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Using an entirely new dataset of audited filings from firms that manage hedge funds, this study examines whether the hedge fund compensation contract aligns managerial incentives and investor interests. Our novel dataset allows us to distinguish between firms focused exclusively on hedge fund management and diversified firms offering products in addition to hedge funds. Our results for compensation data of hedge fund only management firms confirm that compensation increases as assets under management increase, despite increased costs and performance diseconomies of scale. Hedge funds managed by diversified firms have significantly lower performance. A relatively small proportion of the compensation from these firms is generated from hedge funds. The results are consistent with diversified hedge fund firms having weaker alignment between managerial incentives and investment performance.

Prior research in hedge fund and mutual fund management finds a positive relation between portfolio distinctiveness and subsequent performance, suggesting that strategy differentiation is associated with superior skill. We find that commodity trading advisors (CTAs) with returns that correlate more strongly with those of peers feature higher performance and are more highly exposed to a time series momentum factor. Strategy conformity appears to be a signal of managerial skill in CTAs, in contrast to hedge funds and mutual funds. These results indicate that a common trend following strategy drives CTA returns and that CTAs offer investors an opportunity to invest in momentum.

We show that fund-specific return skewness is associated with managerial skill and future hedge fund performance. Specifically, skewness in fund returns reflects managerial skill in avoiding large drawdowns. Using a new measure of investment skill that accounts for this managerial ability, we demonstrate that traditional performance measures under-estimate (over-estimate) managerial performance when returns exhibit positive (negative) fund-specific skewness. Our new measure is particularly valuable during periods of economic crisis, when the annual risk-adjusted out-performance is 5.5%.

Recently, a range of alternative risk premium products has been developed, promising investors hedge fund/Commodity Trading Advisor (CTA)-like returns with higher liquidity and transparency and relatively low fees. The attractiveness of these products rests on the assumption that they can deliver similar returns. Using a novel reporting bias–free sample of 3,419 CTA funds as a testing ground, the authors’ results suggest that this assumption is questionable. They find that CTAs are not a homogenous group. They identify eight different CTA substrategies, each with very different sources of return and low correlation between substrategies. To illustrate the difficulty of modelling the strategies, they specify recently identified alternative risk premiums from the academic literature as factors to examine the sources of return of CTAs. They find that these premiums fail to explain between 56% and 86% of returns. Their results suggest that given the heterogeneity of CTAs, although these new products may deliver on liquidity, transparency, and fees, investors expecting hedge fund/CTA-like returns may be disappointed.

In this paper, we provide the first comprehensive UK evidence on the profitability of the pairs trading strategy. Evidence suggests that the strategy performs well in crisis periods, so we control for both risk and liquidity to assess performance. To evaluate the effect of market frictions on the strategy, we use several estimates of transaction costs. We also present evidence on the performance of the strategy in different economic and market states. Our results show that pairs trading portfolios typically have little exposure to known equity risk factors such as market, size, value, momentum and reversal. However, a model controlling for risk and liquidity explains a far larger proportion of returns. Incorporating different assumptions about bid-ask spreads leads to reductions in performance estimates. When we allow for time-varying risk exposures, conditioned on the contemporaneous equity market return, risk-adjusted returns are generally not significantly different from zero.

During the recent financial crisis dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This article, prompted by this recent episode, investigates DSB hedge fund performance over an extended sample period, from January 1994 to December 2008. Performance and risk evaluation are carried out on an equally weighted DSB hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. The authors conclude that DSB hedge funds are a significant source of diversification for equity market investors and produce statistically significant levels of alpha. Their findings are robust to the specification of traditional and alternative risk factors, nonlinearity, and the omission of the crisis periods, which are particularly favorable for the DSB strategy.

This paper models the returns of the convertible arbitrage hedge fund strategy using a non-linear framework. Investors in the CA strategy have experienced long periods of persistent positive returns accompanied by low volatility, followed by shorter periods of extreme negative returns and high volatility, associated with periods of broad market upheaval. The smooth transition regression (STR) model specified in this study is particularly appropriate for assessing the performance of a strategy of this nature, as it allows for smooth transition between risk regimes. We find that in the alternate regimes the strategy exhibits relatively high (low) exposure to risk factors and alpha is high (low). We suggest that evidence reported in this paper accounts for abnormal returns reported for the strategy in previous studies.

The recent growth in interest in convertible bond arbitrage (CBA) has come predominately from the hedge fund industry. Past empirical evidence has shown that a CBA strategy generates positive monthly abnormal risk adjusted returns. However, these studies have focused on hedge fund returns which exhibit instant history bias, selection bias, survivorship bias and smoothing. This paper replicates the core underlying CBA strategy to generate an equally weighted and market capitalisation daily CBA return series free of these biases, for the period 1990 through to 2002. These daily series also capture important short-run price dynamics that previous studies have ignored.

This paper studies the relation between return skewness, fund flows, and hedge fund performance. Our results show that hedge fund returns exhibit significant skewness and fund investors prefer skewness. Annual flows into hedge funds with positively skewed returns are 11.5% higher than comparable funds with negatively skewed returns. Evaluating hedge fund performance using a new performance measure that accounts for return skewness leads to superior ex-ante fund selection. During the 1994 to 2009 period, the average improvement in out-of-sample annual performance is 2%. Our measure is particularly valuable during periods of economic crisis when returns are more likely to exhibit skewness and the improvement in annual performance is about 4%.

92 percent of hedge funds in the TASS database have returns which exhibit systematic skewness so the alpha of the managers of these hedge funds is difficult to estimate with OLS. To control for skewness the Residual Augmented Least Squares (RALS) estimator is specified to measure the performance of these hedge funds. We demonstrate that the OLS performance assessment error depends systematically on skewness, is economically significant, and that RALS is not sensitive to this bias. Furthermore, portfolios formed on RALS alphas are more persistent than those formed on OLS alphas, particularly during crisis periods.

Returns of hedge funds generally exhibit non-normality. It is well documented that if asset returns have systematic skewness, expected returns should include rewards for accepting this risk. This skewness risk premium should be controlled for in any estimate of performance. To investigate this issue we specify the Residual Augmented Least Squares (RALS) estimator, designed to exploit non-normality in a time series’ distribution. Specifying a linear factor model, we provide robust estimates of hedge fund performance, demonstrating the increase in efficiency of RALS relative to OLS estimation. Our evidence suggests that measuring performance using OLS alphas is inefficient, understating the performance of some hedge funds and overstating the performance of others. We then examine the source of the OLS mispricing. We find that the level of mispricing is positively related to estimates of skewness in the historical fund returns. We conclude that when estimated by OLS the performance of managers who pursue a strategy exhibiting positive skewness is understated and those whose strategy exhibits negative skewness is overstated. Estimation by RALS overcomes this. Our findings are robust to the biases in hedge fund databases.