University of Nottingham Hedge Funds & The Alpha Paradigm Ioannis Logothetis Master of Science in Finance & Investment Hedge Funds & The Alpha Paradigm by Ioannis Logothetis September 2012 A Dissertation presented in part consideration for the degree: ‘Master of Science in Finance and Investment’ 1 Abstract Numerous heavily quantitative strategies, macroeconomic and esoteric investment techniques involving currencies, fixed income products, commodities and equities have proven to be very profitable over the last two decades as math whizzes of Wall Street implemented mathematical and quantum physics models to outperform financial markets in search of Alpha. The development of mathematical algorithms, exotic trading techniques, lightening fast computerized machines and platforms and the effective in-depth skilful macroeconomic analysis from numerous hedge fund managers have resulted in trillions of profits or even losses which have in turn affected the global financial system significantly. This thesis will examine the features of the hedge fund industry focusing on the analysis and the background of the ‘Alpha’ paradigm, the various profitable strategies on record, their performance over the years, the recent developments in the field, their influence and their effects on the global economy and the financial system with the infamous events of 2007- 2008 serving as a backdrop. By assessing historically the hedge fund performance it could be demonstrated that hedge funds produce superior risk-adjusted returns over time comparing with traditional assets, and they carried fewer risks when the volatilities are compared. Our findings also support that hedge funds possess the ability create alpha consistently and systematically with limited volatility and by outperforming traditional asset classes, while there is a limited interaction between hedge fund returns and systematic market factors. 2 Contents List of Figures ..................................................................................................................... 5 List of Tables ....................................................................................................................... 6 Acknowledgements ............................................................................................................. 7 1 Prelude ............................................................................................................................ 8 1.1 Background and Context ............................................................................................. 9 1.2 Scope and Objectives ................................................................................................. 10 1.3 Overview of Dissertation ............................................................................................11 2 State-of-The-Art .......................................................................................................... 12 2.1 History & Characteristics .......................................................................................... 12 2.2 Generating and Chasing Alpha ................................................................................. 14 2.2.1 What is Alpha and Beta? ............................................................................... 14 2.2.2 Driver of Alpha returns .................................................................................. 16 2.3 Hedge funds Performance ......................................................................................... 18 2.3.1 Performance measurement and modelling of returns. ................................ 18 2.3.2 Drivers of Returns and Factor Selection ...................................................... 19 2.3.3 Survivorship Bias ............................................................................................ 21 2.3.4 Performance Persistence ................................................................................ 22 2.4 Strategies ..................................................................................................................... 24 2.5 Summary of the academic research and key trends ................................................ 29 2.6 Market Impact to the global financial markets ....................................................... 30 2.6.1 Historical examples ........................................................................................ 31 2.6.2 What happened to the ‘Quants’ in 2007 ....................................................... 32 2.6.3 Concluding remarks ....................................................................................... 34 3 A Quantitative Approach in the corridors of the Industry ...................................... 35 3.1 Databases .................................................................................................................... 35 3.1.1 Hedge Fund Dataset ....................................................................................... 35 3.2 Methodology ............................................................................................................... 38 4 Empirical results .......................................................................................................... 43 4.1.1 Do Hedge funds produce superior risk-adjusted returns in comparison to traditional assets? .......................................................................................................... 43 4.1.2 Do hedge funds strategies achieve statistical significant different mean monthly returns through time? .................................................................................... 47 5 Conclusion .................................................................................................................... 53 6 References .................................................................................................................... 56 7 Appendices ................................................................................................................... 64 3 7.1 Appendix 1 ................................................................................................................... 64 7.2 Appendix 2 ................................................................................................................... 65 7.3 Appendix 3 ................................................................................................................... 66 7.4 Appendix 4 ................................................................................................................... 67 7.5 Appendix 5 ................................................................................................................... 68 7.6 Appendix 6 ................................................................................................................... 69 7.7 Appendix 7 ................................................................................................................... 71 7.8 Appendix 8 ................................................................................................................... 73 4 List of Figures 1. Hedge Funds Versus Traditional Asset Classes………………………………………….45 2. Market Beta Vs Hedge Funds Vs MSCI…………………………………………………51 3. Industry Trends: Estimated number of hedge funds…………………………………...63 4. Industry Trends: Estimated growth of Assets/Net Asset Flow…………………………64 5. 2000-Bursting of the Internet Bubble……………………………………………………66 5 List of Tables 1. Four global categories of hedge fund academic studies.…………………………………..28 2. Categorizations of hedge fund strategies and differences from academics and practitioners.…………………………………………………………………………………29 3. CS/Tremont hedge-fund index returns for the month of August 2007: Index / Sub Strategies.…………………………………………………………………………………….33 4. Descriptive statistics of the monthly index returns.……………………………………….36 5. Analytical Performance over 1998 - 2011 period.………………………………………….42 6. Analytical Performance over 1998 - Mid 2007 period.……………………………………43 7. Analytical Performance over Mid of 2007- Mid of 2012 period.…………………………44 8. Factors which have been indentified to drive hedge fund returns.………………………65 9. Display of Paired T-Tests Results.……….……………………………………………….....68 10. Display of Pair-wise Correlation Coefficients..…………………………………………….70 11. Detailed Multi-Factor Model Results...……………………………………………………..72 6 Acknowledgements ‘If I have seen further, it is by standing on the shoulders of Giants’. Taking a leaf from the great Isaac Newton, I would like to thank my mentor, Wasim Rehman, Managing Partner at the FWE Group, for his consistent guidance, nurturing, inspiration and encouragement. My greatest appreciation. I would also like to thank my supervisor, Dr. David Newton who provided me with support and advice whenever I needed and for his flexibility for the structure of this thesis. Finally, I would like to thank my close friend Yaw Kyei for acting as a second eye and a bouncing board of the available literature on my chosen subject matter. 7 1 Prelude The world thinks that hedge funds are a magic road to riches for the manager and the investor. That's an illusion and a dangerous one (Barton Biggs, 2006). A layman walking on the streets might not know exactly what a hedge fund is but may be aware of the recent furore surrounding these alternative investment vehicles – especially after the headlines generated by the Bernard L Madoff $50billion Ponzi scheme. An article in Bloomberg Markets Magazine in 2011 notes that: ‘Brownstein’s Mortgage Metaphysics