Can Liquidity Risk Explain the Size-Performance Relationship for Hedge Funds?

Diversification in the hedge fund industry

While the performance of hedge funds has grabbed much attention from researchers, a few studies have been conducted on the drivers of hedge fund liquidity and performance (Shaub & Schmid, 2013). This study proposes new approaches to investigate the effect of share restrictions on European hedge fund performance and liquidity. We run different regressions of 1) returns, 2) flows, and 3) exposure to market liquidity risk on share restrictions, managerial incentives, and a set of control variables as independent variables. Using a sample of 1423 European hedge funds, our results suggest that restrictions imposed by European hedge funds add economic value to investors. Furthermore, we find that European hedge funds with strong share restrictions take on lower liquidity risk. There is a weak difference in liquidity risk exposure across directional European hedge funds with and without share restrictions. In addition, European hedge funds’ experience, large outflows during a crisis, and all share restrictions do not seem to be significantly related to funding flows in the crisis period, as well as in times of non-crisis. Finally, only the groups of young funds are associated with significant funds exposure to market liquidity risk

This study examines the impact of trading costs and related factors on the unobserved performance of hedge funds through a qualitative literature review approach. The review covers recent studies on explicit and implicit costs, liquidity risk, portfolio complexity, hedge fund size, and risk management strategies. The findings reveal that trading costs significantly affect the net returns of hedge funds, while liquidity risk and portfolio complexity hinder asset management efficiency. Large hedge funds benefit from economies of scale but face challenges in risk management and transparency. The study also highlights that data-driven risk management strategies can enhance long-term return stability. This research underscores the need for a holistic evaluation to understand hedge fund performance and discusses limitations associated with the qualitative approach.

Various studies have analyzed the determinants of hedge fund performance. The majority of them, however, come to contradictory conclusions with respect to the direction of influence of different factors on fund performance. The key reason for the inconsistencies is the highly dynamic nature of hedge funds. This paper specifically focuses on the dynamics of the relations between hedge fund performance and various microeconomic factors. It quantifies shifts in the average fund alpha that result from changes in hedge fund style, age, size, and fee structure and investigates the time variation of these shifts. The empirical results highlight the dynamic nature of the hedge fund industry. Hedge funds seem to generate a positive and significant alpha on average; however, the alpha level varies considerably over time. It is hard to predict the exact absolute alpha level based on the hedge fund micro-factors, but it seems to be possible to rank hedge funds using the micro-information. The results suggest that large funds with high relative inflow, charging higher than median management fees, are likely to deliver a higher alpha than their peers most of the time.KeywordsHedge FundHigh AlphaAbsolute FlowFund FlowAverage AlphaThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

Using data from the Lipper/TASS hedge fund database over the period 1994–2011, the authors examine the effect of liquidity risk on the relationship between size and performance for funds of hedge funds (FOFs). After confirming a significant positive size effect for FOFs, they explicitly introduce liquidity risk and find that this scale effect becomes more pronounced among FOFs with lower liquidity risk. To the extent that more illiquid FOFs exhibit higher liquidity risk, the results provide evidence in support of the liquidity hypothesis that size does not erode, but instead helps improve, performance, since FOFs do not directly manage portfolios of securities and thus are less affected by the liquidity costs associated with trading a large portfolio.

Does Size Matter in the Hedge Fund Industry?

Chapter 8 - The Hedge Fund Paradigm

Tail risk of hedge funds: an extreme value application

This chapter focuses on new trends in the hedge fund industry. The chapter begins by creating some historical context for the current perception and state of hedge funds. The remainder of this chapter focuses on the following trends and their potential impact on the industry: (1) growth in all areas of the industry, especially in terms of long-term capital flows from institutional investors; (2) uncertainty about growth in the short term; (3) ways hedge funds approach growth; (4) the need for more diversity among hedge fund managers, including more minorities and women; (5) diverging long-term objectives for larger and smaller hedge funds; (6) future cost savings to investors; (7) development of new investment options to address liquidity concerns for investors; (8) new regulations; and (9) the future role of technology in the hedge fund industry.

Hedge funds increasingly are becoming a focus of investors and U.S. regulatory agencies including the U.S. Securities and Exchange Commission (the “SEC”), the U.S. Treasury Department, the National Association of Securities Dealers, and the Commodity Futures Trading Commission as enhanced regulatory attention is forcing the hedge fund industry for the first time since the near‐collapse of Long‐Term Capital Management, L.P. in late 1998 to examine itself more closely. In light of the dismal performance of U.S. stock market indices over the past several years, investors are turning to “absolute” return vehicles, such as hedge funds, that are able to generate current positive returns in a market that has returned consistently laggard results. Investors’ ability to invest in hedge funds has been further enhanced by the increase of hedge funds‐of‐funds registered under the U.S. Investment Company Act of 1940, as amended (the “1940 Act”). Simultaneously, over the past 18 months, the SEC has become increasingly concerned with a multitude of industry occurrences including (i) the widening access of investors to hedge funds, (ii) the unregulated nature of hedge funds, potentially leading to fraud or conflicts of interest with their investors, and (iii) the impact of hedge funds on the markets, especially in relation to their use of short selling. As U.S. regulatory attention remains focused on the hedge fund industry and industry practice and the themes of potential new regulations become apparent, it has become a cautionary period for hedge fund sponsors and investment managers.

This short article updates research originally published in the February 2007 issue of the investment journal <i>Derivatives Use</i>, <i>Trading &amp; Regulation</i> (re-titled of as May 2007 to <i>Journal of Derivatives &amp; HedgeFunds</i>). The original article and this update attempt to discover whether smaller, younger hedge funds offer stronger performance than larger, older hedge funds. Using indices created with six subsets of hedge fund data (small, medium, large, young, mid-age, and older funds), and Monte Carlo simulations, we examine the performance, volatility, and risk profiles of each fund group. <b>TOPICS:</b>Performance measurement, volatility measures, risk management

Since 1997, the hedge fund industry has grown at a compounded annual growth rate of 16.07%, resulting in a 26-fold increase from its original value to its present value of $3.1 trillion Assets Under Management. This study researched the varying investment strategies used by hedge funds to determine the strategy that provides the highest returns for its investors. From the previous literature, the study identified Long/Short Equity, Global Macro, Arbitrage, Event Driven, and Cross-Asset Multi-Strategy as viable and relevant investment approaches. Using hedge fund index data from Bloomberg, Hedge Fund Research, Eureka Hedge, Barclay’s, and Credit Suisse, returns for each respective strategy were collected and compared against the Bloomberg Global Hedge Fund (BHEDGE) Index and the S&amp;P 500 Index. Alpha adjusted returns for each strategy were later calculated and plotted against the average weighted returns of each individual strategy. The results of this study show that the L/S Equity strategy provided the highest returns for its investors. Specifically, only the L/S Equity strategy outperformed the BHEDGE Index by a narrow margin, while all other strategies provided negative alpha figures. All hedge fund strategies outperformed the overall equity market on a year-to-date basis, however, provided negative alpha returns when compared to the S&amp;P 500 1-Year market gains. This deficit between hedge funds and the overall equity market can be attributed to the COVID-19 pandemic and its inflationary effects through low interest rates, market stimulus packs, and an increased money supply.

THOMAS SCHNEEWEIS is a professor at the School of Management of the University of Massachusetts at Amherst. R ecent events in financial markets have focused interest on the existence and operations of a relatively new form of investment entity, the hedge fund. While many definitions for hedge funds exist, they are basically ‘‘loosely regulated private pooled investment vehicles that can invest in both cash and derivative markets on a leveraged basis for the benefits of its investors.’’ Unfortunately, there are a number of myths surrounding hedge funds and the risk and return opportunities that hedge funds offer. In a short comment one cannot cover in detail all of the misconceptions about the performance of hedge funds or other alternative investments. In fact, journals such as The Journal of Alternative Investments exist to permit a better long term understanding of many of the new alternative investment forms. However, despite a wide range of research conducted on hedge funds and their performance, the following are a number of popular misconceptions.

Systemic Risk and Hedge Funds

PurposeThe purpose of this paper is two fold: educate investors about hedge fund managers' activities prior to the fraud recognition by the authorities and to help investors and other stakeholders in the hedge fund industry identify red flags before fraud is actually committed.Design/methodology/approachThe paper investigates fraud committed by the Bayou Funds, Beacon Hill Asset Management, Lancer Management Group (LMG), Lipper &amp; Company and Maricopa investment fund. The fraud activities took place during 2000 and 2005.FindingsThe five cases alone cost the hedge fund investors more than $1.5 billion. Investors may have had a good opportunity for avoiding the irrecoverable costs of the fraud had they carefully vetted the backgrounds of the hedge fund managers and/or continuously monitored the funds activities, especially during turbulent market environments.Originality/valueThis is the first research paper to identify and extensively investigate fraud committed by hedge funds. In spite of the size of the hedge fund industry and relatively substantial level and inevitably recurring fraud, academic journals are to yet address this issue. The paper is of great value to hedge funds and their individual and institutional investors, asset managers, financial advisers and regulators.