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Abstract:
Using data on the monthly returns of hedge funds during the period 1990:01 through 1998:08, we estimate six-factor Jensen alphas for individual hedge funds employing eight different investment styles. We find that about 25 percent of hedge funds earn positive excess returns, and that the frequency and magnitude of funds' excess returns differ markedly by investment style. Using six-factor alphas as a measure of performance, we also analyze performance persistence over one- and two-year horizons and find evidence of significant persistence among both winners and losers. These findings together with our finding that hedge funds that pay managers higher incentive fees also have higher excess returns are consistent with the view that fund manager skill may be a partial explanation for the positive excess returns earned by hedge funds.

Hedge Funds, Hedge Fund Performance, Manager Skill

Abstract:
Using data on the monthly returns of hedge funds during the period 1990:01 through 1998:08, we estimate six-factor Jensen alphas for individual hedge funds employing eight different investment styles. We find that about 25 percent of hedge funds earn positive excess returns, and that the frequency and magnitude of funds' excess returns differ markedly by investment style. Using six-factor alphas as a measure of performance, we also analyze performance persistence over one- and two-year horizons and find evidence of significant persistence among both winners and losers. These findings together with our finding that hedge funds that pay managers higher incentive fees also have higher excess returns are consistent with the view that fund manager skill may be a partial explanation for the positive excess returns earned by hedge funds.

Hedge Funds, Hedge Fund Performance, Manager Skill

Abstract:
This study examines the performance of sixteen different hedge fund and commodity fund investment styles during rising and falling stock prices over the period 1990:01 through 1998:08. Since a primary motivation for investing in hedge funds and commodity funds is to diversify against falling stock prices, it is important to examine the performance of these funds during bear stock markets. The study evaluates hedge funds and commodity funds both as stand-alone assets and as portfolio assets, and in both bull and bear stock markets. In addition, it utilizes the Sharpe ratio as well as alternative safety-first performance criteria to evaluate the funds. We conclude that commodity funds generally provide greater downside protection than do hedge funds. Commodity funds have higher returns in bear markets than do hedge funds, and generally have an inverse correlation with stock returns in bear markets, while hedge funds typically exhibit a higher positive correlation with stock returns in bear markets than in bull markets. However, three hedge fund styles - market-neutral, event-driven, and global macro - provide fairly good downside protection while still providing more attractive returns over all markets than do commodity funds.

Abstract:
This study examines the performance of sixteen different hedge fund and commodity fund investment styles during rising and falling stock prices over the period 1990:01 through 1998:08. Since a primary motivation for investing in hedge funds and commodity funds is to diversify against falling stock prices, it is important to examine the performance of these funds during bear stock markets. The study evaluates hedge funds and commodity funds both as stand-alone assets and as portfolio assets, and in both bull and bear stock markets. In addition, it utilizes the Sharpe ratio as well as alternative safety-first performance criteria to evaluate the funds. We conclude that commodity funds generally provide greater downside protection than do hedge funds. Commodity funds have higher returns in bear markets than do hedge funds, and generally have an inverse correlation with stock returns in bear markets, while hedge funds typically exhibit a higher positive correlation with stock returns in bear markets than in bull markets. However, three hedge fund styles - market-neutral, event-driven, and global macro - provide fairly good downside protection while still providing more attractive returns over all markets than do commodity funds.

Abstract:
This article examines the relationship between aggregate monthly mutual fund flows (sales, redemptions and net sales) and stock and bond market returns from 1961 through 1996. The sharp growth of mutual funds in recent years has raised concerns about whether mutual fund are responsible for the bull market we have had in stocks and about what might happen to stock prices if large equity mutual fund redemptions were to occur. To determine whether mutual fund flows have affected either stock or bond prices we employ Granger causality analyses and instrumental variables analyses. With one exception, we find that mutual fund flows have not affected prices. That exception is 1971-1981, when large equity fund redemptions appear to have significantly depressed stock prices. Rather than affecting prices, we find generally find that the reverse relationship exists: flows into stock and bond mutual funds are in response to high stock and bond market returns.

Abstract:
The past decade's bull market in U.S. stock market and the experience in recent Asian financial crisis raised interesting questions on the impact of institutional investors (mutual funds, pension funds and hedge funds) on financial markets. Mutual funds in US have experienced unprecedented growth in recent years. Many believe that the U.S. equity bull market of the 1990's is attributable to the huge flows of funds into equity mutual funds during this period, and that a withdrawal of those funds could send stock prices plummeting. This article investigates the relationship between aggregate monthly mutual fund flows (sales, redemptions, and net sales) and stock and bond monthly returns during a 30-year period beginning January l961, utilizing both Granger causality and instrumental variables analysis. We also tests a variety of financial theories that may explain how mutual funds may affect financial markets.

The main findings are as follows. First, on whether flows cause return, with one exception, flows into stock and bond funds have not affected either stock and bond returns. The exception is 1971-81, when widespread redemptions from equity mutual funds significantly depressed stock returns. On the other hand, on whether returns cause flows, the magnitude of flows into both stock and bond funds are significantly affected by stock and bond returns.

These findings suggest, first, that the recent run-up in stock prices cannot be attributed to the rapid growth of equity mutual funds during the 1980's and 1997's; and, second, that the possibility of a mutual-fund-induced downward price spiral in stock prices cannot be ruled out. The results for the 1971-81 period suggest that in a "down" stock market, when stock returns are low and mutual fund redemptions are high, outflows of funds from mutual funds could put downward pressure on stock prices. This is consistent with a noise-trader view of markets. It should be recognized, however, that current mutual fund investors are different from those during 1971-81. Today, more than half of stock and bond mutual fund assets owned by households are held in some type of retirement plan. Thus, current mutual fund investors may have different investment objectives and longer investment horizons than those in 1971-81, and may behave differently in a market downturn.

Abstract:
The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank's subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the "automatic stay" and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor's assets. It is commonly believed that the exemption for derivatives contracts helps reduce "systemic risk" in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring.

A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm's going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code's treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code's treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code's exemptions for derivatives contracts.

Bankruptcy, Derivatives, Systemic Risk, Automatic Stay, Long-Term Capital Management, Enron, Asset Specificity

Abstract:
In recent years, the traditional business of banks - making long-term loans and funding them by issuing short - dated deposits-has declined. This development has raised concerns that more banks will fail or be forced to assume greater risk to remain profitable. This article first examines the economic forces responsible for banks' reduced role in financial intermediation. The authors then consider whether banks may be jeopardizing the stability of the financial system by extending riskier loans or engaging in derivatives dealing and other 'nontraditional' financial activities that bring higher returns but could carry greater risk. The authors conclude that because most nontraditional activities expose banks to risks and moral hazard problems similar to those associated with banks' traditional activities, the new activities can be regulated as effectively as the old.

nontraditional financial activities, risk, regulation

Abstract:
This paper outlines the fundamental economic forces that have led to the decline in traditional banking, that is the process of making loans and funding them by issuing short-dated deposits. The declining competitiveness of traditional banking may threaten financial stability by increasing bank failures and by increasing the incentives for banks to take on more risk, either by making more risky loans or by engaging in 'nontraditional' financial activities that promise higher returns but greater risk. This paper argues that most nontraditional activities, such as banks acting as derivatives dealers, expose banks to risks and moral hazard problems that are similar to those associated with banks' traditional activities, and that these activities can be regulated as effectively as can traditional activities. One regulatory approach to maintain financial stability and strengthen the banking system is to adopt a system of structured bank capital requirements with early corrective action by regulators. An important element in this approach is that market- value accounting principles would be applied to banks and there would be increased public disclosure by banks of the risks associated with their trading activities. With this regulatory structure in place, banks could be permitted greater freedom to expand into nontraditional activities.

Abstract:
The Committee on Capital Markets Regulation issued an Interim Report (known as the "Paulson Report") near the end of 2006 that concluded that the U.S. "is losing its leading competitive position as compared to stock markets and financial centers abroad". This report was quickly followed by a study, which reached similar conclusions, that was commissioned by New York Mayor Michael Bloomberg and Senator Charles Schumer and prepared by McKinsey & Co.

At its July 2007 annual meeting, the Financial Economists Roundtable (FER) - a group of senior financial economists at universities and other organizations recognized as having made significant contributions to the finance literature - discussed the issues raised by the Report and decided to publish its own report. The report makes the following four policy recommendations:

(1) Securities class action suits - Abolish enterprise liability under rule 10b-5 in situations arising out of security purchases and sales in the secondary trading market among outside shareholders, while retaining managerial and firm liability where the company itself or its insiders (officers and directors) transact to their own benefit. Imposing massive liability on a company that is not a party to the securities transactions and does not benefit from the fraud does not serve a deterrence function since it is the continuing shareholders of the corporation who bear the burden of what the company must pay if found guilty, either directly or indirectly through insurance premiums.

(2) Shareholder rights - Require all corporations to obtain shareholder approval to adopt a poison pill, regardless of whether a company has a staggered board. This requirement would conform to the broad principle that the board of any company should not be able to deny its shareholders the opportunity to decide on the merits of a takeover bid, and it would help restore the market for corporate control as an effective disciplinary mechanism for poorly performing boards and managers.

(3) Compliance costs associated with SOX §404 - Adopt a statutory amendment that makes it optional for a company to adopt the §404 procedures for a management assessment and auditor attestation of the effectiveness of its internal controls, with the requirement that if the company chooses not to comply it must explain why in its financial statements. Thus, in effect, the FER effectively recommends that the market be allowed to determine the value of §404 compliance. If a company chooses not to comply, the market will assess its explanation for non-compliance and will value the company accordingly.

(4) Maintaining open markets - Allow both foreign and U.S. firms to choose to report in conformity with either IFRS or U.S. GAAP. The FER recognizes both IFRS and U.S. GAAP as high-quality accounting standards that provide reasonable foundations for financial reporting for investors. Allowing both foreign and U.S. firms to adopt whichever of these standards they believe to be the most cost-effective provides an opportunity for the market and investors themselves to sort out which reporting standard best serves their interests.

Abstract:
The Financial Economists Roundtable (FER) is a group of senior financial economists who have made significant contributions to the finance literature and seek to apply their knowledge to current policy debates. The Roundtable focuses on microeconomic issues in investments, corporate finance, and financial institutions and markets, both in the U.S. and internationally. Its major objective is to create a forum for intellectual interaction that promotes in-depth analyses of current policy issues in order to raise the level of public and private policy debate and improve the quality of policy decisions.FER was founded in 1993 and meets annually. Members attending a FER meeting discuss specific policy issues on which statements may be adopted. When a statement is issued, it reflects a consensus among at least two-thirds of the attending members and is signed by all members supporting it. The statements are intended to increase the awareness and understanding of public policy makers, the financial economics profession, the communications media, and the general public. FER statements are distributed to the financial and economic academic and practitioner communities, relevant policy makers, and the media.