CLUSTER PROJECT 4: BETTER SUPERANNUATION OUTCOMES: FUND INDEXING, STYLE AND HEDGE FUNDS

Project Overview:

This Cluster Project aims to maximise retirement outcomes  for  the superannuant and comprises various sub- projects. The researchers evaluate various alternative indexes recently proposed. They consider the effect of hidden costs on indexing and retirement investments, such as market impact and high frequency traders and how trading style may mitigate such costs. The researchers also explore nonlinear hedge fund cloning as one potential way the costs   of investing in alternative assets such as hedge funds might be reduced to better serve investors.

Principal Researcher: Associate Professor Paul Lajbcygier (Monash University)

Research Team: Dr Huu Duong, Dr Mikhail Tupitsyn, Professor Heather Anderson, Manh Pham, Madeleine Barrow, Rohan Fletcher and the Funds Management Research Cluster

Outcomes:

Fundamental Indexation (FI) creates a broad-based market portfolio, like traditional market capitalisation weighted indices, but weights stocks according to a firm’s economic size, not stock price. Using the Dow Jones Industrial Average index, we find evidence of the ability of FI to time the market during the technology boom and bust (August 1998 to August 2002). However, in the global financial crisis, FI underperforms against a market capital- weighted index, thereby undermining much of its claim to success. Overall, the superior outperformance of FI is clearly linked to loadings on the Fama and French book-to-market and size factors. We find that equal-weighted indexation, which represents a traditional form of non-market capitalisation, performs well and appears to be successful at timing the market, transaction costs aside.

Summary | Working Paper

We examine whether fee structure acts as a reliable signal of hedge fund performance. Recent theoretical work suggests that, given the unique asymmetries faced by hedge fund investors, managers use performance-based incentives to signal skill. We test this hypothesis empirically and find little support for the notion that high incentive fee funds generate superior risk-adjusted returns during normal market conditions. Rather, increases in incentive level are accompanied by an increased proclivity to take on risk and increased leverage. Consequently, higher incentive fee funds suffer higher rates of attrition. Higher incentive fee funds do demonstrate lower market correlations and thus provide enhanced diversification benefits. As a result, high fee funds exhibited remarkable outperformance during the recent global financial crisis.

Summary | Working Paper

Over the past two decades, the CTA industry has grown tremendously in size and    scope, and it is now a unique and important part of the alternative investments asset class. This paper investigates the timing of commodity trading advisers (CTAs) inception and the relationship between their fund flows and performance. Our results show that performance by the CTA industry has, over the long run (short run), a positive (negative) effect on new CTAs. The flow–performance relationship is strongly evidenced, though its functional form differs across CTA subcategories. Also, we do not observe a ‘smart money’ effect, indicating that investors are generally unsuccessful in choosing subsequent well- performing CTAs.

Summary | Working Paper

As a consequence of the recent technological advances and proliferation of algorithmic and high-frequency trading, the cost of trading in financial markets has irrevocably changed. One important change relates to how trading affects prices, known as price impact. We compare different immediate price impact models for individual trades using out-of-sample predictions. Besides employing several parametric price impact models proposed in the literature, this paper introduces a novel semi-parametric approach, known as Generalised Additive Models, to estimate price impact. Using an Australian dataset, we find that the semi-parametric models outperform all other models both in- and out-of- sample. While the dependence of price impact on trading volume is consistent with a power-law function, nonlinearities between price impact and market capitalisation and volatility are much more complicated than what is suggested by the literature.

Summary | Working Paper

This research compares the performance and viability of two prevalent alternative indices, equal and fundamental, with a traditional market capitalisation weighted index (MCWI). The paper assesses the viability of the three strategies in terms of both investment capacity and trading requirements. We find that as fund size and, consequently, transactions costs increase the difference in returns between alternative and traditional indices decreases to the point where no significant outperformance exists. We also consider alternative index implementation and find that alternatives are not viable for large funds, since execution shortfalls induce tracking error. We conclude that the traditional, market capitalisation weight index will remain popular for its simplicity, vast investment capacity and low inherent implementation costs.

Summary | Working Paper

We show that most hedge fund managers are passive, not active. Active management should be manifest through nonlinear exposure to the systematic risk factors that drive hedge fund returns which leads to enhanced performance. However, our findings indicate that approximately two-thirds of hedge funds exhibit only linear factor exposures and hence are ‘passive’. What’s more, these ‘passive’ managers tend to outperform ‘active’ managers. Finally, we also show that many ‘active’ managers, despite initial nonlinear risk exposures, eventually become ‘passive’.

Summary | Working Paper