Academic journal article Journal of Economics and Finance

Hedge Funds, Fund Attributes and Risk Adjusted Returns

Academic journal article Journal of Economics and Finance

Hedge Funds, Fund Attributes and Risk Adjusted Returns

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1 Introduction

Hedge funds, like mutual funds, are pools of money that are invested to make a return. Unlike mutual funds, hedge funds are not necessarily required to register with the SEC and hence, not required to produce periodic reports.1 The characteristics of hedge funds - such as flexible investment strategies, leverage and lack of regulation - have attracted the interests of wealthy and professional investors. In the last 20 years, the hedge fund industry has grown rapidly in size as well as the number of funds operating. The rapid growth in hedge funds promotes further competition among the funds to attract investors. Sophisticated investors choose funds that provide better prospects and expected returns. To cope with increased competition, the increased sophistication of fund investors and the need to help ascertain fund manager skills, hedge funds frequently offer a hurdle rate or a high-watermark or both to attract investors who are concerned with losses or low expected returns. Hurdle rates and high watermarks help ensure that fund managers will not be paid until they achieve target returns or make up for losses in prior years. A hurdle rate is the minimum return that the fund manager must earn before receiving an incentive fee. A high watermark contract requires that fund managers make up past losses in order to receive an incentive fee.

Despite a high demand for research in hedge fund activities, there are relatively few studies in this field. It is attributed to the lack of reliable data and the limited access to databases dealing exclusively with hedge funds. Since hedge funds are not obligated to disclose information on regular basis, most hedge fund managers either report information only when they are meeting or exceeding certain benchmarks or avoid reporting information all together. Amin and Kat (2003) and Edwards and Caglayan (2001) suggest that existing databases may contain errors and omissions because the information is largely self-reported. Similar to existing research, our study is not immune to these problems.

Our study contributes to the existing literature in the following distinct ways. First, we investigate characteristics of hedge funds utilizing data obtained from Barclays, which is likely to be more encompassing compared to other databases. We compare cumulative monthly hedge funds returns of equally weighted portfolios, management fees and performance fees for various types of funds. Second, we examine determinants that lead fund managers to offer a hurdle rate using a binomial logit regression model. Third, we examine what factors may have an impact on performance. We utilize cross-sectional regression on risk-adjusted returns, which is a proxy for fund performance.

Our findings reveal that 74.5% of the funds offering a high-watermark do not offer a hurdle rate. Hedge funds not offering a hurdle rate provide higher risk- adjusted returns than those that do. Hedge funds that offer a high-watermark charge a substantially higher performance fee than those that do not. We find that emerging market, fixed income, and funds of funds are significantly more likely to offer a hurdle rate compared to other fund classifications. Our empirical results indicate that the presence of a performance fee has a positive impact on the likelihood of offering a hurdle rate whereas fund leverage and management fees are negatively related to the variable hurdle rate. We also find that emerging market funds, equity funds, and funds of funds significantly underperform other types of funds, holding other things constant. Funds under management and fund age are positively associated with fund performance. The results of the cross-sectional analysis indicate that funds with a high watermark (or hurdle rate) underperform those without. Funds that charge a high performance fee outperform those that charge a relatively low fee. Offering a high watermark or hurdle rate appears to be insufficient in improving fund performance. …

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