Alternative Tests of the Zero-Beta CAPM
by Pin-Huang Chou
National Central University

Abstract
In this paper I develop an analytical Wald test of the zero-beta capital asset pricing model (CAPM) in a simple iid (independent and identically distributed) setting, and extend the Wald test to the generalized method of moments (GMM) framework that allows for a general form of serial correlation and conditional heteroscedasticity. The size and power of these tests, along with some existing tests, are investigated under normal errors and other alternative distributional specifications. The results show that, under alternative distributional assumptions for the error terms, the proposed Wald and GMM tests have reliable sizes for medium-size samples, while the likelihood ratio test (LRT) tends to reject the efficiency too often, especially when the error terms significantly deviate from normality...

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Comparative Analysis of Linear Portfolio Rebalancing Strategies: An Application to Hedge Funds
University of Florida
November 19, 2001

Abstract
This paper applies formal risk management methodologies to optimization of a portfolio of hedge funds (fund of funds). We compare recently developed risk
management methodologies: Conditional Value-at-Risk and Conditional Drawdown-at-Risk with more established Mean-Absolute Deviation, Maximum Loss, and Market Neutrality approaches. The common property of considered risk management techniques is that they admit the formulation of a portfolio optimization model as a linear programming (LP) problem...

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Growth, Beta and Agency Costs as Determinants of Dividend Payout Ratios
by Michael S. Rozeff
SUNY at Buffalo - Department of Financial & Managerial Economics
September, 2004

Abstract
A model of optimal dividend payout is presented in which increased dividends lower agency costs but raise the transactions cost of external financing. The optimal dividend payout ratio minimizes the sum of these two costs. A cross-sectional test of the model relates dividend payout to the fraction of equity held by insiders, the past and expected future revenue growth of the firm, the firm's beta coefficient, and the number of common stockholders. The coefficients of all variables are significant in the predicted directions. The results indicate that investment policy influences dividend policy.

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Hedge Funds: Bubble or New Paradigm?
by Alexander M. Ineichen, CFA
UBS Warburg
November, 2001

Abstract
To some, hedge fund investing is a bubble, to others absolute return strategies is a New Paradigm in asset management. Reality is probably somewhere in between. On one hand expectations of high positive absolute returns from hedge funds when equity markets fall are probably too exaggerated. On the other hand, the focus on positive absolute returns and defining risk in a value-at-risk context might be in the process of replacing the relative return approach.

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Hedge Funds Investing: A Quantitative Look Inside the Black Box
by François-Serge Lhabitant
August 2001

Abstract
There is an increasing amount of evidence that shows the benefits of considering hedge funds as an asset class at the strategic asset allocation level. The investors’ greatest challenge remains the identification of desirable investment vehicles, since very little formal quantitative analysis of hedge funds has been done in the past. In this paper, we suggest an innovative approach to hedge fund investing, which is valid at the individual fund level as well as at the aggregate portfolio level (e.g. portfolio of hedge funds)...

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High Water Marks
by William N. Goetzmann, Jonathan Ingersoll Jr., & Stephen A. Ross
Yale School of Management
July 9, 1997

Abstract
Incentive fees for money managers are frequently accompanied by high water mark provisions which condition the payment of the incentive upon exceeding the maximum achieved share value. In this paper, we show that these high water mark contracts are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. We provide a closed-form solution to the high water mark contract under certain conditions...

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How to Price Hedge Funds: From Two-to-Four-Moment CAPM
by Angelo Ranaldo & Laurent Favre
UBS Global Asset Management & UBS Wealth Management
October 2003

Abstract
The CAPM model has serious difficulties to explain the past superior performance of most hedge funds. The purpose of this research is to analyze how to price hedge funds. We compare the traditional CAPM based on the Markowitz mean-variance criterion with extensions of the CAPM that account for coskewness and cokurtosis. The key result is that the risk-return characteristics of hedge funds can differ widely. The use of a unique pricing model may be misleading. The beta is an exhaustive risk measure only for some hedge funds. Other hedge funds have significant coskewness and cokurtosis. The lack of consideration of higher moments may lead to an insufficient compensation for the investment risk.

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Learning About Beta: An Explanation of the Value Premium
by Tobias Adrian and Francesco Franzoni
November 26, 2002

Abstract
We develop an equilibrium model of learning about time-varying risk factor loadings. In the model, CAPM holds from investors’ ex-ante perspective. However, positive mispricing can be observed when investors ’expectations of beta are above ex-post realizations...

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The Life Cycle of Hedge Funds: Fund Flows, Size and Performance
by Mila Getmansky
January 2, 2005

Abstract
Since the 1980s we have seen a 25% yearly increase in the number of hedge funds, and an annual attrition rate of 7.10% due to liquidation. This paper analyzes the life cycles of hedge funds. Using the TASS database provided by the Tremont Company, it studies industry and fund specific factors that affect the survival probability of hedge funds...

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Market Bubbles & Wasteful Avoidance:
Tax & Regulatory Constraints on Short Sales
by Michael R. Powers, David M. Schizer, and Martin Shubik
Cowles Foundation For Research In Economics
Yale University
April, 2003

Abstract
Although short sales make an important contribution to financial markets, this transaction faces legal constraints that do not govern long positions. In evaluating these constraints, other commentators, who are virtually all economists, have not focused rigorously enough on the precise contours of current law. Some short sale constraints are mischaracterized, while others are omitted entirely. Likewise, the existing literature neglects many strategies in which well advised investors circumvent these constraints; this avoidance may reduce the impact of short sale constraints on market prices, but may contribute to social waste in other ways. To fill these gaps in the literature, this paper offers a careful look at current law and draws three conclusions. First, short sales play a valuable role in the financial markets; while there may be plausible reasons to regulate short sales – most notably, concerns about market manipulation and panics – current law is very poorly tailored to these goals. Second, investor self-help can ease some of the harm from this poor tailoring, but at a cost. Third, relatively straightforward reforms can eliminate the need for self-help while accommodating legitimate regulatory goals. In making these points, we focus primarily on a burden that other commentators have neglected: profits from short sales generally are ineligible for the reduced tax rate on long-term capital gains, even if the short sale is in place for more than one year.

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Market Microstructure
by Hans R. Stoll
Owen Graduate School of Management
May 19, 2003

Abstract
Market microstructure deals with the purest form of financial intermediation -- the trading of a financial asset, such as a stock or a bond. In a trading market, assets are not transformed but are simply transferred from one investor to another. The field of market microstructure studies the cost of trading securities and the impact of trading costs on the short-run behavior of securities prices...

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Market Price of Variance Risk and Performance of Hedge Funds
by Oleg Bondarenko
March, 2004

Abstract
This paper implements a model-free approach to measure the market price of the variance risk. In this approach, the value of the variance contract is estimated from prices of traded options. We find that the variance risk is priced, its risk premium is negative and economically very large...

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The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias
by Ronald J. Gilson and Reinier Kraakman
October, 2003

This is a propitious time to revisit The Mechanisms of Market Efficiency
(“MOME”). We began that project some twenty years ago, as newly minted corporate law academics trying to understand what to make of a large empirical literature proclaiming the efficiency of the U.S. stock market. In an observation then offered as a simple description of the state of play, Michael Jensen had announced that “there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.”...

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Offshore Hedge Funds: Survival & Performance 1989-1995
by Stephen J. Brown, William N. Goetzmann, and Roger G. Ibbotson
NYU Stern School of Business & Yale School of Management
January 2, 1998

Abstract
We examine the performance of the off-shore hedge fund industry over the period 1989 through 1995 using a database that includes both defunct and currently operating funds. The industry is characterized by high attrition rates of funds, low covariance with the U.S. stock market, evidence consistent with positive risk-adjusted returns over the time, but little evidence of differential manager skill...

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On the Performance of Hedge Funds
by Bing Liang
Weatherhead School of Management
Case Western Reserve University
May, 1998

Abstract
This paper investigates hedge fund performance and risk. The empirical evidence indicates that hedge funds differ substantially from traditional investment vehicles such as mutual funds. The funds with watermarks significantly outperform the funds without watermarks. The average hedge fund returns are related positively to incentive fees, the size of the fund, and the lockup period. Hedge funds follow dynamic trading strategies and have low systematic risk. There are low correlations among different strategies. Compared with mutual funds, hedge funds offer better risk-return trade-offs: they have higher Sharpe ratios, lower mrket risks, and higher abnormal returns. In the period of January 1994 to December 1996, most hedge funds provide positive abnormal returns. Overall, hedge fund strategies dominate mutual fund strategies, hence hedge funds provide a more efficient investment opportunity set for investors.

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Optimal Mixing of Hedge Funds with Traditional Investment Vehicles
by Noel Amenc & Lionel Martellini
EDHEC Graduate School of Business
February 15, 2003

Abstract
In this paper, we discuss the state-of-the art techniques for optimal asset allocation to traditional and alternative investment vehicles, and we specifically account for the difficulties in estimating risk/return parameters from hedge fund return data. We first present various techniques allowing an investor to better assess the contrasted diversification properties of hedge funds. In particular, we introduce a multi-factor framework for the assessment of which funds should be included for which portfolio. We also present various competing models allowing investors to get a quantitative estimate of the optimal fraction of a given portfolio that should be allocated to hedge funds, in a context where only imperfect estimates of hedge fund expected returns are available. We not only discuss optimal strategic asset allocation decisions; we also explain how tactical asset decisions can also be made in a portfolio mixing traditional and alternative investment vehicles. Finally, we show how hedge fund can be used as portable alpha vehicles in a core/satellite portfolio approach.

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The Performance of Hedge Funds: Risk, Return and Incentives
by Carl Ackermann, Richard McEnally, and David Ravenscraft
October, 1998

Abstract
Hedge funds display several interesting characteristics that may influence performance. These include flexible investment strategies, strong managerial incentives, substantial managerial investment, sophisticated investors, and limited government oversight. Using a large sample of hedge fund data from 1988-1995, we find that hedge funds consistently outperform mutual funds, but not standard market indices...

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Quantitative Selection of Long-Short Hedge Funds
by Kaifeng Chen & Alexander Passow
University of Lausanne, GOTTEX, and FAME
July, 2003

Abstract
We develop a quantitative model to select hedge funds in the long-short equity sector. The selection strategy is verified on a survivorship-bias-free hedge fund database, from January 1990 to September 2002. We focus on the hedge funds acting exclusively in the U.S. market. We identify Fama-French factors and GSCI as the risk factors. Based on the evidence that many hedge funds do not exhibit persistent performance, we believe that persistent alpha is not generated based on publicly available information and opportunistic changes of exposure with respect to the risk factors. Instead we expect moderate exposure funds to be those who establish investment decisions based on special information or proprietary research. A hedge fund selection strategy is introduced and checked with out-of-sample data. A simulation of hedge funds from 1927 to 2002 is conducted. The funds selected according to our strategy demonstrate superior performance persistently.

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Realized Beta: Persistence and Predictability
by Torben G. Andersen, Tim Bollerslev, Francis X. Diebold, and Jin Wu
January, 2003

Abstract
A large literature over several decades reveals both extensive concern with the question of time-varying betas and an emerging consensus that betas are in fact time-varying, leading to the prominence of the conditional CAPM. Set against that background, we assess the dynamics in realized betas, vis-à-vis the dynamics in the underlying realized market variance and individual equity covariances with the market. Working in the recently-popularized framework of realized volatility, we are led to a model of nonlinear fractional cointegration: although realized variances and covariances are very highly persistent and fractionally integrated, realized betas, which are simple nonlinear functions of those realized variances and covariances, are less persistent, and arguably best modeled as a standard stationary I(0) process...

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The Relative Efficiency of Beta Estimates (Working Paper)
by Jan Bartholdy & Paula Peare
Aarhus School of Business
March, 2001

Abstract
When estimation of beta is based on the Capital Asset Pricing Model the standard
recommendation is to use five years of monthly data and a value-weighted index.
Given the importance of the beta estimate obtained for financial decisions, such as those involved in portfolio management, capital budgeting, and performance
evaluation, there is surprisingly little research evidence in support of this
recommendation. The objective of this paper is to address this shortcoming. For this purpose the relative efficiency of beta estimates which result from using different data frequencies, time periods, and indexes is examined. It is found that five years of monthly data and an equal-weighted index, as opposed to the commonly recommended value-weighted index, provides the most efficient estimate.

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Return Distributions of Private Real Estate Investments
by Roger Jelks Brown
The Pennsylvania State University - The Graduate School
Department of Insurance and Real Estate
May, 2000

Abstract
This dissertation investigates the distribution of returns accruing to individual
owners of investment real estate property. Previously, most research in investment real estate concentrated upon large institutional owners using finance paradigms, tools and methodology.
Other researchers have questioned the use of finance models, predominantly
Modern Portfolio Theory (MPT), for real estate research...

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The Risk in Hedge Fund Strategies: Theory & Evidence from Trend Followers
by William Fung & David A. Hsieh
PI Asset Management, LLC & Duke University
2001

Abstract
Hedge fund strategies typically generate option-like returns. Linear-factor models using benchmark asset indices have difficulty explaining them. Following the suggestions in Glosten and Jagannarthan (1994), this article shows how to model hedge fund returns by focusing on the popular "trend-following" strategy...

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Risk Management for Hedge Funds: Introduction and Overview
by Andrew W. Lo
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
June 7, 2001

Abstract
Although risk management has been a well-ploughed field in financial modeling for over two decades, traditional risk management tools such as mean-variance analysis, beta, and Value-at-Risk do not capture many of the risk exposures of hedge-fund investments. In this article, I review several aspects of risk management that are unique to hedge funds - survivorship bias, dynamic risk analytics, liquidity, and nonlinearities - and provide examples that illustrate their potential importance to hedge-fund managers and investors. I propose a research agenda for developing a new set of risk analytics specifically designed for hedge-fund investments, with the ultimate goal of creating risk transparency while, at the same time, protecting the proprietary nature of hedge-fund investment strategies...

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Style Consistency and Survival Probability in the Hedge Funds Industry
by Pierre-Antoine Bares, Rajna Gibson, & Sebastien Gyger
University of Zurich - Swiss Banking Institute (ISB)
February, 2001

Abstract
This study focuses on two problems that affect the choice of alternative investments, that is the style consistency of the manager and his survival probability. We first present a new quantitative approach to describe fund managers style consistency. We show, through hard and fuzzy clustering, that the investment style of a manager may depart over time from his reported style...

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