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Hedge Funds
Risk-taking and managerial incentives: Seasoned versus new funds of funds
Authors: Y. Li and J. Mehran
Source: The Journal of Alternative Investments
Date: Winter 2009 - vol. 11, no. 3

In this study, Li and Mehran deal with the impact of age on the risk-taking of funds of hedge funds. The goal is to determine if new funds of hedge funds take more risk than their older peers. If there is a difference, does it have an impact on risk-adjusted performance? They analyse the period from 1995 to 2003. Each year, they define “new funds,” in contrast to “existing funds,” as funds with a return history of less than one year. 1,120 funds of hedge funds are studied. They observe an increase in the number of new funds per year until 2001, with a peak of 230 new funds.

Risk-adjusted performance is measured by alpha, which is obtained through a thirteen-factor model. Factors are the three Fama-French factors, the Carhart momentum factor, high-yield, term premium, and convertible bond factors, five Fung and Hsieh look-back straddle factors, and an emerging market factor. Alpha is calculated on a two-year rolling window, from 1995 to 2003. For each sub-period, alpha is positive for both new and existing funds of hedge funds. A two-sample test is conducted to verify whether the difference in the alpha of the two groups is significant. In two sub-periods, 1995-1997 and 2000-2002, new funds outperform the others significantly at a 5% level, and in one sub-period, 1999-2001, new funds outperform the others significantly at a 1% level. In other sub-periods, differences are not statistically significant. The authors state that after 2002 alpha decreases in magnitude for both groups. They suggest that greater competition may be the reason for this decrease.

Total risk is measured by the return volatility, using a 36-month rolling window. While new funds display a lower total risk than existing funds up to about forty-six months of life with similar trends in the evolution of the risk on this period for both groups, after this point the two converge towards similar risk. The authors sum up the absolute values of beta obtained from the thirteen-factor model to build what they call the Gross Leverage Measure, or GLM. Existing funds may display a GLM superior to 1 from 1995 to 1997 and from 1996-1998, but it decreases after 1998. The same trend is stated for new funds, but GLM starts under 1 and always remains less than that of existing funds.

Do unsystematic risk results confirm total risk results and so suggest that new funds are more cautious than older funds? The Herfindahl index, calculated on the basis of the thirteen-factor model with a 36-month rolling window, is used by the authors to measure the concentration of fund exposure to a few risk factors. Except for the last 36-month sub-period from 2001 to 2003, during which there is no statistical difference between new and existing funds, in the six first sub-periods existing funds of hedge funds exhibit a statistically significant higher Herfindahl index than new funds. This finding suggests that new funds have a more diversified exposure to risk factors, exposure that can be viewed as more cautious. The robustness of previous results is tested by replacing the thirteen factors of the model by “pure strategy indices […] constructed from hedge fund style indices provided by various data vendors.” This method confirms the results.