An Analysis of Hedge Fund Strategies

Daniel P.J. CAPOCCI

HEC-ULG Management School – University of Liège

(Belgium)

PhD Thesis in Management

Abstract

This PhD thesis analyses hedge fund strategies in detail by decomposing hedge  fund performance figures. Our aim is to present hedge funds, to understand what managers expect to do and to understand how they make or destroy value over time. In order to achieve this objective, we develop a multi-factor performance analysis model, use it over several time periods and improve it over time. This model aims to determine  both whether hedge funds create pure alpha over time (alpha over classical markets) and  whether there is persistence in hedge fund returns over time. Following this, I analyse  another specific aspect of hedge funds, their neutrality relative to equity markets in order  to validate hedge fund managers’ claims that they are market neutral. Finally, we develop new efficient frontier measures, which not only include returns and volatility, but also skewness and kurtosis in order to determine whether hedge funds are really beneficial to investors.

Introduction and Purpose

Hedge funds are private investment vehicles that can take long and short  positions in various markets, using various investment strategies and these funds are  accessible to large investors only. On the one hand, this definition is precise; on the  other, it is very broad. This is clear and focused. From another point of view, the funds  may use various kinds of securities on various markets. This part of the definition is  much more open and allows almost anyone to classify his fund as a hedge fund as long  as it is long and short…

Since the early 1990s, when around 2,000 hedge funds were managing assets  totalling ca. $60 billion, the subsequent growth in the number and asset base of hedge funds has never really been refuted. The industry only suffered from a relative slowdown  in 1998, but since then has enjoyed a renewed vitality with an estimated total of 10,000  funds managing more than a trillion US dollars by the end of 2006. The growing trend of  the sector remained remarkably sustained during the stock market collapse that started  in March 2000, when the NASDAQ Composite Index reached an all-time high of 5,132,  and finished three years later with a floor level of 1,253. In the meantime, the global net asset value (NAV) of hedge funds continued to grow at a steady rate of 10.6% (Van Hedge Funds Advisors International, 2002), contrasting with a decrease of 2.7% in the  worldwide mutual fund industry (Investment Company Institute, 2003). More recently, in  2001, Capocci & Hübner (2004) estimated that there were 6.000 HF managing around  $400b. In 2007, Capocci, Duquenne & Hübner (2007) estimate that there are 10.000 HF  managing around $1trillion. This is a growth of 11% in the number of funds and 26% in assets over six years.

In the remainder of this introduction I present a global literature review. Then, I  present the data issue before disserting on investing in hedge funds for the final  investors. Finally, we present the three parts of the Thesis in detail.

The purpose of this doctoral thesis is clearly established: to understand hedge fund strategies by looking at the performance numbers produced. Our first objective of the studies is to understand clearly hedge fund managers and to explain how they create  alpha over time. This involves developing, testing and improving a performance analysis  model to understand hedge fund performance, while developing and adapting a methodology to determine whether there is any persistence in hedge fund returns on the  other. I achieve this objective in three complementary studies grouped in Part 1 (An  Analysis of Hedge Fund Performance, Hedge Fund Performance and Persistence in Bull and Bear Markets and Sustainability in Hedge Fund Performance: New Insights).

The second objective of the thesis is clearly linked to the first. Since the purpose  is to understand hedge fund strategies in detail, I perform a specific analysis on the most represented and the most interesting, market neutral funds. By definition, market neutral funds must a limited exposure to the market. I check for this neutrality and analyse what kind of funds consistently outperform over time: the pure market neutral funds, market timers or funds with a more directional bias (see Part two: An Analysis of Hedge Fund’s Market Exposure).

Finally, the third complementary objective for the thesis is to determine whether  hedge fund strategies should be included in a classical portfolio of stocks and bonds. In  Part three, Diversifying Using Hedge Funds: A Utility-Based Approach, we analyse the inclusion of hedge funds in a portfolio of stocks and bonds. The main originality of this study centres upon the development of a new efficient frontier, based not only on  volatility but also on higher moments (skewness and kurtosis) and on a utility function  that more closely corresponds to that of the investor without normality or other strong  assumption.

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