The earlier research offers little relevant theoretical evidence on derivatives use, fund management, and its performance. Nevertheless, the study by Grossman and Zhou (1996) on the equilibrium analysis of portfolio insurance provides the start-ing point. The study allows one to analyse the use of derivatives and fund per-formance as the study distinguishes between portfolio insurers and non-insurers.
Here, it is interesting that the use of options and other derivatives is originally much motivated by their use for risk management. However, the intention of hedge funds is often to hedge risk, and thus the analysis by Grossman et al.
(1996), indeed, may have some practical relevance.
Grossmann et al. (1996) show that risk in option markets is reallocated between two groups, insurers and non-insurers. The reallocation which is the trading be-tween these groups depends on the size of insurers’ losses. When news are posi-tive, the insurers prefer less insurance and pay lower premiums for non-insurers.
When news are rather negative, the insurers are willing to pay more for insurance.
The most relevant implications by Grossmann et al. (1996) for this study is that when the state of the economy is bad insurers’ activity offers a chance of a higher Sharpe ratio for non-insurers. Due to insurers, the non-insurers can receive a higher risk premium, which may also be a component of hedge fund returns as interpreted.
The relevance of the study by Grossmann et al. (1996) is considerable for hedge funds as their returns resemble short put options on stock indices (see Agarwal et al. 2004) meaning that hedge funds behave like non-insurers. Admittedly, this feature does not exclude the possibility for options to be used for hedging or port-folio insurance as in Grossmann et al. (1996), yet the insurance strategy using options is very likely not the dominant one for hedge funds.
3.1 Derivatives and Mutual Funds
The pioneering empirical evidence of Koski et al. (1999) for derivatives use and
fund performance employed data conducted using telephone interviews with
mu-tual fund managers. The sample period for fund returns in the study is from
Janu-ary 1992 to December 1994. The results of the study suggest that equity mutual
funds using derivatives show similar risk exposures than equity mutual funds not
using derivatives. In addition, the performance between these groups is found to
be similar. However, the results also suggest that mutual funds can alleviate
nega-tive impact of past performance on fund risk. Particularly, when investors invest new capital in a mutual fund as a result of good past performance, the fund faces a problem to fully achieve its objective market exposure. Thus, mutual fund man-agers seem to use derivatives to efficiently employ new fund capital attracted by fund’s performance.
Besides investigating the impact of the use of derivatives on fund performance and risk of a fund, many studies on derivatives use of funds also study the causes of the use of derivatives. Deli et al. (2002) report such information as they inves-tigate funds’ incentives to use derivatives. The key finding is that derivatives of-fer transaction costs benefits. Moreover, their empirical results support the hy-pothesis of the study that the choice of a fund to permit derivative investments is driven by transaction cost benefits weighted against the potential agency costs.
Johnson et al. (2004) study the use of derivatives of 988 mutual funds in Canada on information of funds’ derivatives use as of September 30 1998. In general, their results show that the use of derivatives by Canadian mutual funds does not have an adverse effect on fund return and risk. The results are also heterogeneous for different kinds of funds. Fixed-income funds using derivatives show higher return and risk than derivative non users. Domestic equity funds that use deriva-tives seem to have higher returns and bear higher risks than derivative non users.
However, the exclusion of warrants from the derivative definition causes the risk-return differential of domestic equity funds to disappear
5.
Pinnuck (2004) examines both the characteristics of stocks preferred by 35 Aus-tralian equity investment managers and their use of derivatives over the period 1990-1997. The results show that the use of derivatives by fund managers is more popular among large than small fund managers. Moreover, the study suggests that fund managers use derivatives to both increase and decrease their exposure to stock market risk.
Fong et al. (2005) study the role and benefits of derivative securities in active equity portfolio management. The study also employs Australian data of 48 eq-uity funds obtained from the Portfolio Analytics Database over the period 1993-2003. In light of their results the authors conclude that the use of derivatives has a negligible impact on fund returns. The results for their sample also suggest that options are not used for informed trading. In addition, the study presents evidence
5
The authors relate the effect of excluding equity warrants to natural resource bias in the
Ca-nadian stock market
that options trading patterns of investment managers are related to the execution of momentum trading strategies.
Marín and Rangel (2006) study the use of derivatives in the Spanish mutual fund industry of 1,707 funds from March 1995 to March 2005. The results of the study relate derivatives use to larger fees, large funds, funds with low dividend yield, and members of fund families in which other funds also use derivatives. The au-thors also argue that derivatives are used for speculative purposes instead of hedging purposes and that management of cash inflows and outflows more effi-ciently.
Marin et al. (2006) in line with Koski et al. (1999), Johnson et al. (2004), and Fong et al. (2005) find that the use of derivatives on average does not improve fund performance and in most of their fund categories derivatives users underper-form nonusers. However, for fixed-income funds, the authors find weak evidence supporting outperformance which arises from derivatives use.
Frino et al. (2009) investigate the impact of derivatives use on fund performance using a survey of derivatives use for 274 Australian fund managers. They separate funds that use derivatives for cash equitisation from other derivatives users
6. The survey enquired particularly whether funds trade SPI 200 index futures for cash-equisation. The findings of the study differ from those of Koski et al. (1999), Johnson et al. (2004), and Fong et al. (2005). In particular, the results of the study suggest that derivatives use can reduce the burden of increased fund flow and improve managed fund performance when derivatives are used for cash equitisa-tion.
3.2 Derivatives and Hedge Funds
As the evidence discussed above concerns conventional mutual funds, five recent studies by Chen (2006), Chen and Liang (2007), Aragon et al. (2007), Aragon et al. (2008), and Chen (2009) report evidence of derivatives use of hedge funds.
Specifically, Chen (2006) compares market timing characteristics between portfo-lios of hedge funds that use options and do not use options. The author concludes that the results are not different between the option users and nonusers. Chen et al. (2007) also find that the results for the market timing ability of hedge funds are
6
Cash equitisation refers to the use of derivatives for converting assets such as equities into
cash more easily and with lower transaction prices.
not altered by the use of options but they focus only on market timing hedge funds and examine only a sample of 100 funds reporting their use of options.
Aragon et al. (2007) investigates the quarterly holdings of 250 hedge fund advi-sors over the 1999-2005 period. These adviadvi-sors offer asset management for indi-vidual hedge funds. The authors find that stock holdings have some predictive power but the predictive power of asset holding is found to be more pronounced for options. Moreover, in the sample of Aragon et al. (2007) deep out-of-the-money options and puts exhibit the highest predictive power for future stock re-turns.
In following study after Aragon et al. (2007), Aragon et al. (2008) focus more on hedging and options use by hedge funds. The authors find that option positions by hedge funds are associated with higher than normal subsequent realized volatility on the underlying security. The evidence also suggests that option holdings are significantly used in hedging strategies. In the sub-sample of 179 hedge fund ad-visors, higher Sharpe ratio and lower standard deviation are also found to be asso-ciated with the use of equity options which adds up to the evidence. However, the study by Aragon et al. (2008) does not show evidence for statistically significant association between equity options use by a hedge fund advosor and abnormal returns.
Chen (2009) investigates derivatives use and risk taking in the hedge fund indus-try using the Lipper TASS hedge fund database with a sample period from Janu-ary 1994 to December 2006 and an initial sample of 6,241 hedge funds. Chen (2009) also investigates extensively the determinants of the use of derivatives by hedge funds. His results suggest that higher minimum investment requirement, higher incentive fees, the absence of lockup provision, and effective auditing are associated with greater likelihood of a hedge fund using derivatives. The results of Chen (2009) also suggest that some hedge fund categories affect the probabil-ity of hedge funds using derivatives. The probabilprobabil-ity of using derivatives is high-est for the global/macro strategy (the managed futures strategy is not included in the analysis).
Chen (2009) does not find a significant difference in risk-adjusted performance
between derivatives users and nonusers. For the association between risk and
de-rivatives use, he finds that the use of dede-rivatives is associated with lower risk of a
hedge fund. Chen (2009) also considers the third and fourth co-moments of the
distribution of hedge fund returns in addition to the conventional third and fourth
moments. The results suggest that using derivatives has a positive and statistically
significant impact on the kurtosis of a hedge fund. Moreover, derivatives use is
found to be associated with lower co-kurtosis and co-skewness. Thus, Chen’s
(2009) evidence for the higher moments and higher co-moments may imply that derivatives use is associated with less market-wide risk.
Derivatives may also be used to manipulate performance. Chen (2009) acknow-ledges this potential use of derivatives and uses a manipulation proof performance measure by Goetzmann, Ingersoll, Spiegel and Welch (2007). Chen’s (2009) re-sults do not evince any statistically significant association between the measure and derivatives use by hedge funds. Accordingly, the results suggest that hedge funds do not manipulate their performance using derivatives.
The study by Chen (2009) finds further evidence for responsible use of
deriva-tives by hedge funds. The study evinces that derivaderiva-tives users engage less in risk
gaming. The results also do not show statistically significant evidence for the
re-lation between fund failure likelihood and derivatives use. This result implies that
single cases of hedge fund failures closely associated with derivatives use such as
the collapse of the LTCM may not be generalized.
In document
Do investors benefit from the use of options and complexity of derivative strategy of a hedge fund?
(sivua 70-75)