• Selected
• Entire List

Abstract:
Recent research reveals that hedge fund returns exhibit a range of different, possibly non-linear pay-off patterns. It is difficult to qualify all these patterns simultaneously as being rational in a traditional framework for optimal financial decision making. In this paper we present a simple model based on loss aversion that can accommodate for all of these pay-off structures in one unifying framework. We provide evidence that loss-aversion is a likely assumption for management as well as investor preferences. Following the current empirical literature, we solve a static asset allocation problem that includes a nonlinear instrument. We show analytically that four different pay-off functions may be rationally optimal. The key parameter in determining which of these four to choose in a specific setting, is the financial planner's surplus. The notion of surplus connects hedge fund manager's incentive schemes with the idea of mental accounting as proposed in recent behavioral finance research.

hedge funds, performance measurement, loss aversion, behavioral finance

Abstract:
For an agent with loss averse preferences we derive the optimal payoffs with one option. A total of four different payoffs are found to be optimal, depending on the strike price of the option and whether the initial position of the agent is one of surplus or shortfall. Our results have implications for the hedge fund industry, where funds typically display nonlinear payoffs. Manager compensation typically includes a high-water mark for the incentive fee, which is a likely candidate for the reference point in loss averse preferences. The shape of the optimal payoffs for an initial shortfall position corresponds either to a short put or short straddle. This can be related to managers that are below their customary return, suggesting that investment strategies creating a short put payoff like those followed by LTCM might be driven by loss averse preferences. Furthermore, the steepness of the payoffs under loss aversion increases in the difference to an initial reference point, which corresponds to hedge funds increasing their risk when performance falls further behind.

loss aversion, hedge funds, performance measurement, behavioral finance

Abstract:
Contemporary financial stochastic programs typically involve a trade-off between return and (downside)-risk. Using stochastic programming we characterize analytically (rather than numerically) the optimal decisions that follow from characteristic single-stage and multi-stage versions of such programs. The solutions are presented in the form of decision rules with a clear-cut economic interpretation. This facilitates transparency and ease of communication with decision makers. The optimal decision rules exhibit switching behavior in terms of relevant state variables like the assets to liabilities ratio. We find that the model can be tuned easily using Value-at-Risk (VaR) related benchmarks. In the multi-stage setting, we formally prove that the optimal solution consists of a sequence of myopic (single-stage) decisions with risk-aversion increasing over time. The optimal decision rules in the dynamic setting therefore exhibit identical features as in the static context.

downside-risk, stochastic programming, asset allocation, value-at-risk, time diversification, asset/liability management.

Abstract:
Current research suggests that the large downside risk in hedge fund returns disqualifies the variance as an appropriate risk measure. For example, one can easily construct portfolios with nonlinear pay-offs that have both a high Sharpe ratio and a high downside risk. This paper examines the consequences of shortfall-based risk measures in the context of portfolio optimization. In contrast to popular belief, we show that negative skewness for optimal mean-shortfall portfolios can be much greater than for mean-variance portfolios. Using empirical hedge fund return data we show that the optimal mean-shortfall portfolio substantially reduces the probability of small shortfalls at the expense of an increased extreme crash probability. We explain this by proving analytically under what conditions short-put payoffs are optimal for a mean-shortfall investor. Finally, we show that quadratic shortfall or semivariance is less prone to these problems. This suggests that the precise choice of the downside risk measure is highly relevant for optimal portfolio construction under loss averse preferences.

hedge funds, portfolio optimization, downside risk, expected shortfall

Abstract:
Previous studies have shown that systematic risk in hedge fund returns is partly captured by short positions in put option returns. This is suggestive of a potential 'peso problem' in hedge fund returns: a series of steady returns may alternate with an occasional crash. In this paper, we analyze whether equity option-exposures are actually there, and find they are not. Although some hedge fund indices show some exposure to put or call-returns, several robustness analysis as well as an analysis of individual hedge fund returns show that exposures are not consistent with fundamental characteristics of options, such as put-call parity and the positive relation between option prices and volatility.

hedge funds, nonlinear systematic risk factors, option factors, stability

Abstract:
This study presents a pension model geared to the typical pension contract in the Netherlands. It is based on a defined benefit/average earnings pension system. Nominal benefits are guaranteed and indexation is intended. The model provides a framework for analysing adjustments to such factors as the asset mix, retirement age, returns and the method of discounting, premium setting and indexation. The importance of uncertainty over inflation, interest rate movements and returns on shares is made explicit by means of stochastic and historical simulations. In this, PALMNET differs from existing, often deterministic pension models. The main findings are, first, a conditional wage-indexed defined benefit pension is still affordable despite the current shortfall of wealth of pension funds. If investment returns develop very unfavorable however, benefit cuts can cumulate to over 20% of total benefits and premiums may have to rise to more than 20% of gross wages. Second, fair value accounting considerably increases the volatility of pension premiums. Third, reducing risks by adjusting the asset mix towards more bonds is costly in terms of average premiums, but reduces the volatility.

Actuarial pension model, Monte Carlo simulation, Historical simulation

Abstract:
Little is known about the exact sources and risks of hedge fund’s market neutral strategies. Based on existing views on arbitrage trading, such as done by hedge funds, we formulate and test a hypothesis that market neutrality is affected by market-wide liquidity. We find that such is the case for equity-oriented hedge fund indices as well as portfolios sorted on stock market beta. Also, liquidity has a higher impact on neutrality in a smaller market such as the S&P MidCap and SmallCap. Contrary to our expectations, the relation between liquidity and market neutrality is stronger for portfolios with higher beta.

hedge funds, market neutrality, liquidity

Abstract:
Does Islamic terrorism have an effect on the general attitudes towards Muslim minorities? We use the murder of Theo van Gogh as an event study to address this question. Specifically, we use the hedonic-market model and test for an effect on listed house prices in neighbourhoods where more than 25% of the people belong to an ethnic minority from a Muslim country (type I). Relative to the other neighbourhoods, house prices in type I neighbourhoods decreased in 10 months by about 3%, with a widening gap over time. We use a unique weekly data set from a multi listing service that contains over 70% of all houses for sale and obtain the actual transaction prices from the registers office. Our results are robust to several adjustments including changes in the control group. There is no significant difference in the time it takes for houses to be sold in type I versus other neighbourhoods. Finally, we find evidence that segregation increased. People belonging to the Muslim minority were more likely to buy and less likely to sell a house in a type I neighbourhood after the murder than before.

Hedonic market method, differences in differences, economics of terror, housing market

Abstract:
This paper estimates the impact of the murder of film maker Theo van Gogh on November 2, 2004, on listed house prices in Amsterdam with a unique dataset. We use an hedonic-market approach to show that general attitudes towards Muslim minorities were negatively affected by the murder. Specifically, we test for an effect on listed house prices in neighborhoods where more than 25% of the people belong to an ethnic minority from a Muslim country (type I). Relative to the other neighborhoods, house prices in type I neighborhoods decreased by on average 3%, with a widening gap over time. The results are robust to several adjustments including changes in the control group. There is no significant difference in the time it takes for houses to be sold in type I versus other neighborhoods. Finally, people belonging to the Muslim minority were more likely to buy and less likely to sell a house in a type I neighborhood after the murder than before.

Differences-in-differences, Terror, housing market

Abstract:
Current research suggests that the large downside risk in hedge fund returns disqualifies the variance as an appropriate risk measure. For example, one can easily construct portfolios with nonlinear pay-offs that have both a high Sharpe ratio and a high downside risk. This paper examines the consequences of shortfall-based risk measures in the context of portfolio optimization. In contrast to popular belief, we show that negative skewness for optimal mean-shortfall portfolios can be much greater than for mean-variance portfolios. Using empirical hedge fund return data we show that the optimal mean-shortfall portfolio substantially reduces the probability of small shortfalls at the expense of an increased extreme crash probability. We explain this by proving analytically under what conditions short-put payoffs are optimal for a mean-shortfall investor. Finally, we show that quadratic shortfall or semi-variance is less prone to these problems. This suggests that the precise choice of the downside risk measure is highly relevant for optimal portfolio construction under loss averse preferences.

Abstract:
Downside deviation, semivariance, or the second lower partial moment are different names for the same risk measure, proposed in the literature for capturing the downside risk of investment decisions. This paper analyzes multiperiod decision making under such a risk measure, and finds that a V-shaped decision rule in wealth is prevalent for the most common assumptions on the distribution of uncertainty. Given that a V-shaped rule is acceptable nor desirable in practice, the use of semivariance needs a reconsideration in terms of its plausibility for guiding actual decision making in investment and elsewhere.

semivariance, lower partial moment, downside deviation, decision making under risk, investment

Abstract:
Market valuation is becoming more and more popular, both in accounting and regulation, as well as in academic circles. For pension funds and their participants, the knowledge that market-valued pension liabilities can indeed be transferred to a third party, if necessary, is a great virtue. Using a simulation model, this paper demonstrates the implicit costs and benefits of using market valuation for a typical Dutch pension fund, which offers a guaranteed average pay nominal pension with conditional indexation. The impact turns out to be fairly small, if fixed discount rates are still used for conditional rights. However, if market valuation is used for both unconditional and conditional rights, contribution volatility increases significantly. A remedy is to increase the duration of assets considerably. It is not clear, though, whether this option is available for large pension funds given the limited supply of long-term bonds.

asset and liability management, fair value versus actuarial discounting, defined benefit pension funds, Monte Carlo simulation, pension liabilities, conidtional indexation