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Abstract:
We use a comprehensive dataset of Funds-of-Hedge-Funds (FoFs) to investigate performance, risk and capital formation in the hedge fund industry over the past ten years. We confirm the finding of high systematic risk exposures in FoF returns. We divide up the past ten years into three distinct subperiods and demonstrate that the average FoF has only delivered alpha in the short second period from October 1998 to March 2000. In the cross section of FoFs, however, we are able to identify FoFs capable of delivering persistent alpha. We find that these more successful hedge funds experience far greater (and steadier) capital inflows than their less fortunate counterparts. Berk and Green's (2004) rational model of active portfolio management implies that diminishing returns to scale combined with the inflow of new capital leads to the erosion of superior performance over time. In keeping with this implication, we provide evidence that even successful hedge funds have experienced a recent, dramatic decline in risk-adjusted performance.

Hedge funds, performance, alpha, factor models, flow, funds-of-hedge funds

Abstract:
We use a comprehensive dataset of funds-of-funds to investigate performance, risk and capital formation in the hedge fund industry over the decade from 1995-2004. We first confirm that there are high systematic risk exposures in the returns of funds-of-funds in our data. We then divide up the ten years into three distinct sub-periods and demonstrate that the average fund-of-funds has only delivered alpha in the short second period from October 1998 to March 2000. In the cross-section, however, we are able to identify funds-of-funds capable of delivering alpha. We find that these alpha producing funds-of-funds experience far greater and steadier capital inflows than their less fortunate counterparts. In turn, these capital inflows adversely affect their ability to produce alpha in the future. These findings strongly support Berk and Green's (2004) rational model of active portfolio management, in which diminishing returns to scale combined with the inflow of new capital into better performing funds leads to the erosion of superior performance over time.

hedge funds, funds-of-funds, performance, alpha, factor models, flows, capacity constraints

Abstract:
Using a new database of hedge funds, this paper provides a comprehensive analysis of the risk-return characteristics, risk exposures, style analysis and performance persistence of various hedge fund strategies. We conduct a mean-variance analysis to find that a combination of alternative investments and passive indexing provides significantly better risk-return tradeoff than passively investing in the different asset classes. Using a broad asset class factor model, we find that the hedge fund strategies outperform the benchmark by a range of 6% to 15% per year. We infer the significant risk exposures of different hedge fund strategies using generalized style analysis and find results consistent with their investment objectives. Finally, using parametric and non-parametric methods, we examine persistence in the performance of hedge fund managers. We find a reasonable degree of persistence which seems to be attributable more to the losers continuing to be losers instead of winners continuing to be winners.

Abstract:
Since hedge fund returns exhibit non-linear option-like exposures to standard asset classes (Fung and Hsieh (1997a, 2000a)), traditional linear factor models offer limited help in evaluating the performance of hedge funds. We propose a general asset class factor model comprising of excess returns on passive option-based strategies and on buy-and-hold strategies to benchmark the performance of hedge funds. Our model is a generalized version of Glosten and Jagannathan (1994) and it explicitly accounts for non-linear nature of payoffs displayed by hedge funds. Although in practice hedge funds can follow a myriad of dynamic trading strategies, we find that a few simple option writing/buying strategies are able to explain a significant proportion of variation in the hedge fund returns over time. In general, we find that hedge fund strategies added significant value (in excess of estimated survivorship bias) in the early nineties but less so in the late nineties. We also find that aggregated across all funds in our sample, hedge funds that do not use leverage show, on average, larger alphas and better information ratios compared to the funds that use leverage, across different time periods.

Abstract:
Since hedge funds specify significant lockup periods, we investigate persistence in the performance of hedge funds using a multi-period framework in which the likelihood of observing persistence by chance is lower than that in the traditional two-period framework. Under the null hypothesis of no manager skill (no persistence), the theoretical distribution of observing wins or losses follows a binomial distribution. We test this hypothesis using the traditional two-period framework and compare the findings with the results obtained using our multi-period framework. We examine whether persistence is sensitive to the length of return measurement intervals by using quarterly, half-yearly and yearly returns. We find maximum persistence at quarterly horizon indicating that persistence among hedge fund managers is short-term in nature. It decreases as one moves to yearly returns and this finding is not sensitive to whether returns are calculated on a pre- or post-fee basis suggesting that the intra-year persistence finding is not driven by the way performance fees are imputed. The level of persistence in the multi-period framework is considerably smaller than that in the two-period framework with virtually no evidence of persistence using yearly returns under the multi-period framework. Finally persistence, whenever present, seems to be unrelated to whether the fund took directional bets or not.

Hedge funds, performance, persistence

Abstract:
Since hedge funds specify significant lockup periods, we investigate persistence in the performance of hedge funds using a multi-period framework in which the likelihood of observing persistence by chance is lower than that in the traditional two-period framework. Under the null hypothesis of no manager skill (no persistence), the theoretical distribution of observing wins or losses follows a binomial distribution. We test this hypothesis using the traditional two-period framework and compare the findings with the results obtained using our multi-period framework. We examine whether persistence is sensitive to the length of return measurement intervals by using quarterly, half-yearly and yearly returns. We find maximum persistence at quarterly horizon indicating that persistence among hedge fund managers is short-term in nature. It decreases as one moves to yearly returns and this finding is not sensitive to whether returns are calculated on a pre- or post-fee basis suggesting that the intra-year persistence finding is not driven by the way performance fees are imputed. The level of persistence in the multi-period framework is considerably smaller than that in the two-period framework with virtually no evidence of persistence using yearly returns under the multi-period framework. Finally persistence, whenever present, seems to be unrelated to whether the fund took directional bets or not.

Abstract:
This paper investigates the determinants of money-flows, nature of managerial incentives, behavior of investors, and drivers of performance in the hedge fund industry. It examines performance-flow relation and finds that funds with good recent performance, greater managerial incentives, and lower impediments to capital withdrawals experience higher money-flows. It also analyzes how current money-flows relate to future performance and finds that larger funds with greater inflows are associated with poorer future performance, a result consistent with decreasing returns to scale. It also finds that funds with greater managerial incentives are associated with superior future performance, justifying investors' preference for funds with higher managerial incentives.

Abstract:
Using a robust bootstrap procedure, we find that top hedge fund performance cannot be explained by luck, and that hedge fund performance persists at annual horizons. Moreover, we show that Bayesian measures, which help overcome the short-sample problem inherent in hedge fund returns, lead to superior performance predictability. Relative to sorting on OLS alphas, sorting on Bayesian alphas yields a 5.5 percent per year increase in the alpha of the spread between the top and bottom hedge fund deciles. Our results are robust, and relevant to investors, as they are neither confined to small funds, nor driven by incubation bias, backfill bias or serial correlation.

hedge fund, persistence, Bayesian, alpha, backfill, incubation, bootstrap

Abstract:
In this paper, we shed light on the key drivers of the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds and delta hedging the equity risk can explain the dynamics of their returns. In addition, we demonstrate the effects of extreme market-wide events and supply of convertible bonds on hedge fund performance. We conduct out-of-sample tests using new data and find corroborative evidence. Our findings are consistent with convertible arbitrageurs collectively playing the role of intermediaries that provide funding to convertible bond issuers whilst transferring the equity risk of convertible bond ownership to the equity market through hedging.

Hedge Funds, Convertible Bonds, Convertible Arbitrage, Supply

Abstract:
This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability in managerial skills, fund risk loadings, and benchmark returns. Incorporating predictability substantially improves performance for the entire universe of hedge funds as well as various subsets based on investment styles. Such out-performance is strongest during market downturns when the marginal utility of consumption is relatively high. Moreover, the major source of investment profitability is predictability in managerial skills. In particular, long-only strategies that incorporate predictable skills outperform their Fung and Hsieh (2004) benchmarks by over 12 percent per year. The economic value of predictability obtains for various rebalancing horizons and is robust to style adjustments as well as adjustments for backfill bias, incubation bias, illiquidity-induced serial correlation, and fees.

Hedge Funds, Time-Varying Managerial Skills, Asset Allocation

Abstract:
Using a comprehensive hedge fund database, we examine the role of managerial incentives and discretion in hedge fund performance. Hedge funds with greater managerial incentives, proxied by the delta of the option-like incentive fee contracts, higher levels of managerial ownership, and the inclusion of high-water mark provisions in the incentive contracts, are associated with superior performance. The incentive fee percentage rate by itself does not explain performance. We also find that funds with a higher degree of managerial discretion, proxied by longer lockup, notice, and redemption periods, deliver superior performance. These results are robust to using alternative performance measures and controlling for different data-related biases.

Hedge Funds, Managerial Incentives, Discretion, Performance, Delta, Lockup Period

Abstract:
Recently there has been a rapid growth in the assets managed by "hedged mutual funds" - mutual funds mimicking hedge funds strategies. In this paper, we examine the performance of these funds relative to hedge funds and traditional mutual funds. We find that despite their use of similar trading strategies, hedged mutual funds underperform hedge funds. We attribute this evidence to lighter regulation and better incentives faced by hedge funds. In contrast, hedged mutual funds outperform traditional mutual funds. Most interesting, this superior performance is largely driven by managers with experience in implementing hedge fund strategies. Our findings have important implication for investors seeking hedge-fund-like payoffs at a lower cost and within the comfort of a regulated environment.

Hedge funds, mutual funds, hedged mutual funds, hybrid mutual funds

Abstract:
This paper investigates the trading behavior of major market participants - both dealers and customers - during the six-month period of a well-publicized market manipulation episode: an attempted delivery squeeze in a bond futures contract traded in London. The analyses are based on a rich dataset on the spot and futures trades and inventories reported to the chief governmental regulator by different individual dealers and the Exchange. This simultaneous investigation of price distortions and trading positions of participants are of significant interest to both academics and market regulators. From an academic perspective, this paper provides, inter-alia, empirical evidence on how learning takes place in the market place and on the strategic behavior of major market participants, both dealers and public traders, in a market manipulation setting. It also shows that prices respond selectively to the trading actions of only the group of selected market participants that are relevant at that time. From a regulatory perspective, this paper has several messages. First, regulators and exchanges need to be very concerned about ensuring that squeezes do not take place since they are accompanied by severe price distortions and significant erosion of market depth. Second, exchanges should "mark to market" the specifications of their contracts more frequently, so that the term structure which underlies the calculation of conversion factors does not become dramatically different from the prevailing term structure. Third, regulatory reporting should ask for flagging of possession oriented trades like forward term repos: these trades can currently go un-noticed since they require virtually no regulatory capital. Fourth, and very importantly, delivery non-performance penalties in bond futures markets should be changed to conform to the cash market and the repo market conventions for settlement nonperformance.

Price manipulation, Futures markets, Squeeze

Abstract:
Using a comprehensive data-set from the Bank of England containing the close-of-business positions of individual UK government bond dealers in each bond issue and in all related futures contracts, we examine how the dealers use futures markets to manage the risk of their spot portfolio. We find that the size of dealers' positions in futures contracts is comparable in magnitude to their positions in the spot market, and that the dealers take on significant directional risks often by holding futures that are in the same direction as the spot. Although, in general, the dealers do not seem to use futures to reduce the level of their spot risk, we so find that they actively use futures to offset the changes in the levels of their spot risk. However, this offset is partial in most cases. They use futures to offset changes in their spot exposure to a greater extent when the bonds they hold in their portfolio are more efficiently hedgeable with futures contracts, and on days when the cost of offsetting (as measured by the predictable change in futures mispricing) is lower. They also offset more when the level of their spot risk is high and when recent changes in the spot risk are in a direction that exacerbates their spot risk exposure (i.e., when the potential costs of regulatory distress are high). Finally, we observe that dealers offset changes in their spot exposure to a greater extent immediately prior to important macroeconomic announcements and to a lesser extent immediately thereafter.

Abstract:
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality is adversely affected by their selective risk taking activity. It also investigates the efficiency of market risk sharing within a decentralized semi-transparent market structure. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs of regulatory distress are high, when the cost of such hedging is low, and during periods of greater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that trades in the spot market are not executed by dealers with extreme exposures. In this context, we recommend market reforms such as introduction of central quote posting or limit order book that will enable more efficient matching of liquidity demanders and suppliers, reduce trading costs, and improve the quality of risk sharing.

Abstract:
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality isadversely affected by their selective risk taking activity. It also investigates the efficiency of market risk sharing within a decentralized semi-transparent market structure. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs ofregulatory distress are high, when the cost of such hedging is low, and during periods ofgreater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that trades in the spot market are not executed by dealers with extreme exposures. In this context, we recommend market reforms such as introduction of central quote posting or limit order bookthat will enable more efficient matching of liquidity demanders and suppliers, reduce trading costs, and improve the quality of risk sharing.

Abstract:
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality isadversely affected by their selective risk taking activity. It also investigates the efficiency of market risk sharing within a decentralized semi-transparent market structure. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs ofregulatory distress are high, when the cost of such hedging is low, and during periods ofgreater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that trades in the spot market are not executed by dealers with extreme exposures. In this context, we recommend market reforms such as introduction of central quote posting or limit order bookthat will enable more efficient matching of liquidity demanders and suppliers, reduce trading costs, and improve the quality of risk sharing.

Abstract:
This paper investigates how bond dealers manage core business risk with interest rate futures and the extent to which market quality is affected by their selective risk taking. We observe that dealers use futures to take directional bets and hedge changes in their spot exposure. We find that, cross-sectionally, a dealer with longer (shorter) risk exposure sells (buys) a larger amount of exposure the next day. However, this risk control takes place via the futures market and not the spot market. Finally, we find strong support for the price effects of capital constraints.

Abstract:
This paper examines how bond dealers use futures markets to manage the hedgeable market risk component of their core business risk exposure, and whether market quality is adversely affected by their selective risk taking activity. It also investigates risk sharing among bond dealers in the presence of the futures market. We find that dealers engage in duration targeting, behaving as if they have a comparative advantage in bearing interest rate risk. They make significant directional bets often by holding futures that are in the same direction as the spot. They actively use futures to hedge changes in the spot exposure. They hedge changes in their spot exposure more when the potential costs of regulatory distress are high, when the cost of such hedging is low, and during periods of greater uncertainty. We find that duration targeting by dealers has adverse price effects due to capital constraints as predicted by Froot and Stein (1998). Finally, we find that risk-reduction is undertaken entirely through futures, which implies that spot-market trades are not executed by dealers with extreme exposures. This has important implications for regulators. While a well-functioning bond futures market is a useful risk management tool for all market participants, it also reduces incentives for bond dealers to offer price improvement to move their own spot market inventory, thereby potentially increasing inside spreads, unless the spot market trading structure can be reformed to directly achieve a better matching between public investors and dealers with divergent exposure through, for example, high pre-trade transparency.

Abstract:
This paper is the first to document that hedge fund returns during December are significantly higher than those during the rest of the year. This December spike cannot be fully explained by increase in the funds' risk exposures or by higher factor risk premiums in December. It contends that the contractual features provide hedge funds incentives to inflate returns at year-end and provides strong evidence in support of this argument. It also shows that the spike is higher for funds with greater opportunities to inflate returns. Finally, it demonstrates that funds inflate December returns by under-reporting returns earlier in the year and/or by borrowing from January returns in the following year.

Hedge Funds, Incentives, Returns Management

Abstract:
In October 1997, the London Stock Exchange removed the obligation of dealers to quote firm two-way prices for FTSE 100 index stocks, and allowed the public to compete directly with dealers in these stocks through the submission of limit orders. This article examines the effects of these market reforms on the trading costs of "public" investors, the targeted beneficiary of the reforms, and documents several interesting results. First, the duly signed average effective half-spread of public investors has decreased much more than the corresponding decrease in the absolute effective half-spread documented by Barclay et. al. (1998) for NASDAQ. This is because a sub-set of public investors trade through limit orders, and thereby earn the spread rather than pay it. Second, consistent with the change from obligatory to voluntary market making, there is a significant increase in the "positioning revenue" earned by dealers from a change in the price of a stock while they are carrying the stock in their inventory. As a result, the overall gain of public investors in terms of the realised half-spread is not significantly different from zero. Third, the cross-subsidisation across trade sizes has disappeared, leading to a significant decline in the average execution costs of small public trades and an increase for large public trades. Fourth, the market reforms have caused negative externalities for stocks not going through the new trading system. Finally, in the absence of the price stabilisation provided earlier by dealers, the inside half-spread has increased very sharply in the first hour of trading - a finding which highlights the need for special opening procedures for electronic order books.

Abstract:
The practices of preferencing, internalization, and best execution have been criticized as causing worse execution in dealership markets like NASDAQ relative to auction style markets like the NYSE. We study the quality of executions and the profitability of market making for internalized, preferenced and non-preferenced order flow on the London Stock Exchange for the FTSE-100 stocks (these are the most liquid stocks on the exchange). Our data allow us to identify the broker who initiates and the market maker who executes each trade. Our results indicate that order flow executed by market makers not posting the best quotes (preferenced order flow) receives worse execution relative to non-preferenced order flow while the order flow routed by a broker to a dealer belonging to the same firm (internalized order flow) receives better execution compared to the rest of the order flow. Although preferenced order flow is associated with higher spreads, dealers executing a larger proportion of preferenced order flow do not seem to be make significantly higher trading profits. In addition, we find that the dealers make overall profits that are not statistically different from zero. These results are contrary to the predictions of the `collusion' hypothesis and the `quotes are free options' hypothesis. However, they are consistent with the hypothesis that there are costs of negotiating quotes and that customers have relationships with dealers. We also find evidence that dealers make money on small and large trades but lose money on medium sized trades which is consistent with the `stealth trading' hypothesis. Finally, cross-sectionally in our sample, we do not find any relationship between either the inside spread or the effective spread in a stock and the extent of preferencing or internalization in that stock.

Abstract:
We use a rich dataset of trades of London equity dealers across all stocks to investigate the importance of portfolio considerations in risk management by financial intermediaries. We examine how the trading and pricing decisions of these dealers in individual stocks are conditioned by their ordinary and "equivalent" inventories in that stock, where the "equivalent" inventory is the dealer's ordinary inventory in that stock corrected for any reinforcing or offsetting effects arising from her inventory positions in other correlated stocks. We examine two types of equivalent inventories: the first based on correlations in total returns (as in Ho and Stoll (1983)), and the other based only on correlations in the unhedgeable component of returns (as in Froot and Stein (1998)). In addition to the mean reversion in ordinary inventory documented in earlier studies, we find strong mean reversion in both total and unhedgeable equivalent inventories indicating that portfolio considerations do influence dealers' overall risk management. However, we find that portfolio considerations are not important in determining whether, and at what price, a dealer executes a particular trade. Dealers with divergent ordinary (rather than equivalent) inventories execute large public and inter-dealer trades; and dealers offer significantly higher price improvement, and charge significantly lower effective spread, for large public trades that reduce the divergence of ordinary inventories rather than the those that reduce the divergence of equivalent inventories. We also find that portfolio considerations at the individual trade level are neither significant for small dealer firms nor for large dealer firms, and also neither significant at the level of industry desks, nor for the dealer firm as a whole. Cross-sectionally across stocks, we find that the intensity of mean reversion in individual stock inventories depends only on the specific risk of the stock and not on its "market beta" or its "industry beta". Our findings are contrary to the expectation that a dealer firm would actively manage their inventory risk exposure by taking off-setting positions in different individual stocks based on correlations between pairs of individual stocks. Instead, these findings are consistent with the decentralization of the market making function within securities firms to individual dealers. In this context, our results appear to be driven by the policy of evaluating and rewarding individual dealers according to the trading profits they generate in the stocks assigned to them, rather than by the difficulties of coordinating and sharing information instantaneously across different individual dealers.

Abstract:
This paper examines the impact of insider trading activity on the trading behaviour of dealers and on market quality. Specifically, the activity we investigate is the trading of London Stock Exchange listed equities by incumbent company directors. We find that dealers adjust their inventory control strategies during periods of such insider activity. In the ten day period subsequent to an insider trade, dealers tighten their inventory control resulting in stronger mean reversion in inventories. However, there is no evidence that the depth of the market is affected by the insider trade or that dealers feel the need to utilise the inter-dealer market to share inventory risks to a greater extent. However, when price changes due to temporary inventory considerations are taken into account, the large price changes reported in many insider-trading studies disappear. The paper also investigates if the dealer participating in the insider trade acts as a quasi-insider.

Market Quality, Inventory Control, Insider Trading

Abstract:
We apply a robust bootstrap to evaluate the performance of a large universe of hedge funds. Our bootstrap estimates indicate that the performance of the top hedge funds cannot be attributed to chance alone. This is true even after adjusting for back fill bias, serial correlation, and structural breaks. Also, we find that hedge fund alpha differences persist over three year horizons. However, an investment strategy designed around this will run into difficulties as the persistence is often confined to small funds that are effectively closed to new inflows. Moreover, Bayesian estimates suggest that standard alphas may be overestimated by 41% for the average top fund.

Hedge funds, bootstrap, alpha, persistence

Abstract:
This paper investigates whether dealer firms' trading and pricing decisions are governed by their equivalent inventories, based on total returns as in Ho and Stoll (1983) or on unhedgeable returns as in Froot and Stein (1998), or by their ordinary inventories, as would be the case in a decentralized market-making organisational structure. It finds that ordinary inventories, and not equivalent inventories best explain dealer firms' quote placement strategy, which dealer firm executes trades and the quality of execution offered to the trades. This finding is consistent with decentralized market making where, due to information sharing difficulties or the nature of compensation contracts, individual dealers care only about risk of stocks managed by them, and not the positions of other dealers within the firm.

Dealer firm, equivalent inventory, correlated risk exposure, unhedgeable risk, effective spreads

Abstract:
Using London Stock Exchange data, we test the central implication of the canonical model of Ho and Stoll (1983) that relative inventory differences determine dealer behavior. We find that relative inventories explain which dealers obtain large trades and show that movements between best ask, best bid and straddle are highly correlated with both standardized and relative inventory changes. We show that the mean reversion in inventories is highly nonlinear and increasing in inventory levels. We show that a key determinant of variations in inter-dealer trading is inventories and that inter-dealer trading plays an important role in managing large inventory positions.

Abstract:
Using London Stock Exchange data, we test the central implication of the canonical model of Ho and Stoll (1983) that relative inventory differences determine dealer behavior. We find that relative inventories explain which dealers obtain large trades and show that movements between best ask, best bid and straddle are highly correlated with both standardized and relative inventory changes. We show that the mean reversion in inventories is highly nonlinear and increasing in inventory levels. We show that a key determinant of variations in inter-dealer trading is inventories and that inter-dealer trading plays an important role in managing large inventory positions.

Abstract:
In 1997, the London Stock Exchange, like NASDAQ, allowed the public to compete directly with dealers in a subset of stocks through the submission of limit orders. However, unlike NASDAQ, for these stocks, London also removed the obligation of dealers to quote firm two-way prices, and became a voluntary dealer network competing with a centralized limit order book. In the context of the important differences between the reforms on London and NASDAQ, this London based study addresses several important questions of academic, regulatory and practitioner interest that could not hitherto be examined through U.S. based studies. First, we investigate how the change from obligatory to voluntary market-making affects the provision of financial intermediation services. In particular, we examine the effect of binding market maker obligations on price-stabilisation, and the effect of binding market maker obligations on the adverse selection losses that market makers make in dealing with informed investors. In this context, we also examine the effect of competition and the contestability of markets in competing and non-competing segments, and analyse how the lack of pre-trade quote-transparency, and the resultant increased search costs, affect trading costs. Second, since a major benefit of the London and NASDAQ reforms was the opportunity afforded to "public" investors to earn the spread by posting limit orders, instead of always paying the spread by demanding liquidity, we analyse how the premium charged by individual or institutional "public" investors for supplying liquidity, and the adverse selection losses they face, are different from those of market intermediaries.

Abstract:
This paper investigates whether dealers' trading and pricing decisions are governed by their equivalent inventories, based on total returns as in Ho and Stoll (1983) or on unhedgeable returns as in Froot and Stein (1998), or by their ordinary inventories, as would be the case in a decentralized market-making organisational structure. It finds that ordinary inventories, and not equivalent inventories best explain dealers' quote placement strategy, which dealer executes trades and the quality of execution offered to the trades. This finding is consistent with decentralized market making where, due to information sharing difficulties or the nature of compensation contracts, individual dealers care only about risk of stocks managed by them, and not the positions of other dealers within the firm.

Dealer firm, equivalent inventory, correlated risk exposure, unhedgeable risk, effective spreads

Abstract:
Hedge funds have generated significant absolute returns (alpha) in the decade between 1995 and 2004. However, the level of alpha has declined substantially over this period. We investigate whether capacity constraints at the level of hedge fund strategies have been responsible for this decline. For four out of eight hedge fund strategies, capital inflows have statistically preceded negative movements in alpha, consistent with this hypothesis. We also find evidence that hedge fund fees have increased over the same period. Our results provide support for the Berk and Green (2004) rational model of active portfolio management.

Abstract:
Till recently, hedge funds and their managers were taken to be an elite, and somewhat mysterious, part of the investment fund industry. That can't last, say Narayan Naik and Mark Tapley - and that could be good news for the rest of us.

Abstract:
This paper investigates whether dealers trading and pricing decisions are governed by their equivalent inventories (based on total returns as in Ho and Stoll, 1983 or on unhedgeable returns as in Froot and Stein, 1998) or by their ordinary inventories, as would be the case in a decentralized market-making organizational structure. It finds that ordinary inventories, and not equivalent inventories best explain dealers quote placement strategy, which dealer executes trades and the quality of execution offered to the trades. This finding is consistent with decentralized market making where, due to information sharing difficulties or the nature of compensation contracts, individual dealers care only about risk of stocks managed by them, and not the positions of other dealers within the firm.

Dealer firm, equivalent inventory, correlated risk exposure, unhedgeable risk, effective spreads

Abstract:
This paper characterizes the systematic risk exposures of hedge funds using buy-and-hold and option-based strategies. Our results show that a large number of equity-oriented hedge fund
strategies exhibit payoffs resembling a short position in a put option on the market index, and therefore bear significant left-tail risk, risk that is ignored by the commonly used mean-variance framework. Using a mean-conditional Value-at-Risk framework, we demonstrate the extent to which the mean-variance framework underestimates the tail risk. Finally, working with the systematic risk exposures of hedge funds, we show that their recent performance appears significantly better than their long-run performance.

hedge funds, option-based trading strategies, conditional Value-at-Risk, tail risk and multifactor models

Abstract:
In dealership markets disclosure of size and price details of public trades is typically incomplete. We examine whether full and prompt disclosure of public-trade details improves the welfare of a risk-averse investor. We analyse a model of dealership market where a market maker first executes a public trade and then offsets her position by trading with other market makers. We distinguish between quantity-risk and price-revision risk. We show that if the market maker learns some information about the motive behind public-trade, neither regime is unambiguously welfare superior. This is because greater transparency improves quantity-risk sharing but worsens price-revision risk sharing.

Abstract:
This paper presents a two stage trading model of a competitive dealership market. In the first stage, one among a group of risk averse market makers executes a public trade which contains some information. Details of this trade are not publicly disclosed. In the second stage, an inter-dealer market allows the market maker to offset her inventory position and exploit the information contained in the public order by trading with the other market makers. We show that the price of a trade in such a market depends in a nonlinear way on the informativeness and the size of the trade. We also show that public disclosure of trades in the first stage reveals the information contained in the trade and thus radically alters the structure of the market. We use our model to compare the competitive dealership market (with and without public disclosure) with the standard auction type market and to address some of the issues raised in the continuing public disclosure controversy at the London Stock Exchange.

Abstract:
This paper provides an explanation for the increase in firm value observed upon spin-off that is based upon the transmission of information about the various assets (or divisions) of a firm from informed to uninformed investors. Spin-offs serve to transmit information from informed to uninformed investors by increasing the number of traded securities, from whose prices uninformed investors can infer part of the private information of informed investors. The additional information made available to uninformed investors improves their estimates of, and decreases their uncertainty about value of the assets of the firm. It thus increases their demand for the securities issued by the firm in the presence of positive information about the value of the assets of the firm, in turn increasing the price of these securities and the value of the firm. The increase in firm value made possible by a spin-off is shown to be related to the amount of trading that follows the spin-off, as uninformed investors increase their total holdings of the various securities. The private information made available to uninformed investors is also made available to managers, who are thereby enabled to make better investment decisions.

Abstract:
The practices of preferencing and internalization have been alleged to support collusion, cause worse execution and lead to wider spreads in dealership style markets relative to auction style markets. For a sample of London Stock Exchange stocks, we find that preferenced trades pay higher spreads, however, they do not generate higher dealer profits. Internalized trades pay lower, not higher, spreads. We do not find a relation between the extent of preferencing or internalization, and spreads across stocks. These results do not lend support to the "collusion" hypothesis but are consistent with a "costly search and trading relationships" hypothesis.

Abstract:
This paper investigates the effect of fund managers' performance evaluation on their asset allocation decisions. We derive optimal contracts for delegated portfolio management and show that they always contain relative performance elements. We then show that this biases fund managers to deviate from return-maximising portfolio allocations and follow those of their benchmark (herding). In many cases the trustees of the fund who employ the fund manager prefer such a policy. We also show that fund managers in some situations ignore their own superior information and "go with the flow" in order to reduce deviations from their benchmark. We conclude that incentive provisions for portfolio managers are an important factor in their asset allocation decisions.

Abstract:
Several studies in Finance and Accounting literature have measured security returns subsequent to some economic event. It is well known that when single period returns are cumulated over long horizons, the bid-ask bias in the measured returns could be very high. One way of estimating the bid-ask bias is by simulation. This paper offers an alternative to the simulation approach and provides a closed form expression for the bid-ask bias in cumulated returns. Our analytical approach has two main advantages over the traditional simulation method; first it quantifies the bias precisely and second,it is computationally simpler by several orders of magnitude.

Abstract:
Several studies in Finance and Accounting literature have measured security returns subsequent to some economic events over long-horizons by cumulating the returns over time. It is well known that when single period returns are cumulated over long-horizons, the bid-ask error in the measured returns could be very high. One way of estimating the bid-ask error is by simulation. This paper offers an alternative to the simulation approach and provides a closed form expression for the bid-ask error in cumulated returns. Our analytical approach has two main advantages over the traditional simulation method: first it quantifies the bias precisely and second, it is computationally simpler by several orders of magnitude.

Abstract:
We present an information-based explanation for spinoffs. When the various divisions of a firm are spun off into several firms that have separate stock market listings, the number of traded securities increases. This makes the price system more informative. It improves the quality of the investment decisions made by managers, and reduces uninformed investors' uncertainty about the value of the divisions. Both effects serve to increase the sum-total of the market values of the spun-off divisions above the market value of the original firm.