Indexation doesn’t make sense

Managed Futures and Hedge Funds: A Match Made in Heaven

Abstract: In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. AddingContinue reading

In Search of the Optimal Fund of Hedge Funds

Abstract: In this paper we investigate whether it is possible for a fund of hedge funds to not only offer investors access to a diversified basket of hedge funds but to provide skewness protection at the same time. We study two different strategies. The first is for a fund to buy stock index puts and leverage itself, in line withContinue reading

The Dangers of Using Correlation to Measure Dependence

Taking the Sting Out of Hedge Funds

Abstract: Although the inclusion of hedge funds in an investment portfolio can significantly improve that portfolio’s mean-variance characteristics, it can also be expected to lead to significantly lower skewness and higher kurtosis. In this paper we show how this highly undesirable side-effect can be neutralized by allocating a fraction of wealth to out-of-the-money put options on the relevant equity index.Continue reading

Operational Risk Management

Abstract: We view risk management as an integral part of good management. Risk management should take a balanced view of decision problems encompassing all significant risks and rewards. Operational risks are only one type of risks and therefore are only one piece in the jigsaw puzzle that only makes sense when all pieces are assembled. All risk analyses are basedContinue reading

A Constructive Review of Basel’s Proposals on Operational Risk

Abstract: Risk and loss are common words that need to be clearly defined when embarking on the task of assessing operational risks. Financial institutions may rush into implementing the methodologies proposed by Basel in the hope of achieving better risk management ? or simply to satisfy a regulatory request ? but without giving enough thoughts to this enterprise. We showContinue reading

Smart Fund Managers? Stupid Money? (updated July 2003)

Abstract: We develop a theoretical model of a mutual fund manager’s investment decision that incorporates three well-known observations: (i) past fund performance influences subsequent net fund inflows; (ii) fund manager compensation rises with total assets under management; (iii) trading has short-run price impacts. These observations provide fund managers the incentive to distort investment of new cash inflows toward stocks inContinue reading

Common Correlation Structures for Calibrating the LIBOR Model

Abstract: In 1997 three papers that introduced very similar lognormal diffusion processes for interest rates appeared virtuously simultaneously. These models, now commonly called the ‘LIBOR models’ are based on either lognormal diffusions of forward rates as in Brace, Gatarek & Musiela (1997) and Miltersen, Sandermann & Sondermann (1997) or lognormal diffusions of swap rates, as in Jamshidian (1997). The consequentContinue reading

Correlation of Default Events: Some New Tools

Abstract: Estimating and pricing correlation of credit deterioration is difficult, but can be handled with standard notions of correlation. The same however is not true for default events. The notion of correlation that one needs to use in dealing with credit default is fundamentally different from the notion of correlation that is useful in dealing with credit deterioration in creditContinue reading

The True Distortions in the With Profits Market: “If disclosure is not the problem, then more information is not the answer”

Abstract: The Financial Services Authority’s review of With Profits policies has been motivated by a perception that consumer understanding of these products is insufficiently developed. This paper suggests that these concerns have not so much been overstated as misguided. With profits policies are complicated but consumers don?t need to understand them. Their merits need restating. Recent research has concluded thatContinue reading

Generalization of the Sharpe Ratio and the Arbitrage-Free Pricing of Higher Moments

Abstract: We present an extension of the traditional Sharpe ratio to allow for the evaluation of non-normal return distributions. Combining earlier work in this area with stochastic simulation, we develop a procedure that allows for the construction of a benchmark for the evaluation of the performance of funds with a non-normal return distribution, while maintaining the operational ease of theContinue reading

A Three-Regime Model of Speculative Behaviour: Modelling the Evolution of Bubbles in the S&P 500 Composite Index

Abstract: In this paper we examine whether a three-regime model that allows for dormant, explosive and collapsing speculative behaviour can explain the dynamics of the S&P 500 Composite Index for the period 1888-2001. We extend existing two-regime models of speculative behaviour by including a third regime that allows for a bubble to grow at a steady growth rate, and examineContinue reading

Persistence in Hedge Fund Performance: The True Value of a Track Record

Abstract: In this paper we study the persistence and predictability of several statistical parameters of individual hedge fund returns. We find little evidence of persistence in mean returns but do find strong persistence in hedge funds? standard deviations and their correlation with the stock market. Persistence in skewness and kurtosis is low but this could be due to the smallContinue reading

An Excursion into the Statistical Properties of Hedge Funds

Abstract: This paper provides an overview of the most important statistical properties of individual hedge fund returns. We find that the net-of-fees monthly returns of the average individual hedge fund exhibit significant degrees of negative skewness, excess kurtosis, as well as positive first-order serial correlation. The correlations between hedge funds in the same strategy group are of the same orderContinue reading

Stocks, Bond and Hedge Funds: Not a Free Lunch

Abstract: We study the diversification effects from introducing hedge funds into a traditional portfolio of stocks and bonds. Our results make it clear that in terms of skewness and kurtosis equity and hedge funds do not combine very well. Although the inclusion of hedge funds may significantly improve a portfolio’s mean-variance characteristics, it can also be expected to lead toContinue reading

Performance Evaluation and Conditioning Information: The Case of Hedge Funds

Abstract: In this paper we investigate whether there are any significant differences in the ability of constant and time-varying expected return asset pricing models to detect superior performance in hedge funds. Our results strongly suggest that the static models traditionally employed to measure and evaluate hedge fund performance are misspecified. Allowing for conditioning information to predict changes in the riskContinue reading

The Performance And Long-Run Characteristics Of The Chinese IPO Market

Abstract: We study the short-run and long-run performance of Chinese privatization initial public offerings (PIPOs), using data for 340 and 409 new issues on the Shanghai and Shenzhen Stock Exchanges respectively, from 1 January 1996 through 31 December 1997. The average market-adjusted initial return is found to be 127.31%, and the initial returns on both stock exchanges are not significantlyContinue reading

The Cointegration Alpha: Enhanced Index Tracking and Long-Short Equity Market Neutral Strategies

Abstract: This paper presents two applications of cointegration based trading strategies: a classic index tracking strategy and a long-short equity market neutral strategy. As opposed to other traditional index tracking or long-short equity strategies, the portfolio optimisation is based on cointegration rather than correlation. The first strategy aims to replicate a benchmark accurately in terms of returns and volatility, whileContinue reading

Portfolios of Hedge Funds: What Investors Really Invest In

Abstract: Using monthly return data over the period June 1994 ? May 2001 we investigate the performance of randomly selected baskets of hedge funds ranging in size from 1 to 20 funds. The analysis shows that increasing the number of funds can be expected to lead not only to a lower standard deviation but also, and less attractive, to lowerContinue reading

Who Should Buy Hedge Funds?: The Effects of Including Hedge Funds in Portfolios of Stocks and Bonds

Abstract: Using monthly return data on 455 hedge funds over the period 1994-2001 we study the diversification effects from introducing hedge funds into a traditional portfolio of stocks and bonds. Our results indicate that although the inclusion of hedge funds may significantly improve a portfolio’s mean-variance characteristics, it can also be expected to lead to significantly lower skewness as wellContinue reading

Autoregressive Conditional Kurtosis

Abstract: This paper proposes a new model for autoregressive conditional heteroscedasticity and kurtosis. Via a time-varying degrees of freedom parameter, the conditional variance and conditional kurtosis are permitted to evolve separately. The model uses only the standard Student’s t density and consequently can be estimated simply using maximum likelihood. The method is applied to a set of four daily financialContinue reading

Forecasting the Collapse of Speculative Bubbles: An Empirical Investigation of the S&P 500 Composite Index

Abstract: In this paper we test for the presence of periodically partially collapsing, positive and negative, speculative bubbles in the S&P 500 Composite Index for the period 1888-2001. We extend existing regime-switching models of speculative behaviour by including abnormal volume as an indicator of the probable time of the bubble collapse. Abnormal volume is included as both a classifying variableContinue reading

Disturbing Extremal Behavior of Spot Rate Dynamics

Abstract: This paper presents a study of extreme interest rate movements in the U.S. Federal Funds market over almost a half century of daily observations from the mid 1950s through the end of 2000. We analyze the fluctuations of the maximal and minimal changes in short term interest rates and test the significance of time-varying paths followed by the meanContinue reading

Welcome to the Dark Side: Hedge Fund Attrition and Survivorship Bias Over the Period 1994-2001

Abstract: Hedge funds exhibit a high rate of attrition that has increased substantially over time. Using data over the period 1994-2001, we show that lack of size, lack of performance and an increasingly aggressive attitude of old and new fund managers alike are the main factors behind this. Although attrition is high, survivorship bias in hedge fund data is quiteContinue reading

“Best-advice? and the ?true? mortgage term: Actuaries? endowment advice principles revisited

Abstract: In 1999 the Financial Services Authority recommended that a standard repayment mortgage was the ?best advice? for Independent Financial Advisors to give to essentially all new mortgage customers seeking the best value repayment vehicle. The FSA simply followed the recommendation of the 1999 Report of the Endowment Mortgages Working Party of the Faculty and Institute of Actuaries. This workingContinue reading