The Economics And Finance Of Hedge Funds

Vikas Agarwal

Georgia State University; University of Cologne – Centre for Financial Research (CFR)

Kevin Mullally

Robinson College of Business, Georgia State University

Narayan Y. Naik

London Business School – Institute of Finance and Accounting

August 25, 2015

Foundations and Trends in Finance, Forthcoming


Hedge funds have become increasingly important players in financial markets. This heightened importance has spawned a large academic literature focused on issues pertinent to hedge fund managers, investors, regulators, and policymakers. Although the top-4 finance journals (JF, JFE, RFS, and JFQA) published only 16 papers on hedge funds prior to 2005, they have published 105 papers on hedge funds since 2005. As a result, we felt that it is time to update the survey published in 2005. This update prepared with the help of a new coauthor, Kevin Mullally, extends the previous survey along two dimensions. First, it includes reviews of recent studies on topics that were covered in the earlier survey. Second, it summarizes research on new topics that were not part of the previous survey. These new topics cover a broad gamut of issues ranging from hedge funds’ use of leverage and exposure to different risks to their impact on various asset markets.

This survey consists of five broad sections. The first section reviews the literature examining both the time-series and cross-sectional variation in hedge fund performance. Time-series performance studies cover return generating processes, dynamic risk exposures, and determination of managerial skill. The second section covers studies focused on the cross-sectional relations between hedge funds’ characteristics (including contractual features and time-varying features such as size and age) and fund performance. The third section analyzes the literature on the sources and nature of risks faced by hedge fund investors. In particular, we discuss risks that can arise from managerial incentives and sources of capital. The fourth section summarizes research on the role of hedge funds in the financial system. Specific topics here include hedge funds’ impact on systemic risk, asset prices, and liquidity provision in financial markets. The fifth and final section focuses on potential biases and limitations of hedge fund data sources.

The Economics And Finance Of Hedge Funds – Introduction

Critics of hedge funds often label them as greedy, corrupt, and highly compensated villains that disrupt and pose threat to financial markets. Further, some corporations may also be wary of hedge funds’ aggressiveness in forcing them to change to policies corporations deem as value destroying. In contrast, proponents of hedge funds view them as informed traders that help improve market quality and corporate governance. Despite these divergent beliefs, the hedge fund industry has continued to grow at a phenomenal pace. Hedge Fund Research (HFR) estimates that the total assets under management (AUM) of the hedge fund industry increased from $39 billion in 1990 to more than $2.97 trillion as of the second quarter of 2015. During the same period, the total number of active hedge funds rose from 610 to over 10,000. Hedge funds also hold an increasingly large percentage of the stock market. A recent study by Cao et al. (2014) finds that average holding of hedge funds in publicly traded stocks has risen over time from 3% during 2000-2003 to 9% in 2008-2012.

Given their increased influence on financial markets, it has become even more imperative to gather and disseminate information on hedge funds. However, this task is challenging due to the limited data available on the loosely regulated hedge fund industry. Despite this limitation, academic research by financial economists has kept up with the pace of growth in the hedge fund industry. While there were only 16 papers on hedge funds published in the premier finance journals (JF, JFE, RFS, and JFQA) prior to 2005, these journals have published 105 papers on hedge funds since 2005. Recent research has increasingly focused on new sources of risks in hedge funds, identification of managerial skill using different statistical approaches and databases, different manifestations of agency problems and their relation with the contractual features of hedge funds, and the impact of hedge fund activity on market stability and asset prices. Our goal is to provide readers with a comprehensive update of the hedge fund research that has taken place in the past ten years. To that end, we will use the following format. For each topic, we will first summarize the findings of studies completed prior to 20050 and include references to that literature in footnotes. Readers interested in more detailed discussion of those studies should consult the previous version of this survey article (Agarwal and Naik, 2005).1 We will provide in-depth reviews of papers written since 2005. Finally, for each topic, we will summarize the current state of the literature and offer our views on avenues for future research.

The rest of the paper is organized as follows. The first two sections summarize research on hedge fund performance including the factors that drive hedge fund returns, the dynamic and nonlinear nature of hedge fund risk exposures, performance persistence, and the relation between fund characteristics and performance. The third section of the paper covers research on the sources and nature of risks faced by hedge fund investors. Examples of risks academics have recently studied include operational risk, funding liquidity risk, and tail risk. The fourth section summarizes research on the role of hedge funds in financial markets. Specific topics include hedge funds’ contribution to systemic risk, their impact on asset prices, and funds’ liquidity provision. The fifth and final section discusses the research on the potential biases and limitations of hedge fund data sources. In particular, we summarize the research on selection, backfilling, return smoothing, and survivorship biases.

Section 1: Hedge fund performance

This section covers research on various facets of hedge fund performance including comparison with performance of mutual funds and other asset classes, analyses of returngenerating processes using multifactor models, the nonlinear and dynamic nature of hedge fund payoff structures, estimation of manager skill and timing ability, and investigation of performance persistence. We review each of these topics below.

1.1. Risks and rewards: Hedge funds versus mutual funds and other asset classes Early academic research in this area compared the performance of hedge funds with mutual funds. Since hedge funds are loosely regulated and therefore not obligated to disclose information about their investment strategies or returns, it was a natural starting point to try to understand hedge funds by comparing them to something more familiar like mutual funds. Although hedge funds and mutual funds are both investment vehicles, the trading strategies they employ are very different. Hedge funds employ more dynamic trading strategies, typically take both long and short positions, and often purchase illiquid assets. Moreover, hedge funds claim to be providers of absolute, rather than, relative returns. These distinctions give rise to differences in the risk-return characteristics of these two investment vehicles. Researchers have compared these two types of funds and generally find that hedge funds have both higher risk-adjusted performance and higher levels of risk (Ackermann, McEnally, and Ravenscraft, 1999; Liang, 1999).

The Economics And Finance Of Hedge Funds

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