return distribution and give false signals to investors. For this reason, we
believe that the issue of serial correlation is very important and should not be omitted. It is our
intent to firstly examine the causes for autocorrelation, and secondly to show how a fund
manager can test for it, and how to correct the data if serial correlation is proven to exist in a
return distribution.

3.5.1. Defining autocorrelation

Autocorrelation is by definition a ‘mathematical representation of the degree of similarity


between a given time series and a lagged version of itself over successive time intervals. It is the
same as calculating the correlation between two different time series, except that the same time
series is used twice - once in its original form and once lagged one or more time periods.’ 8
Positive autocorrelation in returns occurs when same sign, positive or negative, appears
repeatedly in consecutive months; negative autocorrelation occurs when signs differ.

After having established that autocorrelation is the correlation of a variable with itself over
successive time intervals, we need to mention that it has an important implication for a security
analysis. In the context of the hedge fund returns, technical analysts would use the
autocorrelation to determine how well the past price of a security predicts the future price. For
instance, if an investor has observed that an asset has historically displayed a high positive
autocorrelation value, and this investor has witnessed that the security has gained in value over
8
http://www.investopedia.com/terms/a/autocorrelation.asp

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

the past several days, then he/she should logically expect the movements in value of the security
for the upcoming several days (the leading time series) to match those of the lagging time series,
and hence the asset value to move upwards.

3.5.2. Causes for the existence of autocorrelation

There are four potential sources for autocorrelation in assets returns: market inefficiencies; time-
varying expected returns; time-varying leverage; and incentive fees with high watermarks
(Getmansky et al., 2004).

Market inefficiencies:

The most common explanation for the existence of autocorrelation is the infringement of the
efficient market hypothesis, which is fundamental in modern finance theory. Samuelson (1965)
proved that when prices are properly anticipated, then they fluctuate randomly. The implication is
that in an efficient market with perfect information, all price changes must be unforecastable if
they are properly anticipated.

The concept of the efficient markets seems a bit contradictory by nature: is generally states that
the more efficient the market, the more random the sequence of price changes generated by that
market. With respect to that, a truly efficient market would be the one, where the price changes
are completely random and unpredictable. This comes as an outcome of the fact that the investors
try to use the information they possess for their own profit.

In the context of hedge fund returns, the presence of autocorrelation can be attributed to the fact
that the hedge fund manager cannot fully utilize the information of alpha (α) contained in his/her
strategy. If the hedge fund manager’s returns are highly positively correlated, then at least in
theory, he/she should be able to exploit this fact to improve the performance of his/her hedge
fund strategy in the following manner: when the performance has been good in the previous
months, then due to the positive serial correlation the investor should increase his/her positions,
anticipating continued good results; in the months of bad performance, the investor should
decrease his/her bets because of the anticipated repeated bad results.

Getmansky et al. (2004), however, point out that autocorrelation is erroneously associated with
market inefficiencies. If this were true then it would imply a violation of the ‘random walk

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hypothesis’ and a predictability of the expected returns. Instead, these researchers argue that
autocorrelation is not a consequence of unexploited profit opportunities, but is a result of illiquid
securities that constitute part of the hedge funds’ portfolio. By illiquid securities they mean all
securities that are not actively traded and for which market prices are not available. Furthermore,
for portfolios of illiquid securities, reported returns will tend to be smoother than true economic
returns, which will understate volatility and thus increase the value of the risk-adjusted
performance measures such as e.g. the Sharpe ratio.

Getmansky et al. (2004) argue that in the context of hedge funds serial correlation is the outcome
of illiquidity exposure, and it may not be entirely attributed to nonsynchronous trading, which
may be one symptom or by-product of illiquidity. It is, however, only one aspect of illiquidity
that affects hedge-fund returns. The researchers allege that even if prices are sampled
synchronously, they may still yield highly serially correlated returns if the securities are not
actively traded.

The economic impact of serial correlation can be quite real. For example, serial correlation yields
misleading performance statistics such as mean, standard deviation, Sharpe ratio, correlation, and
market beta estimates. Specifically, the impact on the Sharpe ratio can be quite significant even
for mild forms of smoothing. All these above listed statistics are widely used by investors to
determine whether or not they should invest in a fund, how much capital to allocate, what kind of
risk exposures they are bearing, and when to redeem their investments.

The empirical findings of Getmansky et al. (2004) with regard to autocorrelation is that hedge
funds with the highest serial correlation tend to be the more illiquid funds, e.g., emerging market
debt, fixed income arbitrage, and after correcting for the effects of smoothed returns, some of the
most successful types of funds tend to display considerably less attractive performance
characteristics.

Time-varying expected returns (TVER)

LeRoy (1973), Rubinstein (1976), and Lucas (1978) allege that serial correlation in asset returns
is not necessarily a result from market inefficiencies, but may be attributed to time-varying
expected returns, which is aligned with the stipulations of the efficient market hypothesis,
meaning that TVER is not an indication of inefficient pricing. It can arise in securities market

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

equilibrium because the equilibrium returns of the available investments change over time; in
particular, the presence of TVER is fully compatible with the absence of arbitrage in securities
markets.

Time-varying leverage

Another possible source of serial correlation in hedge-fund returns could be time-varying


leverage. If investment managers change the extent to which they leverage their investment
strategies, and if these changes occur in response to lagged market conditions, then this is
equivalent to time-varying expected returns.

The typical leverage dynamics is to large degree a consequence of the trade-off between risk and
expected return: by increasing its leverage ratio, a hedge fund enhances its expected returns
proportionally, but also increases its return volatility and hence also its risk of default. Therefore,
creditors to hedge funds will impose some ceiling on the degree of leverage they are willing to
provide. When market prices move against a hedge fund's portfolio and thereby reducing the
value of the fund's collateral and increasing its leverage ratio, or when markets become more
volatile and the fund's risk exposure increases significantly, the creditors will demand the hedge
fund to either post additional collateral or liquidate a portion of its portfolio to bring the leverage
ratio back down to an acceptable level. As a result of this, the leverage ratio of a hedge fund
varies through time usually as a function of market prices and market volatility, and this
fluctuations cause serial correlation.

Incentive fees with high watermark

A last potential explanation for serial correlation could be the compensation structure of a typical
hedge fund. Most hedge funds charge an incentive fee coupled with a high ‘water mark’ that must
be surpassed before incentive fees are paid, so this dependence in the computation for net-of-fee
returns may cause autocorrelation. The incentive fee for the hedge fund industry is normally 20%
of excess returns above a benchmark, which is subject to a water mark, meaning that incentive
fees are paid only if the cumulative returns of the fund are ‘above water’, exceeding the
cumulative return of the benchmark since inception.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

This factor can produce serial correlation. When the fund is ‘below water’, then the incentive fee
is not being paid out, but over time, as the fund's cumulative performance rises ‘above water’, the
incentive fee is charged and the net-of-fee returns are reduced accordingly, and the effect is that
autocorrelation is being created.

3.5.3. Testing for autocorrelation

This thesis makes use of the Ljung-Box (L-B) test statistic to test for autocorrelation. This
particular test is chosen, because it is applicable for small samples. The test is based on the
autocorrelation coefficient rk which tells us how much dependence there is (and by implication
how much interdependency there is) between neighboring data points in the return series. The
autocorrelation coefficient should be zero (or close to zero) if the residuals are uncorrelated
(Pindyck and Rubinfeld, 1998).

The sample autocorrelation coefficient and the L-B statistic are given by:

cov ( rt , rt + k )
rk =
var ( rt )

s
T (T + 2 ) ∑ rk2 / (T − k )
Q=
k =1

where:

T = number of observations;

s = number of coefficients to test autocorrelation;

rk = autocorrelation coefficient (for lag k);

Q = portmanteau test statistic.

If the sample value of Q exceeds the critical value of a chi-square distribution with s degrees of
freedom (s equals the number of lags selected), then at least one value of r is statistically different
from zero at the specified significance level.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The null hypothesis is that none of the autocorrelation coefficients up to lag s are different from
zero. The null hypothesis of no autocorrelation and the alternative hypothesis can be expressed in
the following way:

H 0 : No serial correlation

H1 : Serial correlation exists

3.5.4. Dealing with autocorrelation

The problem of autocorrelation in time series data steered the academic attention towards
creating a framework for data modifications leading to an unbiased, free of autocorrelation data
sets. The researchers advocate two main groups of strategies when dealing with this issue. The
first group consists of ex ante suggestion on how samples should be taken to avoid
autocorrelation in the data. An example could be altering the frequency of observations, more
precisely widening the intervals so that the reasons for autocorrelation are ‘absorbed’ in and
diminish. The weak side of this approach is that the time intervals are often of crucial importance
and cannot be freely changed. The relevance and explanatory power of the model used are at
stake.

Autocorrelation is most often found during analysis of an already completed data set, often from
outside sources, provided by institutions etc. It is not possible to alter the sampling technique and
modifications need to be applied to the existing one. This constitutes the second group of
strategies, ex post approaches. Asness, Krail and Liew (2001) suggest a way of integrating
autocorrelation. Firstly, one needs to calculate the standard deviation based on the quarterly data,
and then annualize the monthly data and the quarterly data standard deviations calculated. If there
is a difference between the two annual standard deviations (e.g. quarterly is higher than the
monthly), then this implies that the data suffers from autocorrelation and the higher of the two
values, namely the quarterly standard deviation is to be used as a correct, unbiased one.

The unsmoothing of the returns according to Brooks and Kat (2002) is an alternative approach (in
the research literature it is also known as a Blundell/Ward filter). The presence of autocorrelation
implicates that the estimates of standard deviation are biased downwards, which is addressed by
creating a new, unsmoothed set of returns. The intention is for the new values to be more volatile,

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

which is believed to more accurately capture the characteristics of the underlying asset. The
assumption is that the observed, smoothed value of an index at a given time is a weighted average
of a true, unsmoothed value and a smoothed value observed in a preceding period. In this way an
equation is derived, one that yields an unsmoothed series with zero first order autocorrelation:

1 α
r *(t ) = r (t) − r ( t − 1)
(1 − α ) (1 − α )

where:

r*(t) is the unsmoothed (true) return time series;

r(t) is the observed (smoothed) return time series;

r(t-1) is the lagged (by one period) observed return time series ;

α is the autocorrelation coefficient at lag 1.

The newly constructed series will conveniently have the same mean and aside from rounding
errors, a value of zero first-order autocorrelation. The standard deviation of the new series can be
used as an unbiased (free from autocorrelation impact) estimate and used in performance
measurement with credibility. The direction and level of change in standard deviation depends on
the autocorrelation coefficient at lag 1. Positive coefficient means growing standard deviation,
with the growth being proportional to the value of the coefficient. Negative α will result in lower
standard deviation (reward for negative autocorrelation).

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

4. Chapter 4: Performance evaluation of hedge fund investment


strategies as standalone assets

4.1. Traditional approach of performance measurement and evaluation

4.1.1. Risk, return, and return/risk ratio

The foremost reason for investing in hedge funds is the assumed superior performance in
comparison to traditional asset classes, especially during bear markets. The alleged absolute
returns attained are at least in theory a consequence of the fact that hedge funds are subject to
almost no regulation and restrictions with regard to using dynamic trading strategies such as e.g.
short selling, using leverage, derivatives, etc. As a result of this, hedge funds supposedly deliver
better long-term results as compared to bonds and equities in times of financial distress. This
chapter’s main objective is to examine to what extent such claims are justified for the unadjusted
and adjusted data of the analyzed indices and individual hedge fund investment styles during the
period of 41 months of data observation between January 2007 and May 2010.

The traditional approach of analyzing the performance of the hedge fund investment strategies,
when measured on an individual basis as well as when juxtaposed with bonds and stocks, implies
that the first two statistical moments of a return distribution, namely the mean return and standard
deviation, along with the return-to-risk ratio for all three different asset classes, ought to be
directly compared. The mean indicates what return the investments have attained; the standard
deviation is a measure of the volatility of returns of the assets, whereas the risk-return ratio
displays the trade-off between return and risk. Comparing these 3 elements gives the initial input
for the intended evaluation of the individual performance of the different hedge fund investment
styles.

Table 2 below presents a summary of the return distributions of the individual hedge fund
investment strategies that comprise the DJCS hedge fund index as well as these of the analyzed
bond and equity indices.

Financiers infer based on empirical evidence that in bear markets bonds as a rule of thumb
outperform equities. The results shown in Table 2 clearly confirm that this assumption pertained
correct to the 41 months of data observation.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Group Index Mean return Standard Return/risk ratio


in % deviation in %
Aggregated Hedge Fund 0.2515 2.3169 0.1086
Convertible Arbitrage 0.2783 3.7411 0.0744
Dedicated Short Bias -0.3029 4.8790 -0.0621
Emerging Markets 0.2595 3.7826 0.0686
Equity Market Neutral 0.1666 1.5472 0.1077
DJCS Event Driven 0.3873 2.2332 0.1734
hedge Distressed 0.2241 2.2339 0.1003
fund index Event Driven Multi-Strategy 0.4907 2.3555 0.2083
Risk Arbitrage 0.4039 1.2770 0.3163
Fixed Income Arbitrage 0.0139 3.2041 0.0043
Global Macro 0.6539 2.1984 0.2974
Long/Short Equity 0.2202 2.8164 0.0782
Managed Futures 0.4390 3.3882 0.1296
Multi-Strategy 0.1749 2.4422 0.0716
Market Bonds Barclay’s Bonds Index 0.3437 1.2145 0.2830
indices S&P 500 -0.4636 5.5781 -0.0831
Stocks MSCI Emerging Markets 0.4577 9.0816 0.0504

Table 2: Mean, Standard Deviation and Risk/Return ratio of the relevant asset classes

On an index level, it is evident that bonds exhibited a much better performance for the period
January 2007 – May 2010 in comparison to the hedge fund general index and both the equity
indices. The general DJCS Hedge Fund Index displayed a modest return of 0.2515% and a return-
risk ratio of 0.1086. MSCI Emerging Markets exhibited a healthier return, which unfortunately
was at a cost of a very high level of volatility, thus bringing the return-risk ratio to a meager
0.0504. Worst performer on an index level for the observed period of 41 months was S&P 500,
which exhibited a negative return, coupled with high level of risk. This result is not surprising,
knowing the slump in the return of equities over the last more than 3 years.

Further, it is interesting to note that beta driven investment opportunities generated by the market
rallies prior to the autumn of 2007 have become scarcer in the period between 2007-2010, and
most equity market performance expectations remained below their prior levels. As a result, we

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

believe that hedge fund strategies’ returns were less driven by systematic or beta risks than they
have been in the last 6 years prior the financial crisis of 2007.

Barclay’s Bond index on the other hand displayed positive and steadier month-over-month
returns compared to the more volatile hedge fund and equity indices. The bond index exhibited a
stable mean return of 0.3437% while demonstrating the lowest level of volatility among all asset
classes, and as a result of this the index yielded a healthy return-to-risk ratio of 0.2830. In fact
Barclay’s Bond Index not only outperformed each of the general hedge fund and equity indices,
but it also indicated better performance compared to all but two individual hedge fund strategies.
Only Event Driven Risk Arbitrage and Global Macro were able to show a better return-to-risk
ratio compared to the bond index. Based purely on the traditional approach, the claims that bonds
are more secure and stable investments than equities in bear markets is completely justified, and
this result is coherent with the academic research, which indicates that bonds should yield better
overall performance than stocks during the turbulent conditions of down markets.

What is surprising though is the fact that despite utilizing dynamic trading strategies, individual
hedge fund investment styles with the exception of only 2, could not match the risk-return
characteristics offered by bonds. In fact, 5 out of 14 hedge fund styles displayed higher return
than the latter, but this came at a cost of a much higher volatility.

When analyzing solely hedge fund investment styles, one should notice that in general these
alternative investment vehicles have successfully navigated the market fluctuations and 13 of the
14 index sectors have finished the 41 months of observation in positive territory. Among the best
performing strategies between January 2007 and May 2010 were Event Driven Risk Arbitrage
with return-to-risk ratio of 0.3163, followed closely by Global Macro with 0.2974 and Event
Driven Multi Strategy with 0.2083. These strategies, which apparently led the way during the
investigated period, have benefited from the idiosyncratic investment opportunities that have
arisen during the crisis as well as in the post crisis recovery period. Conversely, the only strategy
to finish the period with negative returns was Dedicated Short Bias followed very closely by the
Fixed Income Arbitrage investment style. These two sectors were also among the worst
performers in the period of investigation and have struggled to find profitable positions in the
volatile market environment.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Schneeweis, Kazemi and Martin (2002) have found empirical evidence that Equity Market
Neutral is perceived as offering risk reduction because the factors driving its returns are not
similar to the ones that drive returns for bonds and stocks. In fact the observed by us results are
completely in line with the findings of the researchers, which gives a very valuable insight to risk
adverse investors, who can make use of this particular strategy during bear markets.

On the other hand, Schneeweis, Kazemi and Martin (2002) claim that Long/Short Equity displays
exactly the opposite characteristics, and should act as return enhancer. We, however, cannot
confirm the truthfulness of these observations, as Long/Short Equities exhibited a significantly
lower mean return than most of the other hedge fund investment styles. In fact 8 of the analyzed
14 hedge fund strategies displayed higher return distributions, which leads to the conclusion that
the findings of the researchers pertain most probably to a bullish but not a bearish market.

The drawbacks of the traditional approach is that it does not take into account 3 very important
aspects, and namely the distortion of the data due to the existence of autocorrelation, survivorship
bias, and higher order statistical moments. We will scrutinize in a subsequent subsection how
each of these 3 characteristics affects the data points.

4.1.2. Equity Market Neutral and Kingate

During the analysis of monthly returns data obtained from the Dow Jones Credit Suisse database,
the focus was placed on checking for some extreme observations, outlaying data points that could
be a result of the turbulent time and stressed market environment. In most of the cases, data
proves to be appropriate for being analyzed with the use of the standard statistical moments
without any ‘corrections’.

More in-depth treatment was required in the case of the Equity Market Neutral strategy index.
Initial analysis was showing an unexpectedly low mean return, with even more surprisingly high
standard deviation, skewness and excess kurtosis, all for the strategy that is broadly being
described as an effective diversifier across market cycles. Observed results argue with the low
market correlation and limited volatility rules associated with this investment style.

The presented below normal probability plot shows the extreme data point distorting the average
results for the period. It is coherent with the Credit Suisse Asset Management report on the

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Equity Market Neutral strategy from September 2009 9 in which returns are calculated with and
without considering the data point from the very left side of our chart. This point represents the
return for November 2008 and needs further explanation.

Normal Probability Plot Equity Market Neutral

2,5
2
1,5
Ordered Response

1
0,5
0 Serie1
-0,5 -0,4 -0,3 -0,2 -0,1 -0,5 0 0,1

-1
-1,5
-2
-2,5
Normal N(0,1) Order Statistic Medians

Figure 9: Kingate’s impact on the performance of Equity Market Neutral

(Authors’ own creation)

The over –40%, negative return for November 2008 is a result from the bankruptcy of a $2.8
billion Kingate Global Fund owned by Kingate Management. Kingate, being included in the
Equity Market Neutral funds set, invested with Bernard L. Madoff, who at about that time was
revealed to have defrauded billions of dollars from his clients through a Ponzi scheme 10.

The Madoff-related write-down was in a best understanding not a result of systemic risk
exposure. Market mechanisms or overall economy trends were independent from this event. The
volatile, crisis time determined only the moment this fraud was revealed.

Such a unique in its character and size, fraudulent occurrence cannot be accounted for as it is not
the case of investing in wrong assets or lack of expertise, but a human designed swindle.

9
Credit Suisse Asset Management. LLC, Equity Market Neutral: Diversifier Across Market Cycles, New York
September 2009
10
http://dealbook.blogs.nytimes.com/2008/12/12/hedge-funds-reel-as-huge-fraud-is-alleged/

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Nevertheless, it cannot be neglected that the - 40% monthly return was a fact and it reflects the
state of the index at that time. As we keep in mind extreme situations might occur, we believe
that for our analysis, a more insightful and valuable results will be achieved if the Kingate write-
down is excluded from the data. In that way we can show how the real market mechanisms shape
the competitiveness of equity market neutral investment style and how it can contribute to
improving a portfolio selection.

Closing the current discussion, Table 3 contains the comparison of statistical moments with the
Madoff-related write-down and without it 11. The significant differences show how one event can
distort the assessment of the performance during the whole analysis period and make the asset,
potentially attractive appear to be a liability. The influence of the Kingate write-down is
intensified by the short observation period and the total number of 41 data points.

Statistical moments Write-down included Write-down excluded

Mean return -7.47% 1.66%

Standard deviation 6.52% 1.54%

Skewness -5.92 -1.58

Kurtosis 36.69 4.65

Table 3: Impact of the Kingate write-down on the statistical properties of the Equity
Market Neutral investment strategy

4.1.3. Sharpe ratio evaluation

The individual return (in the form of the average monthly returns) and risk (presented as the
monthly standard deviations) values do not allow us to credibly evaluate the performance of the
analyzed assets, neither to rank nor compare them. Both moments give us only partial
information and have to be combined into one measure. It is done with the use of the classical
and basic risk-adjusted performance measurement tool, namely the Sharpe ratio. Following the

11
The return for the single month of November 2008 without the write-down used in the analysis was calculated
with the use of the remaining 11 months’ returns and the whole 2008 no write-down return provided by Credit
Suisse. The final value for November 2008 calculated is -3%.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

well known formula given below, the relevant Sharpe ratios are calculated and included in Table
4.

RP − RF
Sharpe Ratio P =
σP

Sharpe ratio measures the excess mean return of an asset over the return of a risk-free asset
relative to standard deviation. The choice of a risk-free rate is arbitrary and needs some
discussion.

Risk-free rate

The security used in the analysis as a good approximation of a riskless asset, is a 13-week
Treasury Bill. The next step is to pick the value (date) and type (average, single period) of the
return.

It is a greater challenge to determine the appropriate risk-free rate and justify the choice under the
volatile and shrinking market conditions than in the bull markets. When the markets are stable,
then a rolling interest rate, an average interest rate for the period under consideration, or the
interest rate at the beginning of the investigation period would yield identical results. This is not
the case for the period of our analysis.

The risk-free rate closely reflects the basis, wide-economy interest rates set by the central bank.
The latter are used to boost or ‘cool’ the economy, reflecting its current state, as a result the risk-
free rate gradually climbs as economy grows and financial markets flourish, and falls
concurrently with markets to supply cheaper credit. The beginning of the period under analysis is
the decay of bull period, with the 13-week Treasury Bill annualized return reaching its peak value
at 4.99% in February 2007. The respective value reaches the minimum for the analysis period in
January 2010 (0.07%) and 0.15% in the closing month of May 2010. In a broader sense, the right
risk-free rate allows precise evaluation of an asset under analysis. During the specific bear market
period of low returns, unrealistic, too high of a risk-free rate would also push many assets under
the investment grade level showing riskless asset outperform the risky ones. One more
implication of such case is that the Sharpe ratios become negative and lose their explanatory
power.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

It was decided that the average monthly 13-week Treasury Bill rate during the sample period
January 2007-May 2010 will be used, as being a plausible, sufficiently conservative
approximation of a riskless investment alternative.

Risk-free rate used in the analysis, Rf = 0.13%.

Sharpe ratios calculated

Low returns reported for the bear market period under consideration affected the Sharpe ratios
pushing them down significantly. Global Macro with 0.238 is on top of the list with its ratio
being more than 4 times the value for the general Hedge Fund Index with 0.052. Based on that, it
can be said that the big scale, directional bets on the broad markets, economies or currencies pay
back in the times of crisis. Next on the list is the Event Driven Risk Arbitrage strategy with a SR
of 0.215, which can be explained by increased ownership change activities under hard market
conditions. Most research under neutral market conditions would show the broad Hedge Fund
Index and most of individual hedge fund strategies to perform better than the traditional
investment classes, especially before any adjustments are made (Eling, 2005). Denying that is the
Barclay’s Bond Index proving to be a very solid asset class with the third highest Sharpe ratio,
namely 0.176.

Turbulent times of market crisis favor another from the group of Event Driven strategies, namely
Multi Strategy, having a SR of 0.153 and a broad Event Driven index with 0.115. Only Event
Driven Distressed Securities sticks out in the group with a modest Sharpe ratio of 0.042.
Managed Futures is placed in the middle of the ranking with 0.091. The two disappointing
strategies are the Convertible Arbitrage, based on the theory expected to be the winner of the
down markets with 0.04 and often cited as the core strategy and high performer, Equity Market
Neutral with 0.024. MSCI EMF equity index and the Emerging Markets hedge fund strategy
achieve almost identical, modest ratio of about 0.035, mainly due to high standard deviations of
returns. Two strategies, Fixed Income Arbitrage and Dedicated Short have negative Sharpe ratios,
which makes it impossible to compare them with the other, positive values, and means that they
have delivered lower returns in the period under consideration than the risk-free asset. Negative
Sharpe ratio was also calculated for S&P 500, which reflects the nature of the bear market.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Global Macro 0.238 MSCI EAFE 0.036

Event Driven- Risk Arbitrage 0.215 Emerging Markets 0.034

Barclay’s Bond Index 0.176 Long/Short Equity Arbitrage 0.032

Event Driven- Multi Strategy 0.153 Equity Market Neutral 0.024

Event Driven 0.115 Multi-Strategy 0.018

Managed Futures 0.091 Fixed Income Arbitrage -0.036

Hedge Fund Index 0.052 Dedicated Short Bias -0.089

Event Driven- Distressed Sec. 0.042 S&P 500 -0.106

Convertible Arbitrage 0.04

Table 4: The SRs of individual investment strategies

The problem of negative Sharpe ratios

The appropriateness of the Sharpe ratio as a performance measure during declining markets is
often questioned. Explanations available, though reasonable and insightful to some extent, do not
solve the problem of inability to compare ratios of negative value. Sharpe (1975) argues that his
ratio is applicable in any market conditions since it measures performance by relating the risk-
return profile to the risk-free asset, while McLeod and van Vuuren (2004) explain that the fund
with the highest ratio is one most probable to outperform the risk-free asset. The direct
comparison problem remains.

The challenging bear market periods stimulated academic interest and research in the problem of
alternative approaches to the Sharpe ratio. Proposed solutions are applicable in times of lower
mean returns, even below the risk-free level, though remain equally problematic when mean
returns fall below zero, which often is a case during market crisis.

Such modifications include multiplying the mean return and standard deviation in place of
dividing both or calculating a ratio of mean return to the risk-free rate instead of subtracting the
latter (Israelsen, 2003).

More comprehensive refinement to the Sharpe ratio is proposed by Scholz and Wilkens (2006).
Market climate is not only taken into consideration but also its impact separated from the impact

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

of management performance. The ultimate goal is to compare to what extent returns are affected
by market moves and how much are they a result of fund’s managerial skills.

The resulting normalized Sharpe ratio is expressed as follows:

JAi + βi erlM
nSRi =
βi2 slM
2
+ sε2
i

Funds specific characteristics JA (Jensen Alpha showing the excess return of a fund over some
expected return), β (fund’s systematic risk) and s2εi (unsystematic risk expressed as a variance of
a fund specific component εi) are joined with the market parameters of mean and variance of the
market returns. The crucial modification is substituting the market parameters calculated on the
basis of the time period under analysis (in the case of hedge funds typically short, 3 to 5 year
periods) with the values calculated over a longer time horizon suggests 20 years as basis (Scholz,
2007). In this way normalized Sharpe ratio is neutral of the random market climate influence and
enables an unbiased evaluation of funds’ management performance.

In our analysis we face a problem of negative excess returns (consequently negative Sharpe
ratios) presented by the S&P 500 market index and two of the hedge fund strategy indices (with
expected more to turn negative after a survivorship bias adjustment is implemented in the form of
a subtraction from the mean returns calculated), no Sharpe ratio modifications will be performed
in an attempt to restore full comparability though. Portfolio optimization process being the
ultimate step in the project is not affected by the Sharpe ratio sign, and even assets of negative
excess returns can have portfolio improving attributes given the favorable correlation
coefficients. For the individual indices’ performance analysis it is more important to show how
specific adjustments affect the attractiveness of respective assets than to compare them with each
other. Analysis so far has shown that although negative Sharpe ratios are present, a group of well
performing indices with high ratios can be selected too, presenting an initial indication for a
possibility of clear evaluation conclusions.

4.1.4. Discrete vs. continuously compounded returns

The necessary choice between computing discrete or continuously compounded returns is


addressed in this section. From the broad debate on which type of data is more appropriate and

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

what are the pros and cons of using the respective approaches, we decided to follow the reasoning
provided by Dorfleitner (2003), who stresses the importance of matching the right return
calculation with the type of an analysis undertaken and concludes:

“The simple return is to be used whenever portfolio aspects are the topic of interest. Thus it
refers especially to classical capital market theory…The log return is (due to its time additivity)
suited for time series models such as GARCH models.”

The numerical differences are often minimal, especially when the returns are close to zero, but
the compounding approach proves to be delivering invalid results when looking at expected
returns and co-variances in a stochastic context. In practice, it may imply a suboptimal portfolio
selection. Discrete returns are calculated and used throughout the analysis for the sake of
convenience of keeping the same method and values when the optimization part of the project is
reached.

The comparison of the mean returns and standard deviations calculated on the basis of the
discrete and compounded returns shows only small differences, which is in agreement with the
expectations. The specific crisis period under analysis means the returns are lower, ergo even
closer to zero, and the numerical differences drop.

The exact value of the difference between the calculated mean returns varies for different
strategies. In the case of the general Hedge Fund Index, the discrete returns calculated mean is
higher by roughly 12%.

Another issue discussed in relation to the use of log returns is the normality of distribution. The
troubling characteristic of many assets’ returns being their non-normal distribution is in many
cases solved by using the log returns leading to a log-normal distribution. Since the non-normal
distribution of hedge fund returns is one of the major points of interest in our analysis, we have
compared the Jarque-Bera (J-B) statistics for the two types of data. In connection with the present
discussion, logging the data did not alter the J-B results in any significant way. The value of J-B
test statistic has dropped only for the S&P 500 (minimally, from 12.8 to 11.7), increased
marginally for most HF strategies and even grew significantly in three cases (Fixed Income
Arbitrage, Convertible Arbitrage and Emerging Markets).

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Summing up, the discrete returns data was used throughout the project as a desirable for portfolio
optimization, convenient to use in both analysis parts. Furthermore, log data showed no
improvement from the normality of distribution perspective.

4.2. Drawbacks of the traditional approach

4.2.1. Autocorrelation, survivorship bias and fat tails

Based on research literature e.g. Kat and Lu (2002) and Getmansky et al. (2004), we expect some
noticeable degree of autocorrelation in the hedge funds’ and equity’s returns time series. Table 6
presents the results form the test that we performed with the help of the Ljung-Box Q-statistics,
and it indicates the extent of autocorrelation for the different asset classes. Testing for
autocorrelation is an essential and needed step as positive autocorrelation means that the standard
deviation calculated would be understated and therefore it would not inform us on the true value
of risk associated with the asset, ergo this would result in wrong investment decision made,
erroneous portfolio allocations picked and overstated Sharpe ratios.

A lag of 24 is chosen by us to increase the power of the test given the frequency with which the
data is observed.

Below in Table 5 are displayed the upper critical values of chi-square distribution with ν degrees
of freedom 12.

ν degrees of Probability of exceeding the critical value


freedom
10% 5% 2.5% 1% 0.1%

24 33.196 36.415 39.364 42.980 51.179

Table 5: Probability of exceeding the critical value

Table 5 indicates that at lag 24, when the results from the Ljung-Box (L-B) test are in excess of
33.196, then with 90% certainty we can reject the null hypothesis H 0 , which states that returns

are not serially correlated. If the results have value of 51.179 or more, then the probability of

12
The chi-square distribution results when ν independent variables with standard normal distributions are squared
and summed.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

rejecting the null hypothesis rises to 99.9%. In our thesis we opted to work with a 5% probability,
and the relevant result from the L-B test has a value of 36.415 13.

As already mentioned in section 3.5.2, the prevailing explanation of why some hedge fund
returns are serially correlated is due to the exposure to illiquid securities. If the right market price
is not available, hedge fund managers use either the last reported transaction price or an estimate
of the current market price. This can easily create lags in the net asset values and cause serial
correlation in the funds’ monthly returns.

ED Distressed Securities

Fixed Income Arbitrage


Equity Market Neutral
Convertible Arbitrage

Barclay’s Bond Index


Dedicated Short Bias

ED Risk Arbitrage
Emerging Markets

ED Multi Strategy

Long/short Equity

Managed Futures

Multi Strategy
Global Macro
Event Driven

MSCI EAFE
HF Index

S&P 500
Index

Autocorrelation

Autocorrelation

( ρi ) 0.48 0.56 0.04 0.45 0.09 0.42 0.61 0.28 0.46 0.58 0.29 0.35 0.10 0.60 0.34 20.0 0.33

Ljung/Box

statistic ( LBi ) 47.2 37.3 54.7 46.6 23.9 54.3 75.1 40.6 30.6 34.6 16.4 29.5 39.6 51.6 53.7 -0.19 34.3

Higher moments of return distribution

Skewness

( Si ) -1.25 -1.85 0.40 -1.40 -1.58 -0.94 -0.99 -0.86 -0.90 -2.65 -1.17 -0.96 -0.01 -1.36 -0.70 -0.95 -0.64

Kurtosis ( Ki ) 1.86 5.25 -0.40 3.89 4.65 0.63 0.85 0.63 2.17 9.06 2.69 1.07 -1.24 2.54 0.65 2.70 1.08

Jarque/Bera

statistic ( JBi ) 12.9 32.0 20.8 14.7 21.7 15.6 14.5 14.6 6.68 110.7 9.45 12.6 30.8 12.9 12.8 6.30 9.10

Table 6: Testing for autocorrelation, skewness and excess kurtosis

13
Calculations for the L-B test were done with the help of a free correlogram excel add-in available on
http://www.web-reg.de/corr_addin.html

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Table 6 clearly indicates that our expectations about existing autocorrelation in the hedge fund
and equity returns are justified. Based on the L-B test we can reject with 99.9% certainty the null
hypothesis for the returns of ED Distressed Securities, Dedicated Short Bias, Event Driven, Multi
Strategy as well as the S&P500. What is more, for the chosen by us 5% probability level, 9 out of
14 hedge fund investment styles exceed the critical value of 36.415, which is equivalent to 95%
certainty of rejecting the null hypothesis, ergo the returns display a high probability of being
serially correlated, which is coherent with research literature and with our ex ante expectations.
In fact the returns of only Global Macro and Equity Market Neutral may not be subject to
autocorrelation based on the L-B test. The only returns that we can firmly claim not to be serially
correlated are these of the Barclay’s Bond Index: not only do they not exceed the critical values
for any given degrees of freedom, but they display even a negative result from the L-B Q-statistic
test.

All in all, the observed by us data points of the returns of the analyzed asset classes indicate a
high probability of being serially correlated, ergo we need to make adjustments of the results to
account for the effect of autocorrelation.

Table 6 also exhibits information whether the returns of bonds, equities and hedge funds are
normally distributed or suffer from the effect of skewness and excess kurtosis. As already
mentioned in Chapter 3, the Jarque-Bera test is the tool, which enables us to witness if the asset
returns are subject to the effect of statistical moments of higher order. The more the result of the
J-B test deviates from the value of 6, the more conclusive the indication that returns are not
normally distributed.

Clearly, most of the hedge fund investment styles exhibits values in excess of 6, which is
completely coherent with our ex ante expectations. The strategy that exhibits the highest value of
the J-B test is Fixed Income Arbitrage with the overwhelming result of 110.7. This comes as no
surprise given the extremely high value of kurtosis: 9.06. The other two investment styles that
deviate most from the Gaussian distribution are Convertible Arbitrage with 32.0 and Managed
Futures with 30.8. The rest of the hedge fund investment strategies display more modest
deviations from the desired value of 6, but still are far from being normally distributed. In fact,
only ED Risk Arbitrage’s returns seem to be normally distributed having low levels of skewness
and kurtosis and a value from the J-B test of 6.68.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Regarding the results of the other asset classes, our observations are in line with the suggestions
of the research literature. We expected the returns from the Barclay’s Bond Index to be normally
distributed, and the values of the displayed skewness and kurtosis as well as the result of 6.30
from the J-B test clearly confirm the truthfulness of the research conducted prior to our study.
The two equity indices exhibited almost similar results, but still their returns we also subject to
higher order statistical moments. The conclusion from the J-B test is that with small exceptions
the returns of the equities and individual hedge fund investment styles are not normally
distributed, and in order not to underestimate the level of volatility and to overestimate the return
characteristics of the different asset classes we need to make adjustments to the observed data.

4.3. Adjustment of results

When correcting the hedge fund statistical moments and the underlying return time series
historical data, the performance measure used, in a form of Sharpe ratio or simplified return to
risk ratio, is affected in two different ways. First, the nominator is reduced, moreover by a
definite value, identical for all funds. Denominator, initially in the form of the standard deviation
and later VAR (MVAR) is adjusted individually. Both percentage and absolute value changes are
fund specific and reflect the return time series ‘deficiencies’.

Furthermore, adjustments made to the return numbers can push their values into being negative
making the interpretation of results problematic, as it was described before. Denominator can
only be of positive values and is only expected to grow, pushing the overall ratio down.

4.3.1 Bias adjustment results

Despite the fact that the DJCS data is very appealing in terms of the typical hedge fund biases
possessed, the impact of the single, survivorship bias to be accounted for is significant. The
percentage changes of expected returns and return/risk ratios are high, due to the time period
under analysis, when the unadjusted values are already very low. Available approximations of the
survivorship bias to be applied do not distinguish between the bull and bear markets, although it
could be argued that the different market conditions underlying both periods might result in
different level of the bias. As a result, fixed bias adjustment of 0.2% monthly would affect the
measures less during the high return periods.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

From the numerical perspective, the effect of the 0.2% subtraction results in four hedge fund
strategies being of negative mean monthly returns. Dedicated short bias being in minus to start
with, is now joined by the Fixed Income Arbitrage, Multi Strategy, and most notably Equity
Market Neutral. The interpretation of the obtained results is that the true, expected returns based
on the past data under analysis, and therefore for the period of similar market conditions, are in
every case lower by 0.2% monthly to account for the hidden effect of funds going bankrupt,
which is not perfectly expressed in the data set underlying the index. It is right to assume
negative expected returns for four and not only one strategy and the unadjusted values to be too
optimistic and misleading.

Even more significant changes appear when looking at the risk premiums (excess returns). The
risk free rate of 0.13% used in the project effects in further strategies to return negative risk
premiums, the general Hedge Fund Index included (-0.079%). Positive risk premium and
consequently positive Sharpe ratio is present for five strategies- Event Driven, Event Driven
Multi Strategy, Event Driven Risk Arbitrage, Global Macro and Managed Futures. The basic risk
premium interpretation would suggest only five strategies can be considered for investment as the
remaining are outperformed even by the risk-free asset.

Another way to show how severe the impact of the survivorship bias adjustment is on the
expected returns is to express its value as a percentage of the initial mean returns. It is easily
guessed that the number will be highest (lowest) for the index with the lowest (highest) mean
return. Results are within the 30%-1400% range. The highest mean return Global Macro strategy
has only about 30% of the return value ‘eaten away’ by the bias adjustment. For the Fixed
Income Arbitrage strategy, one having the lowest positive mean return, the bias deduction is 14
times bigger than the initial return. All the results over 100% mean that the adjustments push the
return values under zero.

The analysis proves the mean returns are affected severely by the survivorship bias adjustment,
which gains even more importance when it is realized the traditional assets are not a subject to
this modification. The relative attractiveness of hedge funds compared with bonds drops even
more so after the bias is accounted for.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Further adjustments concern all the asset types and will complete the unbiased evaluation and
comparison framework.

4.3.2 Autocorrelation adjustment results

Previously we analyzed the existence and degree of an autocorrelation in the hedge fund
historical return time series data. Existing research proves the problem of autocorrelation exists
and so does our analysis. In this section autocorrelation is being targeted and as a consequence
standard deviations of respective investment assets are being modified as autocorrelation causes
the risk estimates to be biased downwards. Regardless of the results of the initial analysis in the
form of the autocorrelation coefficient at lag 1 or the Q-statistic, the same procedure is being
applied to all hedge fund strategies and traditional assets, while the effecting percentage change
in the standard deviation is the key finding and element to comment on. The new, adjusted
standard deviations calculated on the basis of the unsmoothed returns are shown in Table 7.

The impact of the autocorrelation adjustment on hedge fund strategies is one-sided; all the
standard deviations rise, with the average for the group settling at a solid 56% level. The average
change is nevertheless a result of a significantly diversified set of individual hedge fund
investment styles’ adjustments, effecting from different levels of positive autocorrelation. Among
the best performers are Dedicated Short Bias with only 5% increase in standard deviation, Equity
Market Neutral and Managed Futures with 11% each. The next results are already three times
bigger than the previous, with Event Driven Multi Strategy ‘rising’ by 33%, Global Macro and
Long/short Equity by 37% and 45% respectively. Event Driven meets the group average of 56%
standard deviation growth, while the general Hedge Fund Index exceeds the average with 70%
rise. Emerging Markets and Risk Arbitrage find themselves between the group average and the
HF Index result. Convertible Arbitrage, Fixed Income Arbitrage and Multi Strategy suffer from
autocorrelation even more significantly, and the standard deviation rise is in the range of 90%,
while Distressed Securities top the group with 102% change.

The varying level of autocorrelation from which hedge funds suffer, and consequently the range
of adjustment made to the standard deviations should alert the investor to rethink the risk
attractiveness ranking of these assets. On the list of newly calculated standard deviations, it is
Equity Market Neutral standing out as a group leader with a subtle result of 1.71% monthly,

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

resulting from a low values to start with and only a slight increase due to autocorrelation. Despite
the significant adjustment rise, previously of lowest value, Risk Arbitrage is now having the
second lowest standard deviation of 2.11% monthly. Global Macro follows with an estimate of
3% monthly. Remaining values climb up to 7.14% as shown in Table 7.

The traditional assets expose a more differentiated picture. As a result of a negative


autocorrelation present in the Barclay’s Bond Index, the standard deviation estimate according to
the analysis was biased upwards. The adjustment lowers the standard deviation for the asset class
down to 1.01% monthly, or else, by 17%. The already superior in terms of risk, but also of
return/risk ratio, bonds gain even more attractiveness.

Equity indices both have their standard deviations rising by 43%, to 7.97% in the case of S&P
500 and a repulsive 12.97% for MSCI EAFE. Both before accounting for autocorrelation, and
after, equity indices appear to be delivering very unstable returns. Not even to be compared with
the appealing result of the bond index, both equity indices exceed the standard deviations
estimates of every single hedge fund index.

4.3.3. Skewness/kurtosis adjustment results

The non-normal distribution adjustment results are informative mainly from the perspective of
percentage change between the Value at Risk and Modified Value at Risk measures. The
calculated, numerical values of both measures are of less importance, sensitive to the investment
amount selected and in our analysis serving as a middle step for calculating the dynamics of risk
change. The percentage changes should be interpreted as a level of correction that needs to be
made in order to revoke the impact of non-normal distribution on underestimating the risk
measures.

The results are to a big extent coherent with the previous section, which analyzed data corrected
for autocorrelation. Well performing asset types (ones that prove not to be biased much in their
initial risk estimations) are the same in this section too.

Barclay’s Bond Index is again the sole asset type that has its risk estimator decreasing when
undergone the adjustment. The slight correction of 8% decrease reflects the fact that the monthly
returns for the period analyzed follow the normal distribution closely.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The remaining traditional assets showed returns distribution far from normal, and both have their
risk measures growing by over 58% to compensate for it. The extent to which equity indices
suffer from skewness and kurtosis can be regarded as surprising. Usually deviating from normal
distribution equity markets’ returns in our analysis show to underestimate the risk by as much as
58% just due to that feature, which can be easiest explained by the nature of the crisis period.

ED Distressed Securities

Fixed Income Arbitrage


Equity Market Neutral
Convertible Arbitrage

Barclay’s Bond Index


Dedicated Short Bias

ED Risk Arbitrage
Emerging Markets

ED Multi Strategy

Long/short Equity

Managed Futures

Multi Strategy
Global Macro
Event Driven

MSCI EAFE
HF Index

S&P 500
Index

Monthly σ in
2.32 3.74 4.88 3.78 1.55 2.23 2.23 2.36 1.28 3.20 2.20 2.82 3.39 2.44 5.58 1.21 9.08
%

σ after
3.93 7.14 5.11 6.17 1.71 3.48 4.51 3.13 2.11 6.26 3.00 4.08 3.77 4.87 7.97 1.01 12.97
autocorrelation

% change 70 91 5 63 11 56 102 33 66 95 37 45 11 99 43 -17 43

Skewness/kurtosis adjustment

Value at Risk
0.36 0.59 0.83 0.60 0.24 0.33 0.35 0.34 0.17 0.53 0.30 0.44 0.51 0.38 0.96 0.17 1.45
(VaR)
Modified VaR
0.76 1.42 0.84 1.18 0.34 0.64 0.85 0.55 0.37 1.32 0.52 0.76 0.61 0.95 1.54 0.15 2.28
(MVaR)
(MVaR/VaR)-
112 142 0 99 42 94 146 64 117 152 77 73 18 147 59 -8 58
1 in %

Table 7: Indices’ and hedge fund strategies’ data adjusted for autocorrelation and fat tails

Hedge fund strategies differ in terms of the level of the adjustment just as they differ in the types
of the investments undertaken by them. Dedicated Short Bias is again the one style that is
affected least, risk measure is even unchanged. MVaR is after rounding effect equal to the VaR,
the risk does not grow as the skewness and kurtosis are taken into the equation. The range of
results is however bigger than in the case for autocorrelation. The extreme cases are as before
Fixed Income Arbitrage (152%), Multi Strategy (147%), Distressed Securities (102%) and
Convertible Arbitrage (142%). Both parts of the adjustment suggest that when evaluating the risk

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incorporated in these hedge fund strategies one can be very far from realizing the actual level of it
if only considering the basic risk measures. Other hedge funds of the lowest risk measure growth
are Managed Futures with 18% and Equity Market Neutral with 42%. As a general conclusion it
can be said that hedge funds should have the impact of asymmetric, left-sided tails and infrequent
extreme observations included in their risk assessment.

4.4. Ranking of hedge fund investment styles

An important conclusion investors may have drawn from the financial crisis of the observed by
us period is the degree to which different hedge fund strategies vary in their adaptability to
changes in market cycles. With regards to that the purpose of this section is to measure the
adaptability by examining the performance of all hedge fund investment strategies as standalone
assets. We rank their performance on both unadjusted and adjusted basis and analyze whether the
major index styles lived up to their reputation and the investors’ expectations. We opted for the
S&P 500 as the relevant benchmark that will demonstrate whether hedge fund investment styles
have proved to be better investment choice during the down markets of the observed period than
the aggregate stock index. This will conclude Chapter 4.

Table 8 below demonstrates the ranking of the different asset classes with adjusted and
unadjusted data 14.

Table 8 exemplifies that when data is being corrected for the effects of fat tails, autocorrelation
and survivorship bias, then the risk-return characteristics of the analyzed asset classes change to
certain degree, and when the 3 factors are taken into consideration concurrently, the
attractiveness of the investment strategies is altered. With unsmoothed data, bonds are subject to
the least changes in their performance characteristics and become undoubtedly the most lucrative
and rewarding asset class. It climbs two spots in the new ranking moving from number 3 up to
number 1.

14
The numbers in brackets in Table 8 indicate the place according to the ranking with unadjusted data in the form of
a risk/return ratio, which was already displayed previously in Table 2. The arrows exhibit whether the asset class has
moved up/down as compared to the previous ranking or has kept its place. The values of the unadjusted and the
adjusted data are not directly comparable with each other as the former uses the standard deviation as a risk measure
whereas the latter relies on MVaR.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

1. Barclay’s Bond Index (3)  0.2258 10. Emerging Markets (13)  0.0050

2. Global Macro (2)  0.0866 11. Event Driven - Distressed Sec. (9)  0.0028

3. Event Driven- Risk Arbitrage (1)  0.0553 12. Long/Short Equity Arbitrage (10)  0.0027

4. Event Driven- Multi Strategy (4) - 0.0524 13. Multi-Strategy (12)  -0.0027

5. Managed Futures (6)  0.0394 14. Equity Market Neutral (8)  -0.0099

6. Event Driven (5)  0.0294 15. Fixed Income Arbitrage (15) - -0.0141

7. MSCI EAFE (14) 0.0200 16. S&P 500 (17)  -0.0306

8. Hedge Fund Index (7)  0.0068 17. Dedicated Short Bias (16)  -0.0602

9. Convertible Arbitrage (11)  0.0055

Table 8: Ranking of asset classes on adjusted basis

Global Macro is the best performing hedge fund investment strategy during the investigated
period between January 2007 and May 2010. The fact that it ranks highest among all hedge fund
strategies is attributed by us to the specific investment style employed by Global Macro funds.
More specifically, such funds try to look at the big picture and to find the interrelationship
between different markets and their economic cycles in order to uncover investment
opportunities.

It is evident that managers in Global Macro funds, by using a top down global approach of
investing, have been able to analyze properly the changes in the global economies and to find
investment opportunities that have occurred during the investigated period. This may have been
done i.e. by making their investments via highly liquid derivatives which allow investors to
enhance their returns whilst concurrently limiting the downside risks by utilizing strict risk
controls.

We deem that another reason for Global Macro to have performed so well is that mangers have
been able to identify mispriced assets such as stocks, bonds, currencies, interest rates and
commodities and have exploited the arisen investment opportunities.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Further, Global Macro managers have possibly been able to take positions in multiple markets
across a wide variety of investment instruments around the world. As a result of this flexibility
Global Macro funds have obviously been able to avoid the negative effects of the bear markets on
global scale. The fact that the financial crisis of 2007-2010 did not pertain to a single country has
definitely diminished the investment opportunities for Global Macro funds, and has contributed
to a more moderate than expected performance for the analyzed period of 41 months.

The performance exhibited by ED Risk Arbitrage is also noteworthy. On unadjusted basis this
investment style ranks 1st, on adjusted 3rd. We expected that this strategy would perform stable in
bullish markets when there is larger M&A volume, and thus more investment opportunities,
better spreads, and stable credit market to finance M&A deals. For this reason we were to some
extent surprised to witness the solid performance of ED Risk Arbitrage funds in down markets.

Apparently managers of Risk Arbitrage funds have been able to take advantage of the special
situations such as e.g. asset sales and spin-offs, shareholder changes, capital structure changes,
management changes, regulatory changes, etc. arising in the down markets of the investigated
period between January 2007 and May 2010.

Risk Arbitrage funds have proven adept to generate absolute returns even in worst possible
market conditions. On a position level we deem that this has been done by a risk reward
optimization through investment at different stages of a deal process, and through selection of the
best instruments to implement a hedge: cash, options, convertible bonds. At a portfolio level we
assume that this has been done through i) diversification across sectors, ii) dynamic monitoring
and trading of positions and iii) risk monitoring of exposures to specific regions.

Bearing in mind all these aspects of this investment style, it becomes evident that the stable
performance of ED Risk Arbitrage should not be perceived as surprising.

Another hedge fund investment style that we deem deserves a more specific attention is Managed
Futures. This strategy has traditionally been the asset class, which performs best when global
stock markets are struggling through a crisis 15. History shows us that Managed Futures is the
strategy to adopt during bear markets and crises situations. For this exact reason we expected to

15
http://www.attaincapital.com/alternative-investment-education/managed-futures-newsletter/investment-research-
analysis/382

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see this hedge fund investment style among the best performing ones when considering them as
standalone assets. The results in Table 8 confirm that our ex ante expectations were justified.

Our expectations were based on the fact that futures based investments are typically able to
generate healthy returns due to the leverage intrinsic to the futures contracts and the potential for
large moves. At the same time their low correlation with traditional markets is a reason for
Managed Futures investments to be volatility reducers and portfolio diversifies during the bad
times.

We attribute the good performance results of Managed Futures also to the fact that they present a
good investment opportunity for the investors looking for long volatility exposure. This is due to
the fact that this hedge fund strategy is designed in such a way that investors make money based
on how far the market moves in the trades’ direction. Hence, the more the markets move, the
larger the variable gain amount can become.

Based on all the above mentioned factors, we are not surprised to witness that Managed Futures
funds have performed reasonably well during the investigated by us period. Because of the
magnitude of the dismal economic times we do realize that the good investment opportunities for
these hedge funds go hand in hand with higher level of volatility, thus reducing the overall
performance characteristics.

Dedicated Short Bias is a strategy that needs closer attention as by definition it is expected to be
performing best namely in down markets. For this exact reason it is a bit shocking that Dedicated
Short Bias is the worst performer among all asset classes.

Hedge funds pursuing this strategy rely on selling borrowed securities, hoping to later repurchase
them at a lower price and return them to the lender. Short selling earns a profit if prices fall.
Portfolio is typically exposed to industry, sector, and company-specific risk factors, as well as the
risk that the market will appreciate. Apparently, Dedicated Short Bias managers have been unable
to place correct bets and to generate alpha. This is somewhat conflicting with the assumption that
these funds are quite adept at producing absolute returns, and that they should lose less in bear
markets than one would expect them to lose.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

The controversy about this particular hedge fund investment style is further fuelled by the
opinion that managers of Dedicated Short Bias funds are actually not being paid for what they
have been hired to do. They are being paid for generating return, when they have really been
hired to mitigate beta, break the back of correlation, and reduce the volatility of a long portfolio.

The two most important conclusions stemming from the analysis performed in Chapter 4 are that
firstly with adjusted data the performance characteristics of hedge fund investment styles as
standalone assets change significantly and lose their overall attractiveness. This comes as a
confirmation to our ex ante expectation that fat tails, autocorrelation and survivorship bias cause
an investor to underestimate the risk inherent to hedge funds and to overestimate their
performance. We witness that when data is unsmoothed then 2 more hedge fund index styles end
up in negative territory and the return characteristics of the rest is markedly diminished.

Secondly, on the bright side, every single hedge fund investment strategy except for Dedicated
Short Bias has outperformed the chosen by us benchmark, the S&P 500, on both unadjusted and
adjusted basis. Dedicated Short Bias has done that solely on unadjusted basis. This comes as a
confirmation that even when adjusting the data points for fat tails, serial correlation and
survivorship bias, hedge funds remain a better investment choice in bearish markets for the
investment community than equities.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

5. Chapter 5: Incorporating hedge fund strategies as portfolio assets

The following chapter will gather the calculated values of respective assets’ statistical moments,
and join them with correlation coefficients of linear dependence between assets, in an attempt to
construct possibly most efficient portfolios.

First, Pearson’s correlation coefficients will be presented and commented on. After that, with all
the data required to perform portfolio optimizations in place, series of portfolios will be
constructed, all based on the unadjusted values of returns and risk measures as calculated in
Chapter 4. Obtained portfolio weights, reflecting portfolios with the highest possible return to
risk characteristic will be kept, but the portfolio efficiency will be recalculated taking into
consideration the adjusted values of return and risk measures, coherent with the sequence of
progress from Chapter 4.

The main aim of the present chapter is to show if hedge funds, during the period of analysis, can
contribute to create a more efficient portfolio after inclusion into a set of traditional assets.
Furthermore, if a positive impact is proved, it is critical to observe if it can be kept after
autocorrelation, fat tails, and bias adjustments are considered.

5.1. Pearson’s correlation coefficients

Table 9 contains the Pearson’s correlation coefficients calculated for all the pairs of assets, both
hedge funds and traditional securities. It is nevertheless the lower section of the table, in bold,
that is most interesting for further analysis, since these are the values expressing the strength of
linear relationship among the traditional assets, and between the traditional assets and respective
hedge fund strategies.

Pearson product-moment correlation coefficient (Pearson’s r.) can place anywhere within the
range of (-1, 1), where ‘1’ corresponds to a perfect linear dependence between two variables (data
points lay on exactly one line), ‘0’ means no dependence and ‘-1’ the perfect negative correlation
(data points create a downward sloping line).

The most general expectation would be for hedge funds to show a limited correlation with the
traditional assets, as their main advantage is the availability of tools enabling them to ‘hedge’
against the market exposure. The level of correlation is a result of pursued strategy, but is also

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strongly affected by the time horizon under analysis and an already clear domination of bonds in
terms of the return/risk profile. The limited time period under analysis defined by the recent
economic crisis can affect the values of Pearson’s correlation coefficients the way that the well
(bad) performing hedge funds will show an even greater (lower) linear dependence with bonds,
which are the best individually performing asset. The opposite will be true for the equity indices.
This relationship will have an offsetting impact on the portfolio construction; the attractiveness of
well performing hedge funds is weakened by their undesired, high positive correlation with the
expected to be the core portfolio asset bonds.

Pearson’s r for the S&P500-bond index relationship shows only a small positive dependence
equal to 0.22, while there is practically no dependence between bond index and the ‘exotic’ in
terms of a high return, but also very high standard deviation emerging economies equity index.
The two equity indices, similar in the type of asset they describe, but rather far in terms of the
exact markets and results delivered, end up with a large linear dependence of 0.52.

Most hedge funds expose a large, positive correlation with the S&P500 returns in the period and
certainly fail to present themselves as effective hedging asset to join with equities. There is a
pattern of similarity in the calculated correlations between hedge funds and S&P 500/MSCI
EAFE, with the proceeding equity index taking more extreme values.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Ind 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.


ex#
1. 1
2. 0.85 1
3. -0.44 -0.37 1
4. 0.92 0.84 -0.48 1
5. 0.65 0.46 -0.28 0.62 1
6. 0.96 0.82 -0.45 0.87 0.62 1
7. 0.92 0.81 -0.47 0.83 0.60 0.96 1
8. 0.94 0.80 -0.42 0.86 0.60 0.99 0.91 1
9. 0.77 0.67 -0.34 0.80 0.48 0.68 0.63 0.67 1
10. 0.83 0.90 -0.45 0.82 0.46 0.77 0.81 0.71 0.61 1
11. 0.72 0.64 -0.05 0.68 0.41 0.60 0.53 0.62 0.65 0.59 1
12. 0.94 0.79 -0.54 0.92 0.60 0.90 0.83 0.90 0.81 0.73 0.63 1
13 0.20 -0.08 0.01 0.07 0.15 0.13 0.03 0.19 0.17 -0.13 0.46 0.21 1
14. 0.95 0.92 -0.37 0.87 0.58 0.93 0.92 0.90 0.72 0.85 0.63 0.86 0.03 1
15. 0.71 0.61 -0.73 0.73 0.60 0.68 0.70 0.64 0.62 0.66 0.32 0.77 -0.08 0.64 1
16. 0.14 0.30 0.00 0.26 0.08 0.15 0.19 0.12 0.21 0.31 0.36 0.13 -0.12 0.18 0.22 1
17. 0.52 0.36 -0.34 0.49 0.37 0.53 0.45 0.59 0.34 0.37 0.40 0.53 0.25 0.47 0.52 -0.01 1
1. Hedge Fund Index 2. Convertible Arbitrage 3. Dedicated Short Bias 4. Emerging Markets
5. Equity Market Neutral 6. Event Driver 7. Event Driver- Distressed Securities
8. Event Driver- Multi Strategy 9. Event Driver- Risk Arbitrage 10. Fixed Income Arbitrage
11. Global Macro 12. Long/Short Equity 13. Managed Futures 14. Multi Strategy
15. S&P 500 16. Barclay’s Bond Index 17. MSCI EAFE

Table 9: Pearson’s correlation coefficients for all the pairs of assets

The biggest positive linear dependence S&P500 has is with the Emerging Markets investment
style, most other styles place slightly lower. Only in the case of two hedge fund strategies is their
correlation with the broad equity index negative, both cases can be justified. Managed Futures
style notices only a marginal negative correlation (-0.08) which can be attributed to the asset of
interest of managers pursuing this style, that is the listed commodity and financial futures, that
are not directly connected with the equity market.

Finally, the Dedicated Short Bias style has a large, negative linear dependence with the equity
index (-0.73). It is in agreement with the assumptions of its strategy, as managers attempt to
position their portfolios to counter the market. Dedicated Short Bias has also no correlation with
the Barclay’s Bond Index, which altogether makes it a theoretically fine portfolio inclusion.
Similarly, Managed Futures has a slightly negative Pearson’s r with bonds (-0.12) making it a
promising optimization element. The remaining hedge funds possess mainly low values of

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correlation coefficients. It is worth mentioning that the highly praised Equity Market Neutral has
only a third lowest correlation (0.08). The highest Pearson’s r in relation to the bond index is
observed for the Global Macro style (0.36) and can be attributed to its return/risk profile and the
described small sample impact.

5.2 Portfolio optimization based on the unadjusted statistics

All the portfolio optimizations are performed with the sole goal of maximizing the return/risk
ratio of the selected portfolio, and consequently the weight attached to respective asset types have
to serve the same requirement. No risk preferences, and so no weight limits were set.

Portfolio optimizations conducted with an Excel add-in based on Excel Solver are presented in
Table 10 below.

The initial step, prior to considering any hedge fund in the portfolio creation was to specify the
benchmark portfolio that consists of only traditional assets, that is Barclay’s Bond Index,
S&P500 and MSCI EAFE. The weights specified, and more notably the return/risk ratio of such
defined portfolio will be the clear indicator of which hedge fund styles possesses portfolio
improving qualities and automatically will be included in the mix (every time the return/risk ratio
of a newly calculated portfolio is higher than that of the benchmark portfolio).

Optimization based on the traditional assets confirmed the superior performance of bonds during
the analyzed period, and adding an equity index cannot improve the efficiency of the portfolio.
Given the correlation coefficients calculated, the weak return/risk characteristics of equity indices
cannot be offset by the effect of diversification obtained.

The optimized portfolio consisting of only traditional assets has a return/risk ratio equal with the
one calculated for the bond index only, which is 0.282954.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Hedge Fund Bonds S&P 500 MSCI emer. Retur/risk


HF Index 11.56% 88.44% 0% 0% 0.2913
Convertible Arbitrage 0% 100% 0% 0% 0.283
Dedicated Short Bias 0% 100% 0% 0% 0.283
Emerging Markets 0% 100% 0% 0% 0.283
Equity Market Neutral 21.27% 78.73% 0% 0% 0.2955
Event Driven 18.82% 81.18% 0% 0% 0.3116
Distressed 8.92% 91.08% 0% 0% 0.2868
Multi Strategy 17.98% 82.02% 0% 0% 0.3285
Risk Arbitrage 57.00% 43.00% 0% 0% 0.3847
Fixed Income Arbitrage 0% 100% 0% 0% 0.283
Global Macro 40.08% 59.92% 0% 0% 0.3516
Long/Short Equity 8.64% 91.36% 0% 0% 0.2856
Managed Futures 16.72% 82.93% 0% 0.35% 0.327
Multi Strategy 1.29% 98.27% 0% 0.45% 0.2835

Table 10: Construction of optimized portfolios

With the benchmark return/risk ratio in place, analysis proceeds with fourteen optimizations, in
every case one hedge fund strategy is tested together with all the traditional assets in search for an
efficient portfolio that would beat the benchmark.

Out of the fourteen hedge fund strategies included in the analysis, four do not add value to a
portfolio. No such combination of these hedge funds with bond or equity indices exists that
would result with a return/risk ratio higher than 0.283, and therefore they are excluded from
further analysis. The four styles are Convertible Arbitrage, Fixed Income Arbitrage, Emerging
Markets and most surprisingly Dedicated Short Bias. Expected to be an investment strategy to
beat the market during market declines, Dedicated Short Bias cannot withstand the results
delivered by the bond index.

In two cases, Event Driven Multi Strategy and Managed Futures optimization results in not only
hedge funds being included, though in the former case with a tiny fraction of 1.29%, but also the
emerging markets equity index is being assigned a fraction. Not present when only traditional
assets are considered, now MSCI EAFE contributes marginally with 0.35% and 0.45%
respectively. Out of all the hedge funds, the highest weights are assigned to the two strategies

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

with best individual characteristics, which is highest initial return/risk ratios, exceeding the one
calculated for bonds. These are Event Driven Risk Arbitrage (57%) and Global Macro (40.08%).
The portfolio effectiveness is also highest when composed with addition of the two, with the
return/risk ratio growing by nearly 36% and 24% respectively comparing to the benchmark value.
The general Hedge Fund Index is placed in a portfolio with 11.56% weight while the remaining
being invested in bonds, thus making the portfolio more effective by 2.9%.

5.3 Recalculation of portfolios’ effectiveness based on an adjusted data

The conviction that the first two moments of a return distribution, and namely the mean return
and standard deviation, are insufficient measures to grasp the real performance of quite complex
investment vehicles such as hedge funds is to be examined in this section again.

All the portfolios that profited from inclusion of hedge funds will now, keeping the originally
assigned weights, be adjusted so that the new return/risk ratios are obtained, but this time taking
into consideration the effects of survivorship bias, autocorrelation and fat tails. The aim is to
examine how the conservatively measured performance of the portfolios is standing comparison
with the benchmark portfolio.

In order to incorporate all the adjustments into the portfolio statistics, the new risk measure used
will be Value at Risk (for bond only portfolio and unadjusted hedge fund portfolios) and
Modified Value at Risk as an ultimate, adjusted risk measure. It is impossible to compare the
return/risk ratios based on the standard deviations and VaR (MVaR), only numerical differences
between ratios using same risk measure can be compared.

Table 11 summarizes the adjusted and unadjusted return/risk ratios using the new risk measures.
Included are calculations for the benchmark, bonds only portfolio and the ten portfolios investing
in hedge funds, accordingly to what was presented in the previous section.

Only the benchmark portfolio and Multi Strategy appear more efficient after the VaR to MVaR
based ratio modification is made. Bonds do not suffer from bias adjustment made to the mean
return value. Furthermore, the negative autocorrelation coefficient decreases the standard
deviation that serves as a base for calculating VaR and MVaR. The same portfolio improving
effect will be present in all the portfolios, having they all have significant allocations in bonds,

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

but as it can be seen in Table 11, this is in great majority of cases offset by the harming impact of
bias subtraction and high levels of positive autocorrelation, skewness and kurosis. Portfolio
containing Multi Strategy funds improves in quality after MVaR risk is used due to the
overwhelming fraction being invested in bonds (98.27%), even though, after the adjustment it
cannot ‘beat the bonds’.

MVaR adjusted
Portfolio VaR return/risk
return/risk
Traditional- bonds only 0.2077 0.2258
HF Index 0.215 0.177
Equity Market Neutral 0.219 0.180
Event Driven 0.234 0.165
Distressed Securities 0.211 0.179
Multi Strategy 0.250 0.193
Risk Arbitrage 0.305 0.113
Global Macro 0.272 0.153
Long/Short Equity 0.210 0.193
Managed Futures 0.248 0.237
Multi Strategy 0.2082 0.217

Table 11: Unadjusted and adjusted return/risk ratios

For a hedge fund portfolio to be considered superior to the benchmark one, after the return
adjustments are implemented, the MVaR return/risk ratio has to exceed 0.2258 calculated for
bond only investment. It is only the Managed Futures that fulfill the condition, and can be
considered a superior portfolio based on the past data from the period of recent market crisis.

The efficiency ratio of the Managed Futures portfolio is not the highest to start with but is not
decreased much as an effect of data adjustment. The prevailing reasons are high fraction invested
in bonds that improve in attractiveness (82.93%) and only moderate level of autocorrelation and
close to normal distribution (detailed in Chapter 4.).

All the remaining portfolios not only experience drop in efficiency resulting from implementation
of an adjusted data, but rank below the benchmark portfolio in terms of return/risk profile. The
analyzed ratio decreases by an average of 21.8% among the hedge fund portfolios after the data
modifications. It is mainly the initial heavy investment in an available hedge fund index that is

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

penalized (Risk Arbitrage with 57% fraction drops in efficiency by a record 63%, Global Macro
respectively 40.08% weight in funds and 44% drop).

Other than Managed Futures maintaining its positive portfolio contribution qualities, and Multi
Strategy placing slightly below the benchmark, hedge fund portfolios prove to be highly
inefficient investment addition. It is a drastic departure from the initial analysis showing 10 out of
14 hedge fund strategies improve portfolio efficiency after being included.

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6. Chapter 6: Conclusion
6.1. Summary of the main findings of the thesis

In this part of our study we will summarize what has already been discussed in the previous two
analytical Chapters 4 and 5, and we will link the conclusions made with the problem statement
and the two main hypothesis made in Chapter 1 in order to witness if our ex ante expectations
have been verified or rejected.

The first question that we aimed at answering in our thesis was whether or not individual hedge
fund investment strategies can be considered a sound investment vehicle when taken as
standalone assets during a period of profound financial distress. We analyzed both the unadjusted
and adjusted performance of 14 hedge fund strategies comprising the DJCS Hedge Fund Index,
and compared it with the performance of two major stock indices, the S&P500 and MSCI EAFE,
as well as one bond index, and namely Barclay’s Bond Index.

With the help of the Jarque-Bera test we established empirically that the return distributions of
hedge funds and to some extent of stocks did not follow a normal distribution during the period
analyzed by us, but exhibited skewness and excess kurtosis, the effect of which is being omitted
if analyzed solely with the help of the Markowitz’ classical portfolio theory and the unadjusted
Sharpe ratio. These traditional approaches result in overstatement of the return characteristics and
understatement of the level of volatility of the evaluated asset classes. Thus, adjustment of the
observed data points was needed to avoid the detrimental effect of data distortion resulting in
wrong asset allocations made and erroneous portfolios constructed.

Furthermore, with the assistance of the Ljung-Box Q-statistics we tested the returns of all asset
classes for serial correlation and we found out that with the exception of bonds they were subject
to a substantial level of autocorrelation. Testing for serial correlation was an essential and needed
step as positive autocorrelation meant that the standard deviation calculated was understated and
therefore did not inform us on the true value of the risk associated with the different asset classes,
which could have resulted in wrong investment decisions made based on overstated Sharpe
ratios. The results obtained were coherent with our ex ante expectations formed on the basis of
previous research conducted by academics.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Hence, in order to not to underestimate the level of volatility and to overestimate the return
characteristics of the return distribution of the analyzed asset classes we concurrently corrected
the data, thus combating the effects of i) fat tails in the form of skewness and excess kurtosis, ii)
autocorrelation, and iii) survivorship bias.

It is worth noting that there was considerable difference in the return/risk profile of the observed
asset classes before and after the data points were adjusted. Barclay’s Bond Index was the one
that suffered least from the adjustments made, and this was due to the fact that unlike hedge fund
strategies it was not subject to the detrimental effect of survivorship bias, excess kurtosis and
skewness. For that reason it was not surprising that the bond index exhibited the steadiest month-
over-month adjusted returns as compared to the more volatile hedge fund and stock indices. With
respect to that the sub-hypothesis made by us in Chapter 1 regarding bond returns turned out
correct and was verified.

With both unadjusted and adjusted data, hedge fund individual strategies displayed better
performance compared to the predefined benchmark, namely the S&P500. Only Dedicated Short
Bias performed worse than the benchmark on adjusted basis. The performance of the hedge fund
strategies worsened considerably when data was corrected and 4 out of 14 strategies ended up in
negative territory. For the case of unadjusted data only 2 investment styles displayed negative
returns.

To sum up, the sub-hypotheses made by us regarding the performance of individual hedge fund
investment strategies as standalone assets were in their majority justified and confirmed. Firstly,
we expected that the mean return and the standard deviation would be inadequate measures for
describing the return distributions of the analyzed hedge funds and our expectations were correct.
Secondly, we expected the unadjusted SR to be insufficient for measuring the true values of the
returns of the hedge funds, and this turned out a correct assumption. We calculated return/risk
ratios adjusted for autocorrelation, survivorship bias and fat tails with the help of VaR, the
Cornish-Fisher expansion and eventually the MVaR as the risk estimate to obtain the true picture
of the performance of hedge fund investment styles. Finally, we concluded that hedge funds can
be deemed a sound investment vehicle for the analyzed period of profound financial crisis even
after correcting the data for the above mentioned 3 factors. The adjusted data, however, did

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

diminish the overall level of attractiveness of hedge funds as compared to their risk-return
characteristics when considering unadjusted data.

In our thesis we also added the correlation coefficients as the 3rd dimension into our risk/return
analysis, which resulted in 14 portfolio optimizations, which allowed us to verify whether an
inclusion of hedge fund investment strategies in a portfolio with traditional assets would improve
the characteristics of the newly formed portfolios.

It is worth noting that the ex ante expectations expressed by us in Chapter 1 about hedge fund
strategies having very low and even negative correlations with traditional asset classes were not
fully justified, which is somewhat contradictory with the way this alternative investment vehicle
presents itself to the wider investment community.

It should also be mentioned that the optimizations performed by us were initially made based on
the unadjusted values of returns and risk measures calculated previously for the analysis in
Chapter 4. The obtained portfolio weights, reflecting portfolios with the highest possible return to
risk characteristic were kept, but the portfolio efficiency was recalculated taking into
consideration the adjusted values of return and risk measures. Our main objective was to establish
whether hedge fund investment styles contributed during the observed period for the construction
of more efficient portfolios after their inclusion into a set of traditional assets. We also aimed at
proving if a positive impact could be preserved after autocorrelation, fat tails, and bias
adjustments were considered.

The inclusion of hedge fund investment strategies into a traditional portfolio resulted in 14
optimizations. 10 out of 14 hedge fund investment styles contributed to the construction of
efficient portfolios, beating the predefined benchmark. Only 4 index styles did not yield any
beneficial effect of differentiation for the newly formed portfolios. The result was coherent with
the expectations expressed in our sub-hypothesis in Chapter 1 that with unadjusted data, hedge
fund investment strategies would improve the characteristics of a traditional portfolio.

We also predicted correctly in Chapter 1 that with adjusted data, the beneficial effect of including
hedge fund investment strategies into a traditional portfolio would be significantly diminished.
Table 11 in Chapter 5 demonstrates that when the observed data points are being corrected for

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

autocorrelation, fat tails and survivorship bias, then only 1 strategy adds value to a traditional
portfolio, which is a surprising for us in terms of the magnitude of the data distortion.

Summing up, the two main hypotheses formulated by us in Chapter 1 yielded different result. The
first hypothesis that hedge fund investment strategies, when considered individually as
standalone assets, would prove to be an attractive investment asset class was confirmed for both
the case of unadjusted and adjusted data.

The second main hypothesis, however, that adding a carefully selected hedge fund investment
strategy to a traditional portfolio comprising equities and bonds, would improve the risk-return
characteristics of the newly formed portfolio due to the diversification effect caused by the low or
negative correlation between hedge funds and traditional asset classes, was confirmed only for
the case of unadjusted data. We cannot confirm the validity of this statement, however, for the
case of adjusted data as only 1 out of 14 strategies yielded a beneficial effect on the
characteristics of a traditional portfolio.

The practical implication from this last observation is that our research conducted in this thesis
could have a substantial impact on rethinking the overall attractiveness of hedge funds as vehicles
for obtaining absolute results in times of profound and extensive financial crisis when the
return/risk data is concurrently corrected for autocorrelation, biases and fat tails.

6.2. Suggestions for future research

We do realize the limited scope of our thesis, which is due to some objective factors already
outlined in Chapter 1. Our findings, however, lay the foundations for future research, and we
would like to steer the attention of the reader towards some potential areas of interest.

Firstly, it would be vital to witness if our findings regarding the performance of hedge fund
investment strategies individually and in portfolio context pertain exclusively to the observed
period or can be extended into a more prolonged time period going beyond May 2010.

Secondly, it would be essential to go deeper in detail in order to find out what caused certain
hedge fund strategies to perform in a rather unexpected and surprising manner. It would be
challenging and appealing task to explore why e.g. Dedicated Short Bias funds underperformed
so extensively and instead of beating the bearish market as expected they were outperformed not

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

only by bonds and other hedge fund investment styles, but also by stock indices. This type of
analysis could be extended to every single investment style that displayed to investors rather
unpleasant performance.

Thirdly, it would be helpful to investors to know what would happen with regards to construction
of optimal efficient portfolios given an eventual increase in the interest rates by the Federal
Reserve and/or the European Central Bank as expected to happen prompted by the nature of the
business cycle. Such increase would paint a different landscape for investors making bonds less
attractive asset class.

These are some of the areas of interest that could deepen further the analysis performed by us in
this master thesis, and that could confirm or reject some of the arisen uncertainties regarding the
performance characteristics of hedge funds.

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

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Appendices
The complete explanations of all data calculations regarding the performance measurement of
individual hedge fund investment strategies as well as the portfolio optimizations performed, is to
be found in the appendices of the digital version of the thesis enclosed.

Appendix 1: Explanation of the abbreviations used in the data calculations

Excel key
returns r(41-1) monthly returns from period 41 to 1 (left to right)
ln(r+1) monthly returns logged
risk-free risk free rate used
SR Sharpe ratio
JB Jarque-Bera test value
lag1 Ljung-Box test Q-stat at lag 1
lag24 Ljung-Box test Q-stat at lag 24
p at lag1 autocorrelation coefficient (p-value)
ac st.dev. Standard Deviation corrected for autocorrelation
surv.bias survivorship bias value (monthly)
bias.adj.r. mean return adjusted to bias (subtracted)
invest. 'w' investment value, set
Zα at 5% z-value at 95% confidence level
VaRi Value at Risk
corn-fisher Cornish-Fisher expansion (fat tails correction)
MVaR Modified Value at Risk
SR Sharoe Ratio (basic data)
MSR modified Sharpe Ratio- all adjustments considered
BiasSR Sharpe ratio with bias adjustment only
Bias-Ac-SR Sharpe ratio with bias and autocorrelation adjustment
Acorr.SR Share Ratio after autocorrelation adjustment only
mRet/risk return/risk ratio after all data adjustments (MVaR risk)
opt.fractions portfolio weights (fractions) from optimization
Return/risk ratios- portfolio return/risk ratios
-VaR-risk ratios based on VaR as risk estimate
-st.dev.risk ratios based on standard deviation as risk estimate
-traditional ratio calculated for the traditional portfolio (bonds only)
-portfolio ratio calculated for portfolio including hedge fund
-adj.portfolio ratio for portfolio with hedge fund and adjusted return data
corr.coeff- correlation coefficient (Pearson's r) between assets
weights.sq. portfolio weights squared- used in portfolio variance

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Appendix 2: Individual performance of hedge fund investment styles


Equity Market Neutral excl.Kingate
returns r(41-1) -0,033 0,0043 0,0054 -0,0135 0,001 -0,0087 0,0008 -0,0035 0,0096 0,0131 0,0179
ln(r+1) -0,033557 0,004291 0,005385 -0,01359 0,001 -0,00874 0,0008 -0,00351 0,009554 0,013015 0,017742
summary stats ( r ) SR 0,023647 summary stats ln( r ) SR 0,015746

Mean 0,001666 JB 21,6695 Mean 0,001546 JB 25,33328


Std. Error 0,002416 Std. Error 0,002442
Median 0,0048 Autocorr. Q-stat Median 0,004789
Mode 0,011 lag 1 0,348308 Mode 0,01094
Std.Dev. 0,015472 lag 24 23,8716 Std.Dev. 0,015635
Variance 0,000239 p at lag1 0,088897 Variance 0,000244
Kurtosis 4,647291 2,713569 ac st.dev. 0,017102 Kurtosis 4,9295 3,72297
Skewness -1,57885 2,492754 Skewness -1,6663 2,776567
Range 0,0924 Range 0,093392
Minimum -0,0561 Minimum -0,05774
Maximum 0,0363 Maximum 0,035657
Sum 0,0683 Sum 0,063394
Count 41 Count 41

surv.bias 0,002 bias.adj.r. -0,00033 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,028465 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,95314

MVaR 0,033737 mvar/var 0,185193

MSR -0,04844 mRet/risk -0,0099

SR 0,023647
MSR -0,04844
BiasSR -0,10562
Bias-Ac-SR -0,09555
Acorr.SR 0,021392

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,7873 0,2127
Bonds ( r ) 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio ® -0,000485 0,009103 0,000204 4,16E-05 0,012258 -0,01413 0,010326 0,003113 0,010309 0,010974 0,016483
summary stats r(p)

Mean 0,00306 VARp 0,013972


Std. Error 0,001617 bonds hedge f. portfolio
Median 0,00351 mean 0,003437 -0,00033 0,002635
Mode #N/A st.dev 0,010121 0,017102 0,009016
Std.Dev. 0,010354 variance 0,000102 0,000292 8,13E-05
Variance 0,000107 corn-fish -1,91539
Kurtosis 1,542132 MVAR(p) 0,014634
Skewness -1,14803 Return/risk ratios weights-sq 0,619841 0,045241
Range 0,0477 VAR-risk st.dev.risk
Minimum -0,02849 traditional 0,207757 0,282954
Maximum 0,019206 portfolio 0,219008 0,295524
Sum 0,125458 adj.portfolio 0,180029
Count 41

corr.coeff. 0,07864

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Hedge Fund aggregated Index

returns r(41-1) -0,0276 0,0124 0,0222 0,0068 0,0017 0,0088 0,0211 0,0013 0,0304 0,0153
ln(r+1) -0,02799 0,012324 0,0219572 0,006777 0,001699 0,008762 0,02088 0,001299 0,029947 0,015184
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR 0,052425 SR
Mean 0,002515 Mean 0,002246
Std. Error 0,003618 JB 12,90342 Std. Error 0,003662 JB
Median 0,0068 Median 0,006777
Mode 0,0124 Autocorr. Q-stat Mode 0,012324
Std.Dev. 0,023169 lag1 10,2807 Std.Dev. 0,02345
Variance 0,000537 lag24 47,22564 Variance 0,00055
Kurtosis 1,858899 1,3021116 p at lag1 0,482964 Kurtosis 2,077796 0,850461
Skewness -1,25011 1,5627777 ac st.dev. 0,04099 Skewness -1,32431 1,753794
Range 0,1061 Range 0,107541
Minimum -0,0655 Minimum -0,06774
Maximum 0,0406 Maximum 0,039797
Sum 0,1031 Sum 0,09208
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,000515 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,06691 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,93341

MVaR 0,078736 mvar/var 0,176748

MSR -0,00997 mRet/risk 0,006536

SR 0,052425
MSR -0,0104
BiasSR -0,0339
Bias-Ac-SR -0,01916
Acorr.SR 0,029632

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,8844 0,1156
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104
Portfolio 0,00415 0,010631 0,001505 0,004058 0,013728 -0,01278 0,013848 0,004484 0,0128 0,010966
summary stats r(p)

Mean 0,00333 VARp 0,015476


Std. Error 0,001786 bonds hf portfolio
Median 0,004484 mean 0,003437 0,000515 0,003099
Mode #N/A st.dev 0,010121 0,039321 0,010598
Std.Dev. 0,011433 variance 0,000102 0,001546 0,000112
Variance 0,000131 corn-fisher -1,94145
Kurtosis 2,549031 MVARp 0,017477
Skewness -1,34332 Return/risk ratios weights-sq 0,782163 0,013363
Range 0,056968 VAR-risk st.dev.risk
Minimum -0,03302 traditional 0,207757 0,282954
Maximum 0,023946 portfolio 0,215171 0,291263
Sum 0,13653 adj.portfolio 0,177305
Count 41

corr.coeff. 0,141854

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Hedge Funds’ Performance During The Bear Market Of 2007-2010

Convertible Arbitrage

returns r(41 -0,0251 0,0169 0,0206 0,0047 0,0097 0,0222 0,008 0,0216 0,0323 0,0339 0,058
ln(r+1) -0,02542 0,01675878 0,020391 0,004689 0,009653 0,021957 0,007968 0,02137 0,031789 0,033338 0,05638
summary stats ( r ) risk free 0,0013 summary stats ( r )
SR 0,039639 SR 0,019814
Mean 0,00278293 Mean 0,002067
Std. Error 0,00584265 JB 32,00457 Std. Error 0,006043 JB 43,60966
Median 0,008 Median 0,007968
Mode #N/A Autocorr. Q-stat Mode #N/A
Std.Dev. 0,03741124 lag1 13,99571 Std.Dev. 0,038692
Variance 0,0013996 lag24 37,33127 Variance 0,001497
Kurtosis 5,25388815 5,080012 p at lag1 0,563509 Kurtosis 5,971636 8,830619
Skewness -1,847591 3,413592 ac st.dev. 0,07138 Skewness -2,0431 4,174247
Range 0,184 Range 0,191035
Minimum -0,1259 Minimum -0,13456
Maximum 0,0581 Maximum 0,056475
Sum 0,1141 Sum 0,084732
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,000783 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,1166308 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,9999967

MVaR 0,14197777 mvar/var 0,217327

MSR -0,0036419 mRet/risk 0,005514

SR 0,03963854
MSR -0,0036419
BiasSR -0,0138213
Bias-Ac-SR -0,0072439
Acorr.SR 0,02077497

126
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Dedicated Short Bias


returns r(41-1) 0,0584 -0,0389 -0,0661 -0,032 0,0027 -0,0426 -0,0299 0,0479 -0,0527 -0,0169 -0,0726
ln(r+1) 0,056758 -0,03968 -0,06839 -0,03252 0,002696 -0,04353 -0,03036 0,046788 -0,05414 -0,01704 -0,07537
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR -0,08873 SR -0,11299
Mean -0,00303 Mean -0,00419
Std. Error 0,00762 JB 20,80326 Std. Error 0,007589 JB 21,06389
Median -0,0089 Median -0,00894
Mode #N/A Autocorr. Q-stat Mode #N/A
Std.Dev. 0,04879 lag1 0,055457 Std.Dev. 0,048595
Variance 0,00238 lag24 54,69373 Variance 0,002361
Kurtosis -0,39669 11,53748 p at lag1 0,035472 Kurtosis -0,46045 11,97471
Skewness 0,400012 0,16001 ac st.dev. 0,051107 Skewness 0,298067 0,088844
Range 0,1988 Range 0,198719
Minimum -0,0957 Minimum -0,10059
Maximum 0,1031 Maximum 0,098124
Sum -0,1242 Sum -0,17183
Count 41 Count 41

surv.bias 0,002 bias.adj.r. -0,00503 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,089095 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,53618

MVaR 0,083539 mvar/var -0,06237

MSR -0,07576 mRet/risk -0,0602

SR -0,08873
MSR -0,07576
BiasSR -0,12972
Bias-Ac-SR -0,12384
Acorr.SR -0,08471

127
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Emerging Markets
returns r(41-1) -0,0428 0,0101 0,0389 -0,0045 -0,0076 0,0197 0,0137 0,009 0,0494 0,0106 0,0383
ln(r+1) -0,04374 0,010049 0,038162 -0,00451 -0,00763 0,019508 0,013607 0,00896 0,048219 0,010544 0,037585
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR 0,034239 SR 0,014706
Mean 0,002595 Mean 0,001871
Std. Error 0,005907 JB 14,68402 Std. Error 0,006063 JB 22,90007
Median 0,0101 Median 0,010049
Mode 0,0224 Autocorr. Q-stat Mode 0,022153
Std.Dev. 0,037826 lag1 8,834682 Std.Dev. 0,038819
Variance 0,001431 lag24 46,56917 Variance 0,001507
Kurtosis 3,889819 0,791777 p at lag1 0,447713 Kurtosis 4,742759 3,037209
Skewness -1,39676 1,950937 ac st.dev. 0,061733 Skewness -1,60995 2,591927
Range 0,2059 Range 0,213815
Minimum -0,1363 Minimum -0,14653
Maximum 0,0696 Maximum 0,067285
Sum 0,1064 Sum 0,076706
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,000595 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,10095 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,92684

MVaR 0,118355 mvar/var 0,172414

MSR -0,00596 mRet/risk 0,005028

SR 0,034239
MSR -0,00596
BiasSR -0,01863
Bias-Ac-SR -0,01142
Acorr.SR 0,020979

128
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Event Driven (general)


returns r(41-1) -0,0307 0,0189 0,0285 0,0044 0,0142 0,0228 0,0216 0,0043 0,0289 0,0217 0,0233
ln(r+1) -0,03118 0,018724 0,028101 0,00439 0,0141 0,022544 0,02137 0,004291 0,02849 0,021468 0,023033
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR 0,115223 SR 0,103235
Mean 0,003873 Mean 0,003621
Std. Error 0,003488 JB 15,57785 Std. Error 0,003511 JB 15,28196
Median 0,0085 Median 0,008464
Mode 0,0189 Autocorr. Q-stat Mode 0,018724
Std.Dev. 0,022332 lag1 7,788025 Std.Dev. 0,022482
Variance 0,000499 lag24 54,29783 Variance 0,000505
Kurtosis 0,633316 5,601191 p at lag1 0,420356 Kurtosis 0,764367 4,998055
Skewness -0,93776 0,879388 ac st.dev. 0,034844 Skewness -0,99341 0,986871
Range 0,0997 Range 0,100553
Minimum -0,0575 Minimum -0,05922
Maximum 0,0422 Maximum 0,041334
Sum 0,1588 Sum 0,148456
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,001873 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,055441 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,88218

MVaR 0,063709 mvar/var 0,149128

MSR 0,008997 mRet/risk 0,029402

SR 0,115223
MSR 0,008997
BiasSR 0,025666
Bias-Ac-SR 0,01645
Acorr.SR 0,073849

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,8118 0,1882
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104
Portfolio 0,00096 0,012 0,00439 0,003832 0,015093 -0,00837 0,014537 0,004787 0,013963 0,012527
summary stats r(p)

Mean 0,003519 VARp 0,015059


Std. Error 0,001764 bonds hf portfolio
Median 0,004787 mean 0,003437 0,001873 0,003142
Mode #N/A st.dev 0,010121 0,034844 0,011269
Std.Dev. 0,011294 variance 0,000102 0,001214 0,000127
Variance 0,000128 corn-fisher -1,97372
Kurtosis 2,947894 MVARp 0,0191
Skewness -1,51826 Return/risk ratios weights-sq 0,659019 0,035419
Range 0,052994 VAR-risk st.dev.risk
Minimum -0,03265 traditional 0,207757 0,282954
Maximum 0,020342 portfolio 0,233666 0,311557
Sum 0,144269 adj.portfolio 0,164524
Count 41

corr.coeff. 0,152988

129
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Event Driven Distressed Securities


returns r(41-1) -0,025 0,0169 0,0264 0,0029 0,0202 0,0251 0,0208 0,0071 0,0338 0,0212 0,0225
ln(r+1) -0,02532 0,016759 0,026058 0,002896 0,019999 0,02479 0,020587 0,007075 0,033241 0,020978 0,022251
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR 0,042144 SR 0,030749
Mean 0,002241 Mean 0,001993
Std. Error 0,003489 JB 14,54114 Std. Error 0,00352 JB 14,45525
Median 0,0071 Median 0,007075
Mode 0,0208 Autocorr. Q-stat Mode 0,020587
Std.Dev. 0,022339 lag1 16,49091 Std.Dev. 0,022538
Variance 0,000499 lag24 75,0517 Variance 0,000508
Kurtosis 0,848709 4,628055 p at lag1 0,611683 Kurtosis 0,975743 4,097616
Skewness -0,98537 0,970958 ac st.dev 0,045115 Skewness -1,04451 1,090998
Range 0,0981 Range 0,098927
Minimum -0,0566 Minimum -0,05826
Maximum 0,0415 Maximum 0,040662
Sum 0,0919 Sum 0,081714
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,000241 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,073968 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,88965

MVaR 0,08501 mvar/var 0,149281

MSR -0,01245 mRet/risk 0,00284

SR 0,042144
MSR -0,01245
BiasSR -0,04738
Bias-Ac-SR -0,02346
Acorr.SR 0,020868

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,9108 0,0892
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio 0,00533 0,01098 0,001262 0,003629 0,015737 -0,01197 0,013605 0,005096 0,012578 0,011363 0,016671
summary stats r(p)

Mean 0,00333 VARp 0,015771


Std. Error 0,001813 bonds hf portfolio
Median 0,00533 mean 0,003437 0,000241 0,003152
Mode #N/A st.dev 0,010121 0,045115 0,010746
Std.Dev. 0,011612 variance 0,000102 0,002035 0,000115
Variance 0,000135 corn-fisher -1,93398
Kurtosis 2,954537 MVARp 0,017631
Skewness -1,34636 Return/risk ratios weights-sq 0,829557 0,007957
Range 0,06138 VAR-risk st.dev.risk
Minimum -0,03624 traditional 0,207757 0,282954
Maximum 0,025141 portfolio 0,211151 0,286771
Sum 0,136529 adj.portfolio 0,178757
Count 41

corr.coeff. 0,192787

130
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Event Driven Multi Strategy


returns r(41-1) -0,0353 0,0209 0,0307 0,0057 0,009 0,0213 0,0226 0,0021 0,0252 0,0223 0,0241
ln(r+1) -0,03594 0,020685 0,030238 0,005684 0,00896 0,021076 0,022348 0,002098 0,024888 0,022055 0,023814
summary stats ( r ) risk free 0,0013 summary stats ln( r )
SR 0,153144 SR 0,140348
Mean 0,004907 Mean 0,004624
Std. Error 0,003679 JB 14,62472 Std. Error 0,003698 JB 14,30112
Median 0,009 Median 0,00896
Mode 0,0431 Autocorr. Q-stat Mode 0,042197
Std.Dev. 0,023555 lag1 3,410907 Std.Dev. 0,023681
Variance 0,000555 lag24 40,56498 Variance 0,000561
Kurtosis 0,626961 5,631314 p at lag1 0,278188 Kurtosis 0,765827 4,991528
Skewness -0,85579 0,732374 ac st.dev. 0,031335 Skewness -0,91922 0,844965
Range 0,1048 Range 0,105883
Minimum -0,0617 Minimum -0,06369
Maximum 0,0431 Maximum 0,042197
Sum 0,2012 Sum 0,189569
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,002907 ivest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,048636 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,86177

MVaR 0,055432 mvar/var 0,139727

MSR 0,028996 mRet/risk 0,052449

SR 0,153144
MSR 0,028996
BiasSR 0,068236
Bias-Ac-SR 0,051294
Acorr.SR 0,11512

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,8202 0,1798
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio 0,000461 0,012288 0,004536 0,00406 0,014167 -0,00897 0,014644 0,004397 0,013143 0,01254 0,017538
summary stats r(p)

Mean 0,003701 VARp 0,014833


Std. Error 0,00176 bonds hf portfolio
Median 0,004536 mean 0,003437 0,002907 0,003341
Mode #N/A st.dev 0,010121 0,031335 0,010559
Std.Dev. 0,011267 variance 0,000102 0,000982 0,000111
Variance 0,000127 corn-fisher -1,95586
Kurtosis 2,692867 MVARp 0,017311
Skewness -1,41783 Return/risk ratios weights-sq 0,672728 0,032328
Range 0,054229 VAR-risk st.dev.risk
Minimum -0,03147 traditional 0,207757 0,282954
Maximum 0,022755 portfolio 0,24952 0,328475
Sum 0,151742 adj.portfolio 0,193027
Count 41

corr.coeff. 0,115906

131
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Event Driven Risk Arbitrage


returns r(41-1) -0,0152 -0,001 0,0069 0,003 0,004 0,0038 0,0103 0,0016 0,016 0,0095 0,0112
ln(r+1) -0,01532 -0,001 0,006876304 0,002996 0,003992 0,003793 0,010247 0,001599 0,0158733 0,009455 0,011138
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,214493 SR 0,207277
Mean 0,004039 Mean 0,003951
Std. Error 0,001994 JB 6,680303 Std. Error 0,001998 JB 7,104655
Median 0,004 Median 0,003992
Mode -0,001 Autocorr. Mode -0,001
Std.Dev. 0,01277 lag1 9,403002 Std.Dev. 0,012791
Variance 0,000163 lag24 30,60707 Variance 0,000164
Kurtosis 2,16922 0,690194818 p at lag1 0,461888 Kurtosis 2,295365 0,4965105
Skewness -0,89725 0,805056627 ac st.dev. 0,02114 Skewness -0,95686 0,915578
Range 0,0671 Range 0,067216
Minimum -0,0349 Minimum -0,03552
Maximum 0,0322 Maximum 0,031692
Sum 0,1656 Sum 0,162007
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,002039 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,032734 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,84108

MVaR 0,036882 mvar/var 0,126698

MSR 0,020038 mRet/risk 0,055286

SR 0,214493
MSR 0,061763
BiasSR 0,057873
Bias-Ac-SR 0,034959
Acorr.SR 0,129566

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,43 0,57
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio -0,0051 0,003902 0,003417 0,003301 0,008859 -0,00454 0,011418 0,003019 0,013635 0,009887 0,013307
summary stats r(p)

Mean 0,00378 VARp 0,012381


Std. Error 0,001534 bonds hf portfolio
Median 0,003902 mean 0,003437 0,002039 0,00264
Mode #N/A st.dev 0,010121 0,02114 0,01366
Std.Dev. 0,009825 variance 0,000102 0,0004469 0,000187
Variance 9,65E-05 corn-fisher -1,90893
Kurtosis 2,888669 MVARp 0,023435
Skewness -1,23448 Return/risk ratios weights-sq 0,1849 0,3249
Range 0,049212 VAR-risk st.dev.risk
Minimum -0,02759 traditional 0,207757 0,282954
Maximum 0,021622 portfolio 0,305307 0,384736
Sum 0,154979 adj.portfolio 0,11265
Count 41

corr.coeff. 0,214031

132
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Fixed Income Arbitrage


returns r(41-1) -0,0079 0,0175 0,0144 0,0007 0,0202 0,0076 0,0171 0,0194 0,0277 0,0238 0,0365
ln(r+1) -0,00793 0,017349 0,014297 0,0007 0,019999 0,007571 0,016955 0,019214 0,027323 0,023521 0,03585
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR -0,03623 SR -0,05054
Mean 0,000139 Mean -0,00039
Std. Error 0,005004 JB 110,7421 Std. Error 0,005228 JB 142,4547
Median 0,0076 Median 0,007571
Mode 0,0021 Autocorr. Q-stat Mode 0,002098
Std.Dev. 0,032041 lag1 14,6604 Std.Dev. 0,033473
Variance 0,001027 lag24 34,64461 Variance 0,00112
Kurtosis 9,063559 36,76675 p at lag1 0,576736 Kurtosis 10,17623 51,49825
Skewness -2,64848 7,014473 ac st.dev. 0,062602 Skewness -2,82356 7,972465
Range 0,1837 Range 0,193677
Minimum -0,1404 Minimum -0,15129
Maximum 0,0433 Maximum 0,042389
Sum 0,0057 Sum -0,01606
Count 41 Count 41

surv.bias 0,002 bias.adj.r. -0,00186 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,104835 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -2,08315

MVaR 0,13227 mvar/var 0,261698

MSR -0,0239 mRet/risk -0,01407

SR -0,03623
MSR -0,0239
BiasSR -0,09865
Bias-Ac-SR -0,05049
Acorr.SR -0,01855

133
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Global Macro
returns r(41-1) -0,0063 0,0165 0,0038 0,011 0,0107 -0,0143 0,0352 0,0021 0,0277 0,0086 0,0178
ln(r+1) -0,00632 0,0163654 0,003793 0,01094 0,010643 -0,0144 0,034595 0,002098 0,027323 0,008563 0,017643
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,238312 SR 0,225098
Mean 0,006539 Mean 0,006281
Std. Error 0,0034333 JB 9,447074 Std. Error 0,003456 JB 10,98244
Median 0,011 Median 0,01094
Mode 0,0021 Autocorr. Mode 0,002098
Std.Dev. 0,0219839 lag1 3,773625 Std.Dev. 0,022128
Variance 0,0004833 lag24 16,43446 Variance 0,00049
Kurtosis 2,6934358 0,093982 p at lag 1 0,292606 Kurtosis 2,999799 4,02E-08
Skewness -1,165763 1,359003 a-cor.st.de 0,030047 Skewness -1,26775 1,607187
Range 0,1107 Range 0,112043
Minimum -0,0663 Minimum -0,0686
Maximum 0,0444 Maximum 0,043443
Sum 0,2681 Sum 0,25752
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,004539 invest.'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,0448854 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,896432

MVaR 0,0524432 mvar/var 0,16838

MSR 0,0617625 mRet/risk 0,086551

SR 0,2383116
MSR 0,0617625
BiasSR 0,147336
Bias-Ac-SR0,1077983
Acorr.SR 0,1743605

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,5992 0,4008
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio 0,002448 0,0128449 0,000804 0,006626 0,013456 -0,01508 0,021838 0,003778 0,017394 0,009679 0,016781
summary stats r(p)

Mean 0,00468 VARp 0,017217


Std. Error 0,002079 bonds hf portfolio
Median 0,0049306 mean 0,003437 0,004539 0,003878
Mode #N/A st.dev 0,010121 0,030047 0,015327
Std.Dev. 0,0133123 variance 0,000102 0,000903 0,000235
Variance 0,0001772 corn-fisher -1,91043
Kurtosis 2,348598 MVARp 0,025402
Skewness -1,195103 Return/risk ratios weights-sq 0,359041 0,160641
Range 0,0625642 VAR-risk st.dev.risk
Minimum -0,034702 traditional 0,207757 0,282954
Maximum 0,0278621 portfolio 0,271822 0,351559
Sum 0,1918818 adj.portfolio 0,152684
Count 41

corr.coeff. 0,3634979

134
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Long Short Equity


returns r(41-1) -0,0413 0,0029 0,0299 0,0132 -0,015 0,0169 0,0192 -0,0121 0,0323 0,0142 0,0299
ln(r+1) -0,04218 0,002896 0,029462 0,013114 -0,01511 0,016759 0,019018 -0,01217 0,031789 0,0141 0,029462
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,032042 SR 0,017812
Mean 0,002202 Mean 0,001808
Std. Error 0,004399 JB 12,64778 Std. Error 0,004451 JB 12,40388
Median 0,0071 Median 0,007075
Mode 0,0299 Autocorr. Q-stat Mode 0,029462
Std.Dev. 0,028164 lag1 5,326517 Std.Dev. 0,028498
Variance 0,000793 lag24 29,5256 Variance 0,000812
Kurtosis 1,072285 3,716084 p at lag 1 0,347637 Kurtosis 1,303194 2,87915
Skewness -0,96014 0,921873 a-cor.st.de 0,040753 Skewness -1,04662 1,095414
Range 0,1304 Range 0,132297
Minimum -0,0781 Minimum -0,08132
Maximum 0,0523 Maximum 0,050978
Sum 0,0903 Sum 0,074111
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,000202 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,066832 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,87889

MVaR 0,076368 mvar/var 0,142685

MSR -0,01437 mRet/risk 0,002651

SR 0,032042
MSR -0,01437
BiasSR -0,03897
Bias-Ac-SR -0,02693
Acorr.SR 0,022144

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,9136 0,0864
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio 0,004015 0,009752 0,001487 0,004521 0,012682 -0,01279 0,013444 0,003431 0,012384 0,010728 0,017292
summary stats r(p)

Mean 0,00333 VARp 0,015849


Std. Error 0,001821 bonds hf portfolio
Median 0,004521 mean 0,003437 0,000202 0,003157
Mode #N/A st.dev 0,010121 0,040753 0,010306
Std.Dev. 0,01166 variance 0,000102 0,001661 0,000106
Variance 0,000136 corn-fisher -1,89694
Kurtosis 2,399046 MVARp 0,016393
Skewness -1,1432 Return/risk ratios weights-sq 0,834665 0,007465
Range 0,061635 VAR-risk st.dev.risk
Minimum -0,03316 traditional 0,207757 0,282954
Maximum 0,028474 portfolio 0,210103 0,285595
Sum 0,136528 adj.portfolio 0,192587
Count 41

corr.coeff. 0,127877

135
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Managed Futures
returns r(41-1) -0,0403 0,0189 0,0425 0,0181 -0,0381 -0,05 0,0494 -0,0217 0,0297 0,0092 -0,0043
ln(r+1) -0,04113 0,018724 0,041621675 0,017938 -0,03884 -0,05129 0,048219 -0,02194 0,029267 0,00915794 -0,004309272
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,091206 SR 0,074781964
Mean 0,00439 Mean 0,003825
Std. Error 0,005292 JB 30,75238 Std. Error 0,005273 JB 30,77738646
Median 0,0032 Median 0,003195
Mode 0,0513 Autocorr. Q-stat Mode 0,050027
Std.Dev. 0,033882 lag1 0,416177 Std.Dev. 0,033763
Variance 0,001148 lag24 39,61405 Variance 0,00114
Kurtosis -1,24278 18,00119772 p at lag1 0,097172 Kurtosis -1,24351 18,0074
Skewness -0,00701 4,91734E-05 a-cor.st.de 0,037676 Skewness -0,04644 0,002157
Range 0,1161 Range 0,1153
Minimum -0,05 Minimum -0,05129
Maximum 0,0661 Maximum 0,064007
Sum 0,18 Sum 0,156821
Count 41 Count 41

surv.bias 0,002 bias.adj.r. 0,00239 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,059583 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,67196

MVaR 0,060602 mvar/var 0,017111

MSR 0,01799 mRet/risk 0,039441

SR 0,091206
MSR 0,01799
BiasSR 0,032178
Bias-Ac-SR 0,028937
Acorr.SR 0,082022

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,8293 0,1672 0,0035
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio -0,00018 0,011818 0,00638909 0,006103 0,00612 -0,02116 0,019106 0,000436 0,013985 0,01014406 0,01301322
summary stats r(p)

Mean 0,0036 VARp 0,014507


Std. Error 0,001719 bonds hf MSCI em. portfolio
Median 0,003404 mean 0,003437 0,00239 0,00457674 0,003265628
Mode #N/A st.dev 0,010121 0,037676 0,12965134 0,00995278
Std.Dev. 0,011008 variance 0,000102 0,001419 0,01680947 9,90578E-05
Variance 0,000121 corn-fisher -1,8969358 -1,713167638
Kurtosis 1,270319 MVARp 0,24136352 0,013785152
Skewness -0,33782 Return/risk ratios weights-sq 0,687738 0,027956 0,00001225
Range 0,058773 VAR-risk st.dev.risk
Minimum -0,0267 traditional 0,207757 0,282954
Maximum 0,032069 portfolio 0,248155 0,327035
Sum 0,147601 adj.portfolio 0,236895
Count 41
corr.coeff.bond-hf -0,11724
corr.coeff.MSCI-hf 0,022773
corr.coeff.MSCI-bonds 0,12993

136
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Multi Strategy
returns r(41-1) -0,0219 0,0096 0,0144 0,0056 0,0056 0,0118 0,0096 0,0112 0,0286 0,0143 0,0299
ln(r+1) -0,02214 0,009554 0,014297 0,005584 0,005584 0,011731 0,009554 0,011138 0,028199 0,014199 0,029462
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,018376 SR 0,006082
Mean 0,001749 Mean 0,001451
Std. Error 0,003814 JB 12,94981 Std. Error 0,003872 JB 14,38992
Median 0,0066 Median 0,006578
Mode 0,0096 Autocorr. Q-stat Mode 0,009554
Std.Dev. 0,024422 lag1 15,8403 Std.Dev. 0,024792
Variance 0,000596 lag24 51,55894 Variance 0,000615
Kurtosis 2,537177 0,214206 p at lag1 0,599495 Kurtosis 2,819452 0,032598
Skewness -1,35703 1,841543 acor.st.dev 0,048685 Skewness -1,44834 2,097693
Range 0,1163 Range 0,118251
Minimum -0,0735 Minimum -0,07634
Maximum 0,0428 Maximum 0,041909
Sum 0,0717 Sum 0,059483
Count 41 Count 41

surv.bias 0,002 bias.adj.r. -0,00025 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,080333 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,94489

MVaR 0,094938 mvar/var 0,181805

MSR -0,01634 mRet/risk -0,00265

SR 0,018376
MSR -0,01634
BiasSR -0,06352
Bias-Ac-SR -0,03186
Acorr.SR 0,009218

PART II return time series calculation based on the fractions from optimization
opt.fractions 0,9827 0,0129 0,0045
Bonds 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
Portfolio 0,007461 0,010387 -0,00064 0,003719 0,014853 -0,01501 0,012992 0,004961 0,011087 0,01038 0,016696
summary stats r(p)

Mean 0,00342 VARp 0,016424


Std. Error 0,001884 bonds hf MSCI em. portfolio
Median 0,005723 mean 0,003437 -0,000250,004577 0,003394
Mode #N/A st.dev 0,010121 0,0486850,129651 0,010197
Std.Dev. 0,012064 variance 0,000102 0,00237 0,016809 0,000104
Variance 0,000146 corn-fisher -1,89694 -1,86691
Kurtosis 2,587109 MVARp 0,241364 0,015643
Skewness -1,03541 Return/risk ratios weights-sq 0,965699 0,000166 2,03E-05
Range 0,067506 VAR-risk st.dev.risk
Minimum -0,03651 traditional 0,207757 0,282954
Maximum 0,030997 portfolio 0,208249 0,283509
Sum 0,140232 adj.portfolio 0,217003
Count 41
corr.coeff.bond-hf 0,181498
corr.coeff.MSCI-hf 0,751033
corr.coeff.MSCI-bonds 0,12993

137
Hedge Funds’ Performance During The Bear Market Of 2007-2010

MSCI EAFE Index (equity)


returns r(41-1) -0,0918 0,0096 0,0795 0,0025 -0,0565 0,0381 0,0425 0,0002 0,0889 -0,0054 0,1087

summary stats ( r ) risk-free 0,0013


SR 0,036081
Mean 0,004577
Std. Error 0,014183 JB 9,100786
Median 0,002843
Mode #N/A Autocorr. Q-stat
Std.Dev. 0,090816 lag1 4,871899
Variance 0,008248 lag24 34,29649
Kurtosis 1,077756 3,695023 p at lag1 0,33247
Skewness -0,6388 0,408067 acor.st.dev 0,129651
Range 0,4416
Minimum -0,275
Maximum 0,1666
Sum 0,187646
Count 41

surv.bias 0 bias.adj.r. 0,004577 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,208687 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,79709

MVaR 0,228418 mvar/var 0,094552

MSR 0,014345 mRet/risk 0,020037

SR 0,018376
MSR -0,01634
BiasSR 0,036081
Bias-Ac-SR 0,025274
Acorr.SR 0,025274

138
Hedge Funds’ Performance During The Bear Market Of 2007-2010

Barclays Agg.Bond Index


returns r(41-1) 0,0083 0,0104 -0,0012 0,0037 0,0153 -0,0156 0,0129 0,0049 0,0105 0,0104 0,0161
ln(r+1) 0,008266 0,010346 -0,001201 0,003693 0,015184 -0,015723 0,012818 0,004888 0,010445 0,010346 0,015972
summary stats ( r ) risk-free 0,0013 summary stats ln( r )
SR 0,175917 SR 0,169108
Mean 0,003437 Mean 0,003359
Std. Error 0,001897 JB 6,304165 Std. Error 0,001901 JB 7,051628
Median 0,0049 Median 0,004888
Mode 0,0104 Autocorr. Mode 0,008266
Std.Dev. 0,012145 lag1 1,611763 Std.Dev. 0,012174
Variance 0,000148 lag24 20,00441 Variance 0,000148
Kurtosis 2,703178 0,088103 p at lag1 -0,191229 Kurtosis 2,843932 0,024357
Skewness -0,94897 0,900535 ac st.dev. 0,010121 Skewness -1,012846 1,025856
Range 0,0698 Range 0,069996
Minimum -0,0373 Minimum -0,038013
Maximum 0,0325 Maximum 0,031983
Sum 0,1409 Sum 0,137706
Count 41 Count 41

surv.bias 0 bias.adj.r. 0,003437 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,013211 z-power3 -4,450599
MVaR = −(z σ +r ) w
corn-fisher -1,84322

MVaR 0,015219 mvar/var 0,15193

MSR 0,140394 mRet/risk 0,225816

SR 0,175917
MSR 0,140394
BiasSR 0,175917
Bias-Ac-SR 0,211106
Acorr.SR 0,211106

139
Hedge Funds’ Performance During The Bear Market Of 2007-2010

S&P500 May2010
returns r(41-1) -0,0834 0,0132 -0,0012 0,0309 -0,036 0,0193 0,06 -0,0186 0,0373 0,0361 0,0756 0,002
ln(r+1) -0,08708 0,013114 -0,0012 0,030432 -0,03666 0,019116 0,058269 -0,01878 0,036621 0,035464 0,072879 0,001998
summary stats ( r ) risk-free 0,0013 summary stats ( r )
SR -0,10641 SR -0,13122
Mean -0,00464 Mean -0,00623
Std. Error 0,008712 JB 12,83196 Std. Error 0,008957 JB 11,70537
Median 0,0106 Median 0,010544
Mode -0,0843 Autocorr. Mode -0,08807
Std.Dev. 0,055781 lag1 4,968637 Std.Dev. 0,057353
Variance 0,003112 lag24 53,71342 Variance 0,003289
Kurtosis 0,64982 5,523347 p at lag1 0,335755 Kurtosis 1,069442 3,727053
Skewness -0,70499 0,497011 ac st.dev 0,079694 Skewness -0,88387 0,781218
Range 0,2636 Range 0,275196
Minimum -0,1679 Minimum -0,1838
Maximum 0,0957 Maximum 0,091393
Sum -0,19006 Sum -0,25525
Count 41 Count 41

surv.bias 0 bias.adj.r. -0,00464 invest. 'w' 1

Zα at 5% -1,6449 VaRi = −(zασi+ri ) w z-squared 2,705696


VaRi 0,131088 z-power3 -4,4506
MVaR = −(z σ +r ) w
corn-fisher -1,84546

MVaR 0,151707 mvar/var 0,157292

MSR -0,03913 mRet/risk -0,03056

SR -0,10641
MSR -0,05163
BiasSR -0,00594
Bias-Ac-SR -0,07448
Acorr.SR -0,07448

140

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