Contribution of the Study

By considering the asset specialized use of options, the use of equity index futures and the complexity of the derivative strategy of a hedge fund this study makes a contribution to six different areas of hedge fund research:

• Complexity of the derivative strategy of a hedge fund as a relevant factor of the performance and risk of a hedge fund: Well known fac-tors of hedge fund performance prior to this study are, for example, size (see Getmansky 2005), age (see Liang 1999), leverage (see Schneeweis, Martin, Kazemi, and Karavas 2005), management compensation (e.g.

Kouwenberg and Ziemba 2007), share restrictions (see Aragon 2007), manager’s personal capital invested in the fund (e.g. Kouwenberg et al.

2007), and many other managerial and fund characteristics (see Boyson 2002; Maxam, Nikbakth, Petrova, Spieler 2006). Derivatives use is also considered as a factor of hedge fund performance and risk. Chen (2009) uses a binary variable of derivatives use as a factor of hedge fund per-formance and risk and finds only little statistically significant difference in the results although some weak evidence when the Sharpe ratio is used.

This study extends the debate and presents a proxy for the complexity of a fund’s derivative strategy as a factor of hedge fund risk and performance.

Thus, while Chen (2009) focuses on analysing how those 71 % of hedge

funds using derivatives differ from those not using derivatives, this study

also aims to analyse derivatives use in this 71 % subgroup. The factor is

hypothesized to have an impact on hedge fund risk characteristics and

per-formance. In relation to these studies, the present study proposes the

com-plexity of the derivative strategy of a hedge fund as a new factor of hedge

fund performance. Hedge funds have also been found to exhibit non-normal return distributions by the previous studies (see, e.g., Brooks and Kat 2002; Malkiel and Saha 2004) which make the investigation of this re-lation especially interesting for hedge funds as it is hypothesized in this study that derivatives use can be the cause of these characteristics.

• The use of equity index futures and fund performance: The use equity index futures is of particular interest in the research on derivatives use due to their potential use for cash management. The finding by Koski and Pon-tiff (1999) implies that derivatives users have lower variation in system-atic risk imply the use of index futures for cash management as noted by Frino et al. (2009). The results by Frino et al. (2009) implies that by using equity index futures mutual funds can better adjust exposure to the market when receiving cash inflows. As a result, by using equity index futures funds have an ability to achieve marginally better performance as they can efficiently adjust their portfolio to desired risk level. So far the use of eq-uity index futures by hedge funds has been paid less attention, possibly due to the ability of hedge funds to control their fund flows by imposing share restrictions. Share restrictions in turn are related to higher perform-ance statistics as a result of illiquidity risk premium associated with the re-strictions (see Aragon 2007). This study contributes to the literature as it hypothesizes that the use of these derivatives by hedge funds, as an indica-tor of lower illiquidity risk premium, is associated with lower perform-ance.

• The asset specialized use of options: The results by Fong, Gallagher, and Ng (2005) suggest that mutual funds do not use options for informed trad-ing. Aragon et al. (2007) test predictive information of option holdings by hedge funds and stress the use of stock options for informed trading.

However, they do not align informed trading and options use directly to hedge fund performance and test how the use of options affects hedge fund risk and performance as does this study. Chen (2008) and Aragon et al. (2008) also test the association between options use and hedge fund performance but do not consider the asset specialized use of options

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. This study in turn considers the asset specialized use of options. This type of use options relates to the use of options for primary asset class of a hedge

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The results from this study concerning the use of equity options and hedge fund performance

were published in the Proceedings of the 46th SWFA Annual Meeting (Houston, March

2008).

fund which can be reasonably assumed as the most relevant asset of the strategy of a hedge fund. Therefore, if options use for informed trading or other profitable strategies on aggregate are important factors of the per-formance of hedge funds in their primary activities, they are likely to be seen by investigating asset specialized use of options.

• Complexity of the derivative strategy and the management of a port-folio of hedge funds: For funds of hedge funds, Chen (2009) uses uni-variate analysis but to examine the difference between the performance and risk of derivatives users and nonusers. In the multivariate analysis by Chen (2009) funds of funds are analysed in the same sample with the oth-er funds. Howevoth-er, the use of doth-erivatives may diffoth-er significantly for hedge funds and funds of hedge funds as the latter ones do not engage in trading similar to hedge funds and their objective is to manage hedge fund portfolios. It may also be reasonable to consider that the use of derivatives by funds of hedge funds is biased towards risk management activity. For instance, Denvir and Hutson (2006) present evidence for funds of hedge funds having diversification advantage over hedge fund indices. Deriva-tives use may be associated with this diversification advantage. Therefore, it is important to consider the difference between funds of hedge funds and examine their difference from hedge funds as a relevant contribution to Chen (2009). To further investigate the difference, the analyses con-sider whether the risk and performance characteristics are different for those hedge funds which also invest in other funds. Moreover, the use of derivatives by these special type of funds is not considered in earlier re-search on hedge funds.

• Market-based risk of a hedge fund and complexity of derivative

strat-egy: The relation between the market-based risk, which is the standard

deviation of hedge fund returns explained using market-based risk factors,

and the complexity of the derivative strategy of a hedge fund is also

con-sidered. In the estimation of market-based risk, the option-like risk factors

and other reasonable market-based factors motivated by the previous

re-search are used. Option-like and market-based factors have previously

been advocated by many studies such as Agarwal and Naik (2004) and

Fung and Hsieh (2002a). This study then considers a possible relation

be-tween the estimated market-based factors of hedge fund performance and

the complexity of derivative strategy of an individual fund. The relation is

especially important given the wide use and the credibility of the

market-based factors (see, e.g., Fung and Hsieh 2004b). Chen (2009) considers

the relation between the exposure of a hedge fund to stock market factor

(systematic risk) and derivatives use but does not consider other relevant factors such as the option-like risk factors

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• The relation between the left tail of the return distribution of a hedge fund and fund characteristics: Several studies such as Eling (2006) and Bali, Gockan, and Liang (2007) apply both the Value-at-Risk (VaR) and Modified Value-at-Risk (MVaR) risk measures in their analyses. These studies, however, do not test which hedge fund characteristics affect the difference between the VaR and MVaR estimates using the Cornish-Fischer expansion. The Cornish-Cornish-Fischer expansion is useful as it considers both the skewness and excess kurtosis of the return distribution of a hedge fund. Admittedly, some studies, such as Chen (2009), test characteristics affecting the skewness and excess kurtosis separately but they do not ag-gregate them. This perspective should be extremely interesting as VaR and MVaR are widely used in practice. Unlike the earlier studies, this study considers this issue and tests whether the complexity of the deriva-tive strategy of a hedge fund has an impact on the Cornish-Fischer expan-sion of its returns. This study also investigates other factors beside the complexity of derivative strategy affecting the Cornish-Fischer expansion.

The construction of the proxy for the complexity of derivative strategy of a fund and the focus on the asset specialized use of options allows one to study the im-plications of the use of these financial instruments and complex derivative strate-gies which can contribute to much broader knowledge in finance. The reason is that hedge funds can be considered as a laboratory for the potential consequences of these uses of derivatives due to their free regulation. They are also relatively little restricted in their derivative strategies. The implications relate to the ques-tion: do investors and traders benefit from the use of derivatives and complex derivative strategies?

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Specifically, Chen (2009: 10) defines the measure of market risk used in his

study as follows: “…market risk is estimated by the time-series regression

co-efficient of fund returns on the market portfolio.” In this study, the focus is on

market-based risk, which is important as hedge funds by definition aim to

hedge market risk and focus on alternative sources of returns. Chen (2009: 18)

reports of the use of alternative benchmarks but he does not indicate that the

definition for the market risk is considered differently nor does he explain the

use of any additional risk measures in conjunction with the use of the

alterna-tive benchmarks.

• Performance from the use of derivatives and option strategies: While the previous studies on mutual fund and hedge fund performance such as Koski et al. (1999), Johnson and Yu (2004), Fong et al. (2005), Chen (2009) and Frino et al. (2009) uses binary variables of derivatives use, this study considers the complexity of derivative strategy. This consideration of complexity makes it possible to empirically test the implication of the study by John et al. (2006) that the use of complex derivative strategies may lead to better performance statistics but also to higher probability of incurring larger losses. Earlier studies such as Whaley (2002) suggest that passive option strategies may improve portfolio performance; by focusing on the asset specialized option use this study also attempts to ascertain whether this advantage may really be seen at the fund management level.

• Derivative strategies and the risk of a managed investment portfolio:

Following John et al. (2006) it can be expected that the use of complex de-rivatives and options strategies is related to “hidden risk” strategies. The study by Chen (2009) finds that derivatives use is related to lower risk but the concept of complexity of derivative strategy is not considered by the study as it is, none of the previous studies on derivatives use by funds.

Following John’s et al. (2006) theoretical evidence for derivative

strate-gies and risk, this empirical study aims to assign the use of complex

de-rivative strategies in general to higher moments (the third and the fourth)

of investment returns. This investigation of the prediction may also be

re-lated to use of derivatives by other institutions and investors which are not

strictly regulated.

In document Do investors benefit from the use of options and complexity of derivative strategy of a hedge fund? (sivua 23-27)