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On the economics of hedge fund drawdown status: Performance, insurance selling and darwinian selection

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Author Info

  • Sevinc Cukurova

    ()
    (Universidad Carlos III de Madrid)

  • Jose M. Marin

    ()
    (IMDEA Social Sciences Institute)

Abstract

In this paper we study the drawdown status of hedge funds as a hedge fund characteristic related to performance. A hedge fund's drawdown status is the decile to which the fund belongs in the industry's drawdown distribution (at a given point in time). Economic reasoning suggests that both the current level and the past evolution of a fund's drawdown status are informative of key fund aspects, including the manager's talent, as well as fund investors' assessment of the fund, and, hence, are predictive of future performance. The analysis delivers four completely new insights on hedge funds. First, the presence of insurance selling (shorting deep out-of-the-money puts) in the industry is large enough to make portfolios of low drawdown funds weak performers, in general, and bad performers in times of turmoil. Second, the market operates a Darwinian selection process according to which funds running large drawdowns for a prolonged period of time (survivers) are managed by truly talented traders who deliver outstanding future performance. Third, a completely new dimension of risk arises as a distinctive feature of hedge funds: risk conditional on survival is tantamount to outstanding performance. Fourth, drawdown status analysis raises serious concerns about the role played by other hedge fund characteristics {such as total delta{ on fund performance and casts doubts on the validity of some performance evaluation measures {such as the Calmar and Sterling ratios{ that are widely used in practice.

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Bibliographic Info

Paper provided by Instituto Madrileño de Estudios Avanzados (IMDEA) Ciencias Sociales in its series Working Papers with number 2011-04.

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Date of creation: 24 Jan 2011
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Handle: RePEc:imd:wpaper:wp2011-04

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Keywords: drawdowns; hedge funds; fund characteristics; return predictability; darwinian selection; insurance sellers; survival;

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  1. Jens Carsten Jackwerth & James E. Hodder & Olga Kolokolova, 2008. "Recovering Delisting Returns of Hedge Funds," CoFE Discussion Paper 08-09, Center of Finance and Econometrics, University of Konstanz.
  2. Francesco Franzoni & José M. Marín, 2006. "Pension Plan Funding and Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 61(2), pages 921-956, 04.
  3. Stephen J. Brown & William N. Goetzmann, 2001. "Hedge Funds With Style," NBER Working Papers 8173, National Bureau of Economic Research, Inc.
  4. Titman, Sheridan & Wei, K. C. John & Xie, Feixue, 2004. "Capital Investments and Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 39(04), pages 677-700, December.
  5. Baquero, Guillermo & ter Horst, Jenke & Verbeek, Marno, 2005. "Survival, Look-Ahead Bias, and Persistence in Hedge Fund Performance," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 40(03), pages 493-517, September.
  6. Marcos Mailoc López de Prado & Achim Peijan, 2005. "Measuring Loss Potential of Hedge Fund Strategies," Finance 0503010, EconWPA.
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