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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Financial integration in the EMU: The Fama and French Factors in the Euro zone

H.W.C. Vreedenburgh

ERASMUS UNIVERSITY ROTTERDAM

ERASMUS SCHOOL OF ECONOMICS

MSc Economics & Business

Master Specialisation Financial Economics

July 2010

ABSTRACT

Integration in the EMU stock markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks. This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market is can regarded as an integrated market, and what this means for the way stocks should be priced. This paper’s main contribution is providing evidence of EMU stock market integration by using a non-correlation method and asset pricing models, and what asset pricing model is able to price the stocks best in the integrated EMU zone. Using the principal component analysis, we have shown that there is an increasing degree of integration in the EMU zone. Although the rate of the smaller EMY countries is higher, the larger EMU countries were already quite integrated.This article also uses local, EMU and combined (EMU and local) factor models to see which model is able to price EMU stocks as a way of testing integration. We show that the Fama and French three factor model is better at pricing stocks for individual countries better than CAPM. This article shows that the EMU factors are doing quite well on pricing stocks, especially in the larger countries, although local factors still have an impact. Considering different time frames, we see that the local factors have lost much of their additional explanatory power in the post-2001 period. Finally, this paper shows that an EMU factor model is able to price all EMU stocks better than countries individually.

Keywords:  Asset pricing, Portfolio Choice, International Financial Markets, Financial Aspects of Economic Integration

JEL: F36, G11, G12, G15

Introduction

After the completion of the European Economic and Monetary Union (EMU), with the signing of the Maastricht Treaty in 1992, and eventually the introduction of the euro in 1999, Europe is supposed to have seen a remarkable economic integration ever since. As the euro was only introduced relatively recently, there are still limited academic studies on what impact the EMU (and the introduction of the euro) has on the EMU stock market, the integration of the EMU stock markets and its impact on stock pricing alone.

Integration in the EMU equity markets has some major implications for investors, their international portfolio diversification possibilities and the way they should price stocks.

This paper will add an insight and provide evidence in the discussion whether or not the EMU stock market can be regarded as an integrated market, and what this means for the way stocks should be priced.

This paper’s main contribution is providing evidence of EMU stock market integration by using a non- correlation method and asset pricing models, and to show what asset pricing model is best to price the stocks in the integrated EMU zone.

 The structural changes in the financial markets of the EMU zone have resulted in a changing approach to the use of EMU stocks in international portfolio management. An integrated European market could have a major impact on the way investors price stocks and how to achieve a well-diversified portfolio.  Although the size of the EMU equity market is - compared to the United States- not that big in terms of global market value, it has attracted a large number of non-EMU investors for its diversification benefits.

These investors have looked for opportunities to reduce portfolio risk by investing in stocks across different national markets where low correlations in return exist, while keeping the expecting return at the same level.

However, the assumed integration process of the EMU zone could potentially limit these benefits, as correlations between the EMU countries will rise. This could result in new optimizations in the commonly used mean-variance frontier in modern portfolio theory (Markowitz, 1952) for investors in the EMU zone.

On the other hand, the integration will lead to new opportunities and policies. The integration of the EMU stock market could result in one big investment area instead of several different ones, resulting in better risk sharing benefits, improvements in allocation efficiency and a reduction in economic volatility (Baele et al., 2004).

The creation of the EMU made it also possible for investors to buy EMU stocks without any limitations, as it is supposed to be a single market. Often, (institutional) investors were often restricted (for a  certain amount) to a certain country (or currency). This limitation could be removed if the EMU appears to be actually one single market. This could result in more investments in the EMU zone. It could also limit the question which EMU country is a better option, as the EMU zone will appear as one investment opportunity, and shifts the question to which industry in the EMU is a better investment.

In this paper we assume that the integration in the EMU market means that every stock within the EMU countries is subject to same (financial) circumstances and sensitive to the same (financial) shocks, regardless of the country in which they are traded. There should be no market frictions within the EMU stock markets and EMU countries.

This means that every investor in the EMU has the same opportunity set, the same limitations, same costs and risks when investing in stocks. We consider this as a fair expectation of an integrated market, however, we will look for evidence to support this assumption.

If this is the case (which we expect), then it is interesting to know if the stocks could be priced by the same risk factors, which could indicate if the market is really integrated. Do national risk factors still add something to the pricing of EMU stocks? Or is one EMU risk factor able to price all EMU stocks?

If we think about risk factors, it is a logical step to come to the Capital Asset Pricing Model (CAPM). At present, the CAPM is a model which probably is the most widely used model to price assets in the financial market. Even in the corporate world the CAPM is present, as it is the foundation to calculate the cost of equity. Hence it has a major impact in calculating the Weighted Average Cost of Capital (WACC), as the cost of equity is directly related to CAPM (investors want compensation for being exposed to none diversifiable risk) (Arzac, 2005).

The CAPM is presumed that in a case of a fully integrated market, with the assumption that purchasing power parity holds, CAPM should be able to price all assets (Grauer et al., 1976).

From the ‘basic’ CAPM - a one factor model - the multifactor extension by Fama and French is the most widely used (1992, 1993, 1995, 1996, 1998); the Fama and French Three Factor Model (3FM). They showed in their papers that the two variables (risk factors) ‘size’ and ‘value’ add to the explanatory power of the model. So it is interesting to see how the CAPM and 3FM perform in an integrated EMU market.

In this paper we will compare the two models and see if they are able to price the EMU countries and the EMU zone as a whole. As both models are based on the same principle, it is easy to compare them and it is interesting which one significantly performs better at pricing the European market.

This paper could also contribute to the methodological discussion on which asset pricing models perform better. Although most academic papers provide evidence that the 3FM performs better than CAPM, most research has been focused on the United States (US) and on European countries individually (the United Kingdom in particular). Limited articles are written about the EMU as a whole or on the EMU countries together. This is mostly because of the lack of data, different currencies before the euro and the small number of stocks in many European countries.

The creation of the EMU created potentially a new data area in which different theories could be tested, besides the UK, Japan and the US. The empirical results in this paper could contribute to the discussion if the models are able to explain the returns of stocks and possibly add support for (one of) the models. At first, we will look (a) if there is evidence for the stock markets of the 12 initial EMU countries (which do not contain current EMU members Cyprus, Malta, Slovenia and Slovakia) to be integrated.  We will use the principal component analysis (PCA) for the EMU zone in order to see if the equity markets in the EMU equities are correlated with the first principal component.

By doing this we want to find evidence which supports our assumption that the EMU zone is integrated and is subject to (some of) the same financial circumstances. Also we want to see what the impact of the EMU is on the integration in the EMU stock markets.

Secondly, we will construct the CAPM and the Fama and French three factor model (3FM) for the 12 EMU countries and for the EMU zone as a whole. We will compare the results in order to see if the CAPM is better a pricing EMU stocks then 3FM (b) when using national factors and (c) when using EMU factors.

We also add national factors to the EMU CAPM and 3FM to see (d) if the addition of these factors to an EMU 3FM has any significant impact. We can look if the EMU risk factors are able explain the returns, which could be evidence for EMU integration in the stock markets. We will look (e) if there is evidence that the EMU got more integrated after 2001 by looking at the impact of national factors in the asset pricing models.

Finally, we will look (f) for evidence if the EMU factors are able to price the EMU zone as a whole. We will test the PCA for the period January 1992 until December 2009, while the CAPM and 3FM will be tested for the period of July 1993 until June 2009 by using the adjusted R2 and – only for the CAPM and 3FM - the pricing error α (Jensen, 1968).

This paper is structured as follows. Section 2 will provide background information and a review of prior research. Section 3 describes the data employed. Section 4 defines the methodology used. Section 5 shows how the risk factors are constructed. Section 6 presents the descriptive statistics used and the results. Finally, section 7 will conclude the paper.

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