Derivatives Use and Hedge Fund Performance

Table 13 presents the results for the impact of derivatives use on the Sharpe ratio,

the Sharpe ratio with downside volatility, alpha, and appraisal ratio of a hedge

fund. The results are denoted for testing Hypotheses 1 and 2. The results support Hypothesis 1 only in the case of hedge funds which are equity specialized, and thus have a primary asset focus on equity. More specifically, the impact of the asset specialized use of equity options increases the Sharpe ratio of a hedge fund by 0.023 % and the impact is statistically significant at the 5% level.

In relation to the study by Holmström (1979), the positive impact on the Sharpe ratio is consistent with a characteristic that performance based-compensation of managers attracts skilled managers which is also considered by Chen (2008). But this study does indeed find further evidence. More specifically, the use of options is consistent with higher incentive fees only when the performance is higher in the terms of Sharpe ratios. Thus, the results so far provide an explanation that informed hedge funds seem to use equity options and receive higher incentive fees. The other explanation, which is also consistent with the results by Aragon et al. (2008), is that equity options are used for risk management. This use can better explain Sharpe ratio associated with equity options use, and therefore investors may reward equity options users with higher incentive fees for better risk man-agement.

Table 13 also presents the results for the impact of option use on the Sharpe ratio with downside volatility of a hedge fund. The asset specialized use of options for equity does not have a positive and statistically significant impact on the perform-ance measure.

The results for alpha and appraisal ratio are different in relation to the results of

the Sharpe ratio. Specifically, the asset specialized use of equity options does not

have a statistically significant impact on the performance and the impact is rather

negative according to these statistics. This result clearly implies that the empirical

factor model is capable of accounting for the positive performance impact of the

asset specialized use of equity options. Thus, Hypothesis 1 is supported for equity

specialized use of options only when the Sharpe ratio is used. Overall, the results

for the multivariate analysis of hedge fund performance are consistent with those

of the univariate analysis.

Table 13. Regression Statistics of Performance Measures on Derivatives Use

This table presents parameter estimates of cross-sectional analysis for performance estimates of hedge funds. The model for the cross-sectional analysis is the following (Model 2):

MEASURE

_ji

= +

_j

CONTROL

_ji

where MEASURE

_ji

defines a performance measure j of fund i; CONTROL

_ji

defines an addi-tional control variable j of fund i, and DERIVATIVE

_ji

defines a dummy variable for the use of a derivative j by fund i (1 if the derivative is used, otherwise 0). Asset dummies include controls for assets and primary assets in which hedge funds report investing. This table also presents the Durbin-Watson test for the first-order serial correlation. t-statistics are given in italics. The stan-dard errors are White (1980) heteroskedasticity robust. t-statistics are given in italics. See Table 1 for definitions of the other variables.

Dep.: SHARPE All Equity Fixed-Income Commodity Currency Variable Coef. t Coef. t Coef. t Coef. t Coef. t

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level

Table 13. Continued

Dep.: SHARPED All Equity Fixed-Income Commodity Currency Variable Coef. t Coef. t Coef. t Coef. t Coef. t

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level

The asset specialized use of these derivatives has a statistically significant and negative impact so that the use of these derivatives decreases the alpha of a hedge fund by -0.188 %. Consequently, the statistics for alpha suggest that the equity specialized use of index futures is associated with poorer performance providing support for Hypothesis 2. The result may be explained by the primary use of these securities for uninformed trading and their substitute for share restrictions, and thus less illiquidity risk premium. Admittedly, appraisal ratio, the Sharpe ratio and the Sharpe ratio with downside volatility of hedge funds are not associated with the use of equity index futures, which may be explained by the affect of risk characteristics associated with equity index futures on the denominator of these performance measures.

The lack of support for Hypothesis 2 in the univariate analysis is a concern of bias

associated with the inclusion of variables in the multivariate analysis. As a further

analysis it is tested whether dropping the asset and strategy dummies results in an

insignificant relation between the use of equity index futures and the alpha of a

hedge fund. The logic of this test is that the use of equity index futures and its

liquidity characteristic has no relevance for some strategies which use the futures primarily to perform their trading. For example, managed futures funds may use only futures to perform trend-following strategies and the use of equity index fu-tures has less implication regarding their liquidity management. Consequently, the statistical significance of the results may be weak when hedge fund strategies are not controlled. The further analysis is performed by testing the use equity in-dex futures separately for two subsamples. The first group of strategies (GROUP 1) includes all equity-based strategies which more likely manage their liquidity using equity index futures. These strategies are the dedicated short bias, event-driven, equity long/short, emerging market, and equity market neutral strategies.

The second group of strategies (GROUP 2) includes the remaining strategies which may use equity index futures for their primary strategy or do not invest heavily in equities. These strategies are the managed futures, global/macro, con-vertible arbitrage, and fixed-income strategies. The result for these groups and hedge fund performance are presented in Appendix 2, which clearly demonstrates that the negative relation between the index futures and the alpha of a hedge fund is negative and statistically significant for the first group which potentially may use these derivatives for cash management.

The results in Table 13 also provide some evidence for other type of use of de-rivatives than that of asset specialized use. In contrast to the use of equity options, the use of other currency derivatives than options has a statistically significant (10% level) and negative impact on the Sharpe ratio of equity specialized funds.

Equity specialized funds may use these derivatives to hedge currency related risk,

and therefore this finding is slightly surprising. Alternatively, the result may

sug-gest that risk management by derivatives is not efficient for fund performance. It

may also imply that hedging is expensive. For fixed-income specialized funds, the

use of options for commodity has also a statistically significant and positive

im-pact on the Sharpe ratio of a hedge fund.

Table 13. Continued

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level.

Table 13. Continued

* refers to a statistical significance at the 10% level; ** refers to a statistical significance at the 5% level; *** refers to a statistical significance at the 1% level.

Fixed-income specialized hedge funds seem to benefit from the use of other

de-rivatives than options and warrants for both equity and currency as the use of

these variables is associated with better performance of these funds. They also

seem to benefit from the use of warrants issued with equity securities. This result

is the opposite in the case of warrants issued with fixed-income and commodity

derivatives other than options which are associated with poorer performance. In

general, the asset specialized use of options has an impact on the Sharpe ratios of

hedge funds but only in the case of equity specialized hedge funds. This finding is

indeed interesting as the use of equity options as the only derivative instrument

coincidences with higher incentive fees (see Table 5) in accordance with the first

hypothesis concerning informed trading.

In relation to the study by Aragon (2007), it is an interesting finding that lockup period has a statistically significant affect on the alpha of a hedge fund only when using the sample of all hedge funds. Restriction period also has a statistically sig-nificant affect on the alpha of a hedge fund only when using the samples of all funds and equity specialized funds. Moreover, the result suggests that lockup pe-riod does not have statistically significant affect on the appraisal ratio of a hedge fund. These findings may imply that controlling for asset specialization of hedge funds can explain much of illiquidity risk premium in hedge fund returns.

7.5 Derivatives Use and Higher Moments of Hedge

In document Do investors benefit from the use of options and complexity of derivative strategy of a hedge fund? (sivua 123-130)