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Abstract: Hedge funds provide an opportunity for investing with few government regulations and high potential returns. Since 1980 this has lead to a dramatic 25% annual increase in the number of hedge funds, with nearly $700 billion managed by hedge funds in 2003. However, high risks associated with hedge fund strategies, competition and limited arbitrage opportunities contributed to an annual attrition rate of 7.10%. In this thesis, models were developed and tested that describe the characteristics of fund returns, fund flows, optimal size and hedge fund life cycles. The TASS hedge fund database provided by the Tremont Company was used for analysis. In Essay One, it was found that hedge fund returns are highly serially correlated compared to the returns of more traditional investment vehicles such as mutual funds. Several sources of such high serial correlation were explored and the research illustrated that the most likely explanation of this derived from asset illiquidity and smoothing of returns. Illiquid securities are not actively traded and market prices are not always available for them. In the case of smoothing, brokers or managers have the flexibility to report partial returns. Consequently, for portfolios of illiquid or smoothed securities, reported returns will tend to be smoother than true economic returns, thereby understating volatility and increasing risk-adjusted performance measures such as the Sharpe ratio. An econometric model of illiquidity exposure was further proposed and estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio were developed. Estimated smoothing coefficients were found to vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure. In Essay Two, the life cycles of hedge funds were analyzed. The findings show that in general, investors chasing individual fund performance decrease the probability of an individual hedge fund liquidating. However, when investors pursue a category of hedge funds that has performed well, the probability of hedge funds liquidating within that category increases because of growing competition among hedge funds; and in such environment, marginal funds are more likely to be liquidated than funds that deliver superior risk-adjusted returns. In the Essay, a model was proposed for calculating an optimal asset size by balancing out the effects of past returns, fund flows, market impact, competition and favorable category positioning.

An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns
with Andrew W. Lo and Igor Makarov, 2003 (Forthcoming, Journal of Financial Economics)

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Abstract: The returns to hedge funds and other alternative investments are often highly serially correlated in sharp contrast to the returns of more traditional investment vehicles such as long-only equity portfolios and mutual funds. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure, i.e., investments in securities that are not actively traded and for which market prices are not always readily available. For portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk-adjusted performance measures such as the Sharpe ratio. We propose an econometric model of illiquidity exposure and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.

The Life Cycle of Hedge Funds: Fund Flows, Size and Performance, 2003 (Job Market Paper)

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Abstract: Since the 1980s we have seen a 25% yearly increase in the number of hedge funds, and an annual attrition rate of 7.10% due to liquidation. This paper analyzes the life cycles of hedge funds. Using the TASS database provided by the Tremont Company, it studies industry and fund specific factors that affect the survival probability of hedge funds. The findings show that in general, investors chasing individual fund performance decrease probabilities of hedge funds liquidating. However, if investors follow a category of hedge funds that has performed well, then the probability of hedge funds liquidating in this category increases. We interpret this finding as a result of competition among hedge funds in a category. As competition increases, marginal funds are more likely to be liquidated than funds that deliver superior risk-adjusted returns. We also find that there is a concave relationship between performance and assets under management. The implication of this study is that an optimal asset size can be obtained by balancing out the effects of past returns, fund flows, market impact, competition and favorable category positioning that are modeled in the paper. Hedge funds in illiquid categories are subject to high market impact, have limited investment opportunities, and are more likely to exhibit an optimal size behavior compared to those in more liquid hedge fund categories.

Limits to Arbitrage: Understanding How Hedge Funds Fail, 2003

Abstract: Even if arbitrage opportunities can be found in statistical sense, they might not be exploitable. This paper models such limits to arbitrage in the framework of a hedge fund. In particular, the paper explores how hedge funds fail given arbitrage opportunities. Dynamic relationships between a hedge fund, dealers, a bank, and market are modeled. As a case study, Long Term Capital Management is studied. The model explores a phenomenon that a fund manager who engages in arbitrage and uses high leverage might lose all his money before realizing positions at a profit. As assets go down in value, the firm has to post more collateral. If it is unavailable, this often leads to a hedge fund collapse. However, given that positions are well diversified and not closely correlated, leverage by itself does not lead to collapse of a fund. Correlated positions in the absence of leverage might lead to a loss, but are not subject to collateral collapse. However, the superimposition of both leverage and induced high correlation between assets can lead to collapse. The paper explores these "flight to quality" and "collateral collapse" dynamics.

The Dynamics of Global Financial Crises
with Kevin Amonlidviman, Andrew W. Lo, and Rishi Kumar, 2003

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Abstract: This paper presents a Markov chain model of the transmission of financial crises. Using bilateral trade data and a measure of exchange market pressure, a method to determine a set of transition probabilities that describes the crisis transmission dynamics is developed. The dynamics are characterized by one-month conditional crisis probabilities and the probability of a crisis occurring within one year. The framework allows for modeling and comparing various channels of contagion, such as investments and bilateral trade. Using macroeconomic data on 45 countries, the model predicts and gives insights into all of the financial crises that we studied: Mexico (1994), Asia (1997), Russia (1998), Brazil (1999), Turkey (2001), and Argentina (2002).

Extrapolation Expectations: An Explanation for Excess Volatility and Overreaction
with Jannette Papastaikoudi, 2002

Abstract: In this paper, we explain excess market volatility by means of momentum and acting on analysts' forecasts. We show excessive price movements with respect to fundamentals can be caused either by "irrational" trend chasing behavior of investors, or by trading too often based on experienced analysts' forecasts (in case of continuous earnings). Price volatility depends on the prevalent investor type and on the type of analysts an investor listens to. Within our market framework, price setting mechanisms are introduced based on demand/supply balance and on trading strategies. In forming their demand, investors consider three factors: their beliefs about the intrinsic value of the marketed assets, past stock performance, and predictions of financial analysts of assets' price targets.

An Overview of Major Hedge Fund Collapses
with Andrew W. Lo, 2003

Abstract: This paper studies structural and statistical properties of major hedge fund collapses. Several variables such as investment and accounting strategy, crisis outcome, internal dynamics, fee structure, performance, leverage, asset types, geographical location of investments, transparency, personal characteristics of a hedge fund manager and relationships with brokers are analyzed.