Hedge fund and mutual fund performance in the financial crisis

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HEDGE FUND AND

MUTUAL FUND

PERFORMANCE IN THE

FINANCIAL CRISIS

David Sterken

10627804

Abstract

I will investigate how hedge funds and mutual funds performed during the financial crisis using two performance measures, the Sharpe ratio and Jensen’s alpha. The gathered data will be split up in three periods which are the pre-crisis period, the crisis period and the post-crisis period. Comparing the pre-crisis period and the crisis period my research concludes that hedge funds and mutual funds performed worse during the financial crisis than during the pre-crisis period. My research also concludes that hedge funds outperform mutual funds in the pre-crisis period as well as the crisis period.

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Statement of Originality:

This document is written by David Sterken who declares to take full responsibility for

the contents of this document.

I declare that the text and the work presented in this document is original and that no

sources other than those mentioned in the text and its references have been used in

creating it.

The Faculty of Economics and Business is responsible solely for the supervision of

completion of the work, not for the contents.

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Chapter 1. Introduction

Hedge funds and mutual funds have the same economic function which is that investors in both these funds hope to receive back their investment plus some extra return (Stulz, 2007). Hedge funds have climbed from $38 billion of assets under management in 1990 to $2.48 trillion of assets under management at the peak in 2007 (Dichev & Yu, 2011). Hedge funds have thus become more attractive to investors over the years. The financial crisis, however, caused the monthly performance of hedge funds to be negative. This negative hedge fund performance increased investor risk aversion and investors reacted to this negative

performance by redeeming their hedge fund shares (Haberfelner & Kaiser, 2012). According to Maslakovic (2010) assets under management of the hedge fund industry decreased 30% in 2008 while assets under management increased with 13% in 2009. Hedge funds thus performed worse during the financial crisis than the pre-crisis period. Investor demand for mutual funds also declined in 2009 with investors withdrawing from all types of mutual funds which amounted to $150 billion (2010 Investment Company Fact Book). This could indicate that the performance of mutual funds got worse during the financial crisis.

Both hedge funds and mutual funds thus worsened during the financial crisis but did the financial crisis change the relationship between hedge fund performance and mutual fund performance. This is what I will try to research and the main research question that I thus will try to answer in this bachelor’s thesis is how the performance difference of hedge funds and mutual funds was affected by the financial crisis of 2008-2009. In order to give an answer to this research question I will compare the performance of hedge funds with mutual funds and will also compare the performance of both funds with two benchmarks, an equity index and a bond index. I will gather data over the period 2002-2015 and have divided this period into three subperiods in order to compare performance and investigate the performance of hedge funds and mutual funds during the financial crisis. These subperiods are 2002-2007 which represents the pre-crisis period, 2008-2009 which represents the crisis period and 2010-2015 which will represent the post-crisis period. Both the Sharpe ratio and Jensen’s alpha will be used as performance measures. Examining the gathered data using the two

performance measures I find evidence that both hedge funds and mutual funds performed worse in the financial crisis and that hedge funds outperformed mutual funds no matter the time period. These findings are in line with previously done research.

This bachelor’s thesis is organized as follows. In chapter 2 of the thesis I will give a general overview of the structure, the fees and regulation of both hedge funds and mutual funds. Chapter 3 investigates the performance of hedge funds and mutual funds by discussing previously done research. Chapter 4 will contain the methodology in which I discuss my expectations as well as where I found the data I am using and biases that might

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4 arise when investigating hedge fund and mutual fund performance. In chapter 5 the results of my research will be presented and discussed. In chapter 6 a conclusion will be given.

Chapter 2. Hedge funds and mutual funds

I first will give a general overview of what hedge funds and mutual funds exactly are. To give a general overview I will be discussing the most important characteristics of hedge funds and mutual funds such as the structure of both funds, the fees of both funds and the regulation of both funds. After this I take a look at previous research done on the performance of hedge funds and mutual funds

2.1 Structure of hedge funds and mutual funds

According to Ackermann et al. (1999) hedge funds started as investment partnerships that could take both long and short positions but have since then changed in such a way that you can’t simply give a short definition of a hedge fund. A hedge fund, however, has some characteristics such as that hedge funds are largely unregulated, have flexible investment strategies, are only open to sophisticated investors, have substantial managerial investment and have strong managerial incentives. According to Stulz (2007) hedge funds are

unregulated pools of money managed by a hedge fund manager who has a lot of flexibility. These hedge fund managers have the right to take short positions, to borrow and to make use of derivatives which are contracts that derive their value from the performance of an underlying asset (Bodie et al., 2014). Stulz (2007) also mentions that investors in a hedge fund have to be individuals or institutions who meet certain requirements, set out by the Securities and Exchange Commission, to make sure that these investors know what they are doing and can bear a significant loss.

Ackermann et al. (1999) also discusses mutual funds. A mutual fund is a more common pooled investment mechanism which is regulated by the Securities and Exchange Commission. Mutual fund have the requirement to disclose their prospectus. Both regulation and the requirement to disclose their prospectus limit the usage of short selling, leverage, concentrated investments and derivatives. Stulz (2007) mentions that the common investor can most likely investment in a mutual fund because mutual funds don’t have the

requirements which the Securities and Exchange Commission set out for hedge funds. Stulz (2007) asks the question why hedge funds and mutual funds coexist because both hedge funds and mutual fund have the same economic function which is that investors in both these funds hope to receive back their investment plus some extra return. His answer is that hedge funds exist because mutual fund can’t deliver complex investment strategies

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5 while hedge funds can deliver complex investment strategies. The reasons for not being able to deliver complex investment strategies are that mutual funds are regulated and that mutual funds are open to the more common investor.

According to Bodie et al. (2014) hedge funds have lock-up periods which means that investors can’t redeem or sell their shares in the hedge fund for a certain amount of time. This causes hedge fund to be more illiquid than mutual funds and investors want a return premium to be willing to hold these less liquid hedge funds. Stulz (2007) mentions in his research that mutual fund investors can typically withdraw funds daily which means mutual funds need to have cash to be able to pay these possible withdrawals. This in turn means that it is riskier for a mutual fund than for a hedge fund to invest in strategies that need time to generate profits. Hedge funds thus have a wider range of possible investment strategies than mutual funds.

2.2 Fees of hedge funds and mutual funds

According to Bodie et al. (2014) the typical hedge fund has a management fee of 1% to 2% of assets plus an incentive fee equal to 20% of profits beyond the performance of a

predetermined benchmark. Both Dichev and Yu (2011) and Stulz (2007) put the

management fee at 1% to 2% but put the incentive fee at 15% to 25% of profits beyond a benchmark. Bodie et al. (2014) also note that hedge funds make use of high water marks. A high water mark ensures that hedge fund managers don’t get an incentive fee for poor performance because if a hedge fund is experiencing losses a hedge fund manager can’t charge an incentive fee until the value of the hedge fund is above this high water mark. According to Ackermann et al. (1999) these high water marks could lead to excess risk taking but there are counter measures in place to ensure that excess risk taking doesn’t take place. Ackerman et al. (1999) concludes that incentive fees give hedge fund a higher

performance than mutual funds because the combination of an incentive fee and a high water mark makes the hedge fund manager work hard to increase the value of the hedge fund and thus increase the performance of this hedge fund.

Stulz (2007) mentions that the fee structure of mutual funds differ from the fee

structure of hedge funds because the fee structure of mutual funds is restricted by regulation. The fee structure of mutual funds is symmetric which means that a gain needs to have the same impact as a loss while a hedge fund has an asymmetric fee structure making it possible for hedge funds to receive a part of the profit. Having a symmetric fee structure means that there are no or a relatively low amount of incentive fees for mutual fund

managers. According to Bodie et al. (2014) a mutual fund has the option to implement four types of fees which are the expensive ratio, front-end load, back-end load and the 12b-1

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6 charges. The expense ratio represents the cost incurred by a mutual fund and ranges from 0,2% to 2%. A front-end load is a sales charge when you purchase the shares and cannot exceed 8,5%. A back-end load is an exit fee when you sell shares and this fee starts at 5% to 6%. The back-end load fee reduces by 1% each year the mutual fund is not redeemed. 12b-1 charges is a fee that has to be paid every year and can’t exceed 12b-1% per year.

2.3 Regulation of hedge funds and mutual funds

According to Stulz (2007) hedge funds are mostly unregulated while mutual funds are heavily regulated in how they can invest their funds and how hedge fund managers get paid. Stulz (2007) argues in his research article that the majority of hedge funds will start to look more and more like the traditional mutual fund because of increased hedge fund regulation. According to Patton et al. (2015) the Securities and Exchange Commission proposed a rule in January 2011 to increase hedge fund regulation. The SEC proposed a rule in which large hedge funds, those managing over $1,5 billion, are required to deliver detailed quarterly reports. These reports will only be available to the regulator but hedge funds still argued against this proposed rule because they were afraid that the content of this quarterly report could still fall in the hands of the public.

Why are hedge funds less regulated than mutual funds in the first place? According to Stulz (2007) hedge funds manage to avoid regulations because hedge funds limit the

number of investors who can invest in a hedge fund and hedge funds don’t make public offerings. Ackermann et al. (1999) adds to this that hedge funds are limited partnerships with fewer than 100 investors which exempts the hedge funds from the Investment Company Act of 1940.

Before I continue with discussing the performance of hedge funds and mutual funds I will give a summary of the above mentioned information. In the above three subchapters I discussed the structure, fees and regulation of hedge funds and mutual funds and in doing so shed light on the differences between these two funds. In short, hedge funds are only open to sophisticated investors while mutual funds are open to the more general public. Hedge funds can also invest in more complex investment strategies because hedge funds are less regulated than mutual funds. Hedge funds also have a lock-up period which makes them less liquid and hedge fund managers can achieve an incentive fee above a certain high water mark.

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Chapter 3. Performance of hedge funds and mutual funds

Now that we have a theoretical background in hedge funds and mutual funds we can take a look at what previous research has concluded on the performance of hedge funds and mutual funds.

Ackermann et al. (1999) first investigates the performance of hedge funds and compares this performance with two equity indices which are the S&P500 index and the Morgan Stanley Capital International EAFE Total Return index. Ackermann et al. (1999) investigate the 2-, 4-, 6- and 8-year sample periods ending in 1995. Over the full 8-year sample period hedge funds, on average, earn an annualized return of between 9,2% and 16,1% but they note that there are big differences between the different hedge fund styles. When comparing the performance of hedge funds with the equity indices they conclude that over the full 8-year period there is a draw between hedge funds and equity indices meaning that eight hedge fund styles outperform the market while the other eight underperform the market. Ackermann et al. (1999) also note that outperformance of a hedge fund depend on the time period, the used index and the style of the hedge fund. The above results, however, ignores the differences in risk between hedge funds and the market indices and they next turn to the Sharpe ratio. Ackermann et al. (1999) compare the Sharpe ratio of hedge funds with the Sharpe ratio of eight different market indices and conclude that hedge funds do not consistently outperform the market. However, when you look at the 6-year sample period hedge funds significantly outperform all indices except for the bond-based indices.

Ackermann et al. (1999) also investigate Jensen’s alpha and conclude that Jensen’s alpha is significantly positive for hedge funds in all sample periods except the 2-year sample period.

Next Ackermann et al. (1999) compares the performance of hedge funds with the performance of mutual funds. They use the Sharpe ratio of both funds to compare their performance and conclude that hedge funds outperform mutual funds but that hedge funds have more volatility. Ackermann et al. (1999) then try to explain the performance and volatility of hedge funds by doing a regression analysis and note that incentive fees constantly have a positive effect on the performance of hedge funds.

Stulz (2007) uses the Credit Suisse/Tremont Hedge Fund index, the S&P 500 index and the Financial Times World index to compare the performance of hedge funds with the performance of mutual funds. He concludes that from 1994 to 2000 the S&P 500 index outperformed the hedge fund index but that after 2000 the hedge fund index outperformed. He notes that actively managed mutual funds don’t outperform the stock market and thus when the hedge fund index outperforms the S&P 500 index this also means that the hedge fund index outperforms mutual funds.

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8 investigate the performance of 3538 hedge funds in the period January 1999 to March 2004. Ibbotson and Chen find an average alpha of hedge funds of 3,7%. Stulz (2007) then uses a study by Malkiel (1995) to compare the alphas of hedge funds with mutual funds. Malkiel (1995) finds that equity mutual funds have an alpha of -3,2% and hedge funds thus

outperform mutual funds. Next Stulz (2007) discusses research performed by Kosowski, Naik and Teo (2005) who conclude that the average alpha of hedge funds in the period 1994 to 2002 is 0,42% per month which is not statistically significant. The top performing hedge funds, however, have a significant alpha of between 1% and 1,25%. The last research Stulz (2007) looks at is performed by Fung, Hsieh, Naik and Ramadorai (2007) who investigate the performance of funds-of-funds. They investigate three different time periods and conclude that in one of the three periods the alpha of these funds-of-funds is significantly positive while in the other two periods the alphas are not significant.

Stulz (2007) concludes that hedge funds performance has exceeded the performance of mutual funds or the stock market performance over the last 15 years.

I will shortly discuss a research paper done by Dichev and Yu (2011). They

differentiate between the returns of hedge funds and the returns of investors in these hedge funds because ‘’as hedge funds proliferate and grow, deploying larger amounts of capital becomes progressively more difficult and chasing the same investment opportunities yields diminishing returns, implying mediocre performance for the greater mass of investors who joined the funds only after the initially superior performance (Dichev & Yu, 2011, p. 248).’’ In their research the returns of hedge funds is given by the buy-and-hold return on the fund, while the return of investors is given by the dollar-weighted return on the fund. Dichev and Yu (2011) conclude that the dollar-weighted return is 3% to 7% lower than the buy-and-hold return. Looking at the dollar-weighted return, hedge funds underperformed the S&P 500 while hedge funds outperformed the S&P 500 when we looked at the buy-and-hold-returns. Their conclusions have no further impact on my own research because I will be looking at the returns of hedge funds and will not distinguish between the two above mentioned returns but this short discussion of the paper just serves as a reminder that the results you get from a statistical test depend on the specific instruments you use for this statistical test.

Capocci and Hübner (2004) first look at previous research on the performance of mutual funds. This research illustrates that mutual funds outperform passive strategies for a short period of 1 to 3 years and attribute it to hot hands which means that if a mutual fund performed better than another fund this mutual fund will also perform better next year. Research of the performance of hedge funds is less frequent but previous research concludes that hedge funds constantly obtain better performance than mutual funds.

Next Capocci and Hübner (2004) do their own research using CAPM, Fama-French 3-factor model, Carhart model and a model that extends the Carhart model. They measure

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9 the performance using the above mentioned models for the period 1994-2000. Using CAPM, two thirds of the hedge fund strategies produce significantly positive alphas. Using the multi-factor models they find that 27% of the hedge funds show significant excess return. They conclude that taking more factors in account decreases the number of hedge funds that significantly outperformed the market.

Capocci and Hübner (2004) also divide the full period into sub periods. By using sub periods they could see what happened to hedge fund performance during the Asian crisis, which fell in the second sub period. They note that the abnormal performance of the whole period 1994-2000 is mainly due to the first sub period. The second sub period showed that most hedge funds suffered from the Asian crisis.

Eling and Faust (2010) analyze the performance of emerging market hedge funds. Short selling and derivatives were of relatively limited usage in these emerging markets and this raises questions about the value of emerging market hedge funds in comparison with mutual funds. For their research Eling and Faust (2010) make use of factor models such as CAPM, Fama-French 3-factor model, Carhart model and they add a new model specifically to investigate the emerging market. They gather data for the time period 1995-August 2008. Eling and Faust (2010) conclude that hedge fund returns and alphas are higher than those of mutual funds. They also conclude that some hedge funds outperform benchmarks while most mutual funds underperform benchmarks. Lastly, they conclude that in bad or neutral market environments hedge funds outperform mutual funds. A reason for these conclusions is, according to Eling and Faust (2010), that emerging market hedge funds are more active in shifting their asset allocation because emerging market hedge funds are less restricted by their investors.

Ben-David et al. (2011) note that hedge funds depend on outside financing which may hinder the hedge funds in exploiting profit opportunities. This limitation is likely to be more severe during market crisis because investors might withdraw their fund and in doing so forces the hedge funds to close their fund. They look at the research of Nagel (2011) and Aragon and Strahan (2011) and conclude that these researchers found that in the recent financial crisis hedge funds withdrew from the market.

Ben-David et al. (2011) then do their own research and provide direct evidence on hedge fund trading in the financial crisis of 2007-2009. Their main finding is that hedge funds exited the U.S. stock market in large numbers as the crisis continued. Hedge fund withdrawal was relative large compared to mutual fund withdrawal which is a sign of decreasing hedge fund performance. The main motives behind the withdrawal of hedge funds are redemptions and leverage, these factors explain about 80% of the decline in average hedge fund equity holdings. Mutual fund equity portfolios did not significantly decrease during the financial crisis. Mutual funds and hedge funds differ in terms of leverage, restrictions and investors

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10 which means these two funds react differently to poor performance. Ben-David et al. (2011) conclude that hedge fund investors withdrew almost three times more capital than mutual fund investors. Reasons for this is that hedge funds are less liquid and at times of crisis investors preemptively respond to this once they observe poor performance. Hedge funds also have more sophisticated investors which increases the speed of reaction to (bad) news. Even though mutual fund investors withdrew less capital than hedge fund investors, the returns of mutual funds were worse than the returns of hedge funds during the crisis.

Schaub and Schmid (2013) investigate the impact of share restrictions such as lock-up periods on the performance of hedge funds in crisis and non-crisis periods. They note that less liquid stocks compensate investors by giving these investors an illiquidity premium. Hedge funds, which have lock-up periods, are illiquid investments. Schaub and Schmid (2013) look at previous research and that research concluded that there is a positive relationship between share restrictions and hedge fund performance in a non-crisis period because share restrictions provide hedge fund managers with more managerial discretion and allows these hedge fund managers to efficiently manage illiquid assets. However, in a crisis period this relationship between share restrictions and hedge fund performance turns into a negative relationship.

Petajisto (2013) investigates mutual fund performance and used the financial crisis to see whether mutual fund performance changed during the financial crisis. What he found was that the average actively managed fund has had weak performance, losing to its benchmark by -0,41% but that the most active managed funds have beaten their

benchmarks by 1,26% after fees and expenses. Petajisto (2013) then uses the Active Share and the tracking error to identify 5 different mutual fund categories. ‘’Active Share is simply the percentage of the fund’s portfolio that differs from the fund’s benchmark index’’ (Petajisto, 2013, p. 74). The ‘’tracking error measures the volatility of the fund that is not explained by movements in the fund’s benchmark index’’ (Petajisto, 2013, p. 74). Using statistical tests on these 5 different mutual fund categories he concludes that most of these mutual fund

categories performed similarly to how these mutual funds performed before the financial crisis.

I will briefly summarize what I discussed in this chapter. In the pre-crisis period hedge fund outperformed both mutual funds and equity indices. There has been done less research on how hedge fund performance was affected by the financial crisis in comparison with mutual fund performance and equity indices. The above discussed research indicates that hedge funds performed worse during the financial crisis than before the financial crisis. Mutual funds, however, are not as clear because one research paper suggest that mutual fund returns are worse during the crisis while another research paper suggest that mutual fund performance wasn’t affected much by the financial crisis.

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Chapter 4. Methodology

4.1 What do I expect?

Before I can start my own research I have to form expectations regarding how fund

performance reacted to the financial crisis. As I will explain in more detail in subchapter 4.2 I will use two performance measures namely the Sharpe ratio and Jensen’s alpha. My

expectations will thus be built around these performance measures. I will investigate, using the two performance measures, whether the performance in the pre-crisis period which in my research is the period 2002-2007 differs from the crisis period which in my research is the period 2008-2009. I will also take a look at the post-crisis period which in my research is the period 2010-2015.

I will first be testing whether the financial crisis worsened or improved the

performance of my chosen hedge funds and mutual funds. I expect that both hedge fund and mutual fund performance worsened during the financial crisis. I thus expect that both the Sharpe ratio and Jensen’s alpha will be lower in the crisis period for hedge funds as well as mutual funds. For the post-crisis period I expect that the Sharpe ratio and Jensen’s alpha will be higher in comparison with the crisis period.

Next I will be looking at what happened between the performance difference of hedge funds and mutual funds during the financial crisis. I expect that in the pre-crisis period hedge funds outperformed mutual funds and that this outperformance will not change because of the financial crisis. I thus expect that the Sharpe ratio and Jensen’s alpha will be higher for hedge funds, compared to mutual funds, in both the pre-crisis as well as the crisis period.

I will also be comparing the performance of hedge funds and mutual funds with two benchmarks, the equity benchmark and the bond benchmark. I expect that hedge funds will outperform the equity benchmark over the whole time period but that the bond benchmark will outperform hedge funds in the crisis period because bonds might be considered safer during a period of economic downturn. I also expect that the relationship between mutual funds and the equity benchmark will not drastically change. I thus expect that the Sharpe ratio and Jensen’s alpha of hedge funds will be higher than the equity benchmark but that the Sharpe ratio and Jensen’s alpha of hedge funds will be lower than the bond benchmark during the financial crisis.

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4.2 How will I test my expectations?

To test these expectations I will make use of two performance measures. The first performance measure I will use is the Sharpe ratio. According to Bodie et al. (2014) the Sharpe ratio measures the reward to total volatility trade-off. The Sharpe ratio can be defined as:

𝐒 =

𝐑𝐩−𝐫𝐟_𝛔𝐩 Where:

Rp: portfolio return Rf: risk-free rate

σp: portfolio standard deviation

The portfolio return and standard deviation will be the return and standard deviation of the hedge funds, mutual funds or benchmarks.

The second performance measure I will use is Jensen’s alpha. According to Bodie et al. (2014) Jensen’s alpha is the average return on the portfolio over and above that predicted by, in my research, the Fama-French three-factor model. Jensen’s alpha can be defined as:

𝛂𝐩 = 𝐑𝐩 − [𝐫𝐟 + 𝛃𝟏(𝐫𝐌𝐚𝐫𝐤𝐞𝐭 − 𝐫𝐟) + 𝛃𝟐(𝐒𝐌𝐁) + 𝛃𝟑(𝐇𝐌𝐋)]

Where: αp: Jensen’s alpha Rp: portfolio return Rf: risk-free rate Rm: market return

SMB: Small Minus Big meaning the return of a portfolio of small stocks in excess of the return on a portfolio of large stocks.

HML: High Minus Low meaning the return of a portfolio of stocks with a high book-to-market ratio in excess of the return of a portfolio of stocks with a low book-to-market ratio. Jensen’s alpha of a hedge fund will be obtained by doing a regression in which the hedge fund excess return is the dependent variable and the market excess return as well as SMB and HML are the independent variables. The same applies to mutual funds and benchmarks but then the mutual fund excess return or the benchmark excess return will be the dependent variable.

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4.3 Data and investment strategies

In order to get data on hedge fund performance you have to be an accredited investor meaning that you have to meet certain requirements such as having high wealth so that you can bear losses. These accredited investors are willing to pay a large amount of money to get access to detailed records of hedge funds but I am not an accredited investor and thus had to look for a substitute. The Credit Suisse database will be used to gather data on hedge fund performance. The Credit Suisse database was the first and is the leading

asset-weighted hedge fund index. An advantage of the Credit Suisse Hedge Fund Index is that this index can be divided into thirteen subdivisions. I will gather the monthly returns of these thirteen subdivisions and the monthly return of the hedge fund index itself and use these returns to calculate the standard deviations. These monthly returns are also net of fees. Table 1 below explains what the strategy of each subdivision is. The information in table 1 is mostly taken from the book Investments by Bodie et al. (2014). Information about the three event driven strategies was not given by Bodie et al. (2014) and I have taken this information from the Credit Suisse website.

Table 1: Hedge fund investment strategies

Credit Suisse Hedge Fund Index

Convertible Arbitrage Hedged investing in convertible securities, typically long convertible bonds and short stock.

Dedicated Short Bias Net short position, usually in equities, as opposed to pure short exposure. Emerging Markets Goal is to exploit market inefficiencies in emerging markets. Typically

long-only because short-selling is not feasible in many of these markets. Equity Market Neutral Commonly uses long/short hedges. Typically controls for industry, sector,

size, and other exposures, and establishes market-neutral positions designed to exploit some market inefficiency. Commonly involves leverage.

Event Driven Attempts to profit from situations such as mergers, acquisitions, restructuring, bankruptcy, or reorganization.

Distressed Typically invest across the capital structure of companies subject to financial or operational distress or bankruptcy proceedings.

Multi-strategy Typically invest in a combination of event driven equities and credit. They have the flexibility to pursue event investing across different asset classes and take advantage of shifts in economic cycles.

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Risk arbitrage Typically attempt to capture the spreads in merger or acquisition

transactions involving public companies after the terms of the transaction have been announced.

Fixed-income Arbitrage Attempts to profit from price anomalies in related interest rate securities. Includes interest rate swap arbitrage, U.S. versus non-U.S. government bond arbitrage, yield-curve arbitrage, and mortgage-backed arbitrage. Global Macro Involves long and short positions in capital or derivative markets across

the world. Portfolio positions reflect views on broad market conditions and major economic trends.

Long/short Equity Hedge Equity-oriented positions on either side of the market (i.e., long or short), depending on outlook. Not meant to be market neutral. May establish a concentrated focus regionally (e.g., U.S. or Europe) or a specific sector (e.g., tech or health care stocks). Derivatives may be used to hedge positions.

Managed Futures Uses financial, currency or commodity futures. May make use of technical trading rules or a less structured judgmental approach.

Multi-strategy Opportunistic choice of strategy depending on outlook.

Data of mutual funds is collected from The Vanguard Group which offers a broad range of types of mutual funds. I will gather the monthly prices of five different types of mutual funds in order to make sure I have taken a broad range of mutual funds for my bachelor’s thesis. These monthly prices will then be used to calculate the monthly returns and the standard deviations. Table 2 below explains the strategy of these five different types of mutual funds I have picked for my bachelor’s thesis.

Table 2: Mutual fund investment strategies

500 Index Fund Investor Shares Stock funds: large market capitalization (large-cap) Total Bond Market Index Fund Investor Shares Bond funds: treasury/agency

Balanced Index Fund Investor Shares Balanced funds: traditional

Capital Opportunity Fund Investor Shares Stock funds: average market capitalization (mid-cap) Small-Cap Index Fund Investor Shares Stock funds: small market capitalization (small-cap)

I will also be comparing the performance of hedge funds and mutual funds with two benchmarks. These benchmarks are the S&P 500 index which will represent the equity market and the Barclays US Aggregate Bond index which will represent the bond market. Monthly return data of these benchmarks is gathered from the University of Amsterdam Datastream. Lastly, in order to calculate the Sharpe ratio and Jensen’s alpha using the

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15 Fama-French three-factor model I will need data on the monthly risk-free rate as well as data on the three Fama-French factors. I can gather all the above mentioned data from the

Kenneth R. French data library. This data library uses the 1-month treasury bill return from Ibbotson and Associates Inc. as the risk-free rate.

4.4 Biases

Hedge fund data can suffer from biases. Fung and Hsieh (2000) and Bodie et al. (2014) discuss a couple of biases including the selection bias, survivorship bias and instant history bias or also known as the backfill bias.

Selection bias occurs because hedge funds are not obligated to report their

performance to the public. Poorly performing hedge funds will thus refrain from publishing their performance to the public. This can create a bias because only hedge funds which are performing well will publish their performance data. There are, however, hedge funds which are performing well and still refrain from published their performance to the public. According to Fung and Hsieh (2000) there are no estimates of the size of the selection bias in hedge funds but because both hedge funds which are performing well and hedge fund which are performing poorly refrain from published their performance the selection bias could have limited effect on hedge fund data and will thus not be of concern for my own statistical research.

According to Bodie et al. (2014) as well as Fung and Hsieh (2000) survivorship bias occurs because unsuccessful hedge funds stop reporting their performance to a database which only leaves the successful hedge funds. Bodie et al. (2014) also report that estimated size of survivorship bias ranges from 2% to 4%. The Credit Suisse database I use for my hedge fund data, however, does not remove closed hedge funds from the index. A hedge fund will only be dropped from the Credit Suisse Hedge Fund Index when it fails to meet certain requirements but even then the hedge fund in question will not be removed from index until it is fully liquidated. This minimizes the survivorship bias.

According to Bodie et al. (2014) instant history bias or backfill bias occurs when hedge funds join a database after a period of success and report this past performance to the database. This historical data, however, may not be a good representation of the hedge fund performance and thus can create a bias. The Credit Suisse database, however, doesn’t allow backfill bias to occur and thus backfill bias will also be of no concern for my own

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Chapter 5. Results

Using the above discussed Sharpe ratio and Jensen’s alpha I conducted a performance analysis for all the hedge fund strategies discussed in table 1 and for the five mutual fund strategies which can be found in table 2. I also carried out a performance analysis for the S&P 500 equity index and the Barclays US Aggregate bond index. I will first discuss the Sharpe ratio results and later on I will discuss the results of the regression analysis which I conducted in order to get Jensen’s alpha for all hedge fund strategies, mutual fund strategies and benchmarks. As a reminder: all results are net of fees.

Table 3 illustrates the Sharpe ratio of all the chosen hedge funds, mutual funds and benchmarks for the period 2002-2007 which represents the pre-crisis period. The bold investment strategies represent the two benchmarks, the italic investment strategies represent the mutual fund investment strategies and the normal type represents all the hedge fund investment strategies. For table 4 and table 5 all the above mentioned

characteristics apply except that table 4 illustrates the crisis period 2008-2009 and table 5 illustrates the post-crisis period 2010-2015. All three tables are sorted from highest Sharpe ratio to lowest Sharpe ratio.

The Global Macro hedge fund strategy is the best performing strategy in the period 2002-2007. A reason for this might be that, according to table 1, a portfolio which follows the

Table 3: Sharpe ratio 2002-2007

Global Macro 2,797

Equity Market Neutral 2,645

Multi-Strategy 2,096

Event Driven 2,019

Event Driven Distressed 1,990

Hedge Fund Index 1,887

Emerging Markets 1,882

Event Driven Multi-Strategy 1,861

Long-Short Equity 1,367

Fixed Income Arbitrage 0,968

Convertible Arbitrage 0,739

Event Driven Risk Arbitrage 0,679

Managed Futures 0,513

Small Cap Index Fund Inv 0,437

Capital Opportunity Inv 0,359

S&P 500 Index 0,213

500 Index Fund Inv 0,176

Balanced Index Fund Inv 0,149

Dedicated Short Bias -0,316

Total Bond Mkt Index Inv -0,726

Barclays US Agg Index -0,782

Global Macro 0,289

Barclays US Agg Index 0,122

Total Bond Mkt Index Inv 0,042

Event Driven Multi-Strategy -0,029

Event Driven -0,112

Small Cap Index Fund Inv -0,148

Long-Short Equity -0,208

Event Driven Distressed -0,261

Hedge Fund Index -0,264

Capital Opportunity Inv -0,266

Multi-Strategy -0,272

Emerging Markets -0,303

Fixed Income Arbitrage -0,331

S&P 500 Index -0,367

Balanced Index Fund Inv -0,397

500 Index Fund Inv -0,503

Equity Market Neutral -0,641

Global Macro 1,261

500 Index Fund Inv 0,836

S&P 500 Index 0,797

Small Cap Index Fund Inv 0,740

Event Driven 0,615

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17 Global Macro hedge fund strategy reflects the view of the economy and in the period 2002-2007 the economy was in a good position. The Global Macro hedge fund strategy was still one of the top performing strategies in the period 2008-2009 but decreased in performance compared with the period 2002-2007. The period 2008-2009 represents the financial crisis period and thus a period in which the economy was in a bad position which the Global Macro hedge fund strategy reflected accordingly. In the period 2010-2015 the Global Macro hedge fund strategy is still one of the top performing strategies. The performance of the Global Macro hedge fund strategy increased compared with the previous period 2008-2009 and an explanation for this can be that the economy was recovering in the period after the financial crisis.

Another interesting hedge fund strategy to discuss is the Event Driven Risk Arbitrage hedge fund strategy. The performance of this hedge fund strategy actually increased when you compare the period 2008-2009 and the period 2002-2007. The Event Driven Risk Arbitrage hedge fund strategy attempts, according to table 1, to capture the spreads in mergers or acquisitions and an explanation for the performance increase might thus be that companies went bankrupt in the financial crisis which gave these companies no other choice then to sell their company for a heavy discount.

The Equity Market Neutral hedge fund strategy is also interesting to discuss. This hedge fund strategy went from being the second best performer in the period 2002-2007 to being the worst performing investment strategy in the period 2008-2009. The Equity Market Neutral hedge fund strategy attempts, according to table 1, to establish market neutral positions by having both long and short positions in a sector. The financial crisis, however, had a negative impact on the economy as a whole and this could have made it near impossible to establish a market neutral position. This could be an explanation why the performance of the Equity Market Neutral hedge fund strategy worsened so drastically.

Overall table 3 illustrates that thirteen out of the fourteen hedge fund strategies outperform the two benchmarks as well as the five chosen mutual fund strategies. An explanation for this can be that hedge funds and mutual funds have different characteristics such as discussed in the first chapter and these characteristics lead to performance

differences. Both the hedge fund strategies and the mutual fund strategies outperform the Barclays US Aggregate bond index. Thirteen out of the fourteen hedge fund strategies outperform the S&P 500 equity index while only two out of the five mutual fund strategies manage to outperform the S&P 500 equity index.

Table 4 illustrates that the Sharpe ratio of almost all investment strategies is lower in period 2008-2009 and thus it can be concluded that performance of both hedge funds and mutual funds worsened in the financial crisis. Most hedge fund strategies still outperform mutual fund strategies but this performance difference is not as one-sided as it was before

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18 the crisis. An explanation for this could be that hedge funds typically have lock-up periods which investors might dislike during a period in which the economy is in a bad position. Another explanation could be that hedge fund managers didn’t receive any incentive fees in the financial crisis which decreased the performance of hedge funds. The performance of the Barclays US Aggregate bond index increased in relation with hedge fund and mutual fund performance and an explanation for this could be that investors prefer to invest in the safer US bonds when there is a period of economic downturn. Thirteen out of the fourteen hedge fund strategies still outperform the S&P 500 equity index while three out of the five mutual fund strategies outperform the S&P 500 equity index.

Table 5 illustrates that the performance of both hedge funds and mutual funds

increased in comparison with the period 2008-2009 but the performance of hedge funds and mutual funds did not return to the performance levels of the period 2002-2007. An

explanation for why the performance of hedge fund strategies did not return to their

performance levels of the period 2002-2007 might be that hedge fund regulation increased after the financial crisis which is also previously mentioned by Patton et al. (2015).

I will now discuss the results of the regressions I did. These regressions delivered a constant which can be classified as Jensen’s alpha. Table 6 illustrates Jensen’s alpha of all the chosen hedge funds, mutual funds and benchmarks for the period 2002-2007 which represents the pre-crisis period. The bold investment strategies represent the two

benchmarks, the italic investment strategies represent the mutual fund investment strategies and the normal type represents all the hedge fund investment strategies. For table 7 and table 8 all the above mentioned characteristics apply except that table 7 illustrates the crisis period 2008-2009 and table 8 illustrates the post-crisis period 2010-2015. All three tables are sorted from highest Jensen’s alpha to lowest Jensen’s alpha.

Jensen’s alpha and the Sharpe ratio might give different results. A reason for this could be that these two performance measures make use of different variables. For Jensen’s alpha I use the Fama-French three-factor model while the Sharpe ratio follows Bill Sharpe’s work on the capital asset pricing model (CAPM). The Fama-French three-factor model is an extension of CAPM and Jensen’s alpha and the Sharpe ratio might thus give different results. You could, however, use the same reasoning as with the Sharpe ratio for why a certain investment strategy might differ in different time periods.

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19 Overall table 6 illustrates that all hedge fund strategies outperformed the two benchmarks and that twelve out of the fourteen hedge fund strategies outperformed the mutual fund strategies and the reasoning for this could be the same as for the Sharpe ratio. Four out of the five mutual fund strategies as well as both benchmarks have a negative Jensen’s alpha. The S&P 500 equity index outperforms four out of the five mutual fund strategies. All hedge fund strategies have a positive alpha in the period 2002-2007. Jensen’s alpha and Sharpe ratio thus give different results for the period 2002-2007 but these differences do not lead to different conclusions for the period 2002-2007.

Table 7 illustrates that Jensen’s alpha of almost all hedge fund strategies is lower and thus that the performance of hedge funds worsened during the financial crisis. In table 6 all mutual fund strategies had a negative alpha but in table 7 only two out of the five mutual fund strategies have a negative alpha. According to Jensen’s alpha most mutual fund strategies performed better in the crisis period than in the pre-crisis period. To give a possible

explanation for this let’s take a look at the Total Bond Market Index Fund Investor Shares mutual fund strategy. This mutual fund strategy is, according to the Vanguard Group, designed to provide broad exposure to U.S. investment grade bonds and bonds could be safer during a period of economic downturn which thus could explain why their performance increased during the period 2008-2009. Most hedge fund strategies, however, still performed better than mutual fund strategies. Table 4 illustrated that the Barclays US Aggregate bond index was one of the top performers. Using Jensen’s alpha, however, the Barclays US

Table 6: Jensen's alpha 2002-2007

Global Macro 0,007861

Event Driven 0,005333

Dedicated Short Bias 0,000662

S&P 500 Index -0,00148

Total Bond Mkt Index Inv -0,00218

Event Driven 0,002121

Barclays US Agg Index 0,000121

S&P 500 Index -0,006864

S&P 500 Index 0,011978

Event Driven Risk Arbitrage -0,000212

Long-Short Equity -0,000297

Event Driven -0,000357

Emerging Markets -0,001032

Event Driven Multi-Strategy -0,001409

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20 Aggregate bond index is performing poorly in comparison with hedge fund performance. All mutual fund strategies outperform the S&P 500 index while twelve out of fourteen hedge fund strategies outperform the S&P 500 index.

Table 8 illustrates that twelve out of the twenty-one investment strategies report a negative Jensen’s alpha. Four out of five mutual fund strategies have a negative alpha which is a worse performance than table 7 indicated. The Barclays US Aggregate bond index also performed worse in comparison with the crisis period while the S&P 500 equity index performed better. The S&P 500 is also the best performing investment strategy in the post-crisis period. Only five out of the fourteen hedge fund strategies have a positive alpha in the post-crisis period which is also a deterioration compared to the crisis period.

My first expectation was that the Sharpe ratio and Jensen’s alpha would be lower in the crisis period for hedge funds as well as mutual funds. The Sharpe ratio supports my expectation for both hedge funds and mutual funds but Jensen’s alpha only supports my expectation for hedge funds so it can be concluded that hedge fund performance worsened during the financial crisis while a conclusion about mutual fund performance depends on the chosen performance measure. My second expectation was that the Sharpe ratio and

Jensen’s alpha would be higher for the post-crisis period in comparison with the crisis period. The Sharpe ratio supports my expectation while Jensen’s alpha doesn’t support my

expectation.

My third expectation was that the Sharpe ratio and Jensen’s alpha of hedge funds would be higher than mutual funds in both the pre-crisis period as well as the crisis period. Both the Sharpe ratio and Jensen’s alpha supports my expectation. My fourth expectation was that the Sharpe ratio and Jensen’s alpha of hedge funds would be higher than the equity benchmark. In the pre-crisis and crisis period the Sharpe ratio and Jensen’s alpha support my expectation. For the post-crisis period, however, the Sharpe ratio doesn’t fully support my expectation but Jensen’s alpha doesn’t support my expectation at all. My last expectation was that the Sharpe ratio and Jensen’s alpha of hedge funds would be lower than the bond benchmark in the crisis period. The Sharpe ratio shows some support for my expectation when you compare the Sharpe ratios of the pre-crisis and crisis period because the Sharpe ratio of the bond benchmark increased from being the worst performer to being the fourth best performer. Jensen’s alpha shows less support because Jensen’s alpha of the Barclays US Aggregate bond index only increased from being the worst performer to being the sixth worst performer.

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Chapter 6. Conclusion

In this bachelor’s thesis I investigated how hedge funds and mutual funds performed during the financial crisis. I first discussed the differences between hedge funds and mutual funds by discussing the structure, fees and regulation of both funds. After I discussed these characteristics of hedge funds and mutual funds I discussed previous research done on the performance of hedge funds and mutual funds. I also conducted my own research on how hedge funds and mutual funds performed during the financial crisis using two performance measures, the Sharpe ratio and Jensen’s alpha. My research concluded that the Sharpe ratio of both hedge funds and mutual funds is lower in the crisis period and thus that hedge funds and mutual funds performed worse during the financial crisis than during the pre-crisis period. My research also concluded that the Sharpe ratio and Jensen’s alpha are higher for hedge funds than for mutual funds in both the pre-crisis and crisis period and thus it can be concluded that hedge funds are the better investment strategy. My research, however, has some limitations which can also be seen as recommendations for further research. Data on hedge funds is not easy or cheap to come by because you have to be an accredit investor. The Credit Suisse database is a good representation of the hedge fund market but usage of more detailed hedge fund data would never be a bad thing. Another limitation or

recommendation would be to increase the amount of mutual funds used in the research. I selected five different mutual fund strategies but for further research it could be

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Reference List

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Bodie, Z., Kane, A., & Marcus, A. J. (2014). Investments (10th Global Edition). McGraw-Hill Education. Capocci, D., & Hübner, G. (2004). Analysis of Hedge Fund Performance. Journal of Empirical Finance,

11(1), 55-89.

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Maslakovic, M. (2010, May 18). IFSL Hedge Funds 2010: Recovery begun in 2009 looks set to continue. The Hedge Fund Journal. http://www.thehedgefundjournal.com/node/6571 Patton, A. J., Ramadorai, T., & Streatfield, M. (2015). Change You Can Believe In? Hedge Fund Data

Revisions. The Journal of Finance, 70(3), 963-999.

Petajisto, A. (2013). Active Share and Mutual Fund Performance. Financial Analysts Journal(69(4)), 73-93.

Schaub, N., & Schmid, M. (2013). Hedge fund liquidity and performance: Evidence from the financial crisis. Journal of Banking & Finance, 37(3), 671-692.

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Appendix

In all the below regressions I have used _cons as Jensen’s alpha. Hedge fund regressions:

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37 Mutual fund regressions:

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42 Benchmark regressions:

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