Grey matters

Two recent literature surveys on hedge funds offer useful summaries of the relevant academic literatures.


Hedge funds: A survey of the academic literature
Vikas Agarwl, Kevin Mullally, and Narayan Y. Nalk,


Foundations and Trends in Finance (forthcoming), available at


Hedge funds have become increasingly important players in financial markets. This heightened importance has spawned a large academic literature focused on issues pertinent to hedge fund managers, investors, regulators, and policymakers. Although the top-4 finance journals (JF, JFE, RFS, and JFQA) published only 16 papers on hedge funds prior to 2005, they have published 105 papers on hedge funds since 2005. As a result, we felt that it is time to update the survey published in 2005. This update prepared with the help of a new coauthor, Kevin Mullally, extends the previous survey along two dimensions. First, it includes reviews of recent studies on topics that were covered in the earlier survey. Second, it summarizes research on new topics that were not part of the previous survey. These new topics cover a broad gamut of issues ranging from hedge funds’ use of leverage and exposure to different risks to their impact on various asset markets.

This survey consists of five broad sections. The first section reviews the literature examining both the time-series and cross-sectional variation in hedge fund performance. Time-series performance studies cover return generating processes, dynamic risk exposures, and determination of managerial skill. The second section covers studies focused on the cross-sectional relations between hedge funds’ characteristics (including contractual features and time-varying features such as size and age) and fund performance. The third section analyzes the literature on the sources and nature of risks faced by hedge fund investors. In particular, we discuss risks that can arise from managerial incentives and sources of capital. The fourth section summarizes research on the role of hedge funds in the financial system. Specific topics here include hedge funds’ impact on systemic risk, asset prices, and liquidity provision in financial markets. The fifth and final section focuses on potential biases and limitations of hedge fund data sources.


Hedge funds: A dynamic industry in transition
Mila Getmansky, Peter A. Lee and Andrew W. Lo


available at


The hedge-fund industry has grown rapidly over the past two decades, offering investors unique investment opportunities that often reflect more complex risk exposures than those of traditional investments. In this article we present a selective review of the recent academic literature on hedge funds as well as updated empirical results for this industry. This review is written from several distinct perspectives: the investor’s, the portfolio manager’s, the regulator’s, and the academic’s. Each of these perspectives offers a different set of insights into the financial system, and the combination provides surprisingly rich implications for the efficient markets hypothesis, investment management, systemic risk, financial regulation, and other aspects of financial theory and practice.

CFR comment:

Agarwl, et al, is lengthy (over 100 pages) summary of the academic literature on hedge funds that will be a valuable resource for regulators, industry participants, and academics. It updates a 2005 paper, covering the 105 papers in the top four finance journals on the topic published since then. Getmansky, et al, is just as long, and just as useful. The two papers are organized quite differently, and so are useful in tandem as alternative entry points into the literature. Unusually for an academic paper, it also offers some advice on how to use the results in evaluating investment strategies and so may be of particular interest to those managing funds or investing in them. Financial professionals ought to care about the academic literature because it can form the basis for triggers of regulatory action and policy change. These articles are a (relatively) quick way to identify the broad themes that are emerging from the literature.

Several recent data-driven papers offer interesting perspectives on global financial instruments, trends, and investments.

Passive hedge funds
Mihail Tupitsyn and Paul Lajbcygier

available at


This paper shows 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. In order to demonstrate managerial skill enhanced performance should accrue as a consequence of active management. Using generalized additive models the authors find that approximately two-thirds of hedge funds exhibit only linear factor exposures and hence are “passive”. What’s more such “passive” managers tend to outperform “active” managers. Finally, the authors also show that many “active” managers, despite initial nonlinear risk exposures, eventually become “passive.”


Financial intermediation in private equity: How well do funds of funds perform?
Robert S. Harris, Tim Jenkinson, Steven N. Kaplan and Ruediger Stucke,

available at



This paper focuses on funds of funds (FOFs) as a form of financial intermediation in private equity (both buyout and venture capital). Compared to investments in hedge funds or publicly traded stocks, private equity investments in direct funds are less liquid, less easily scaled and have higher search and monitoring costs. As a consequence, FOFs in private equity may provide valuable intermediation for investors who want exposure to the asset class. The authors benchmark FOF performance (net of their fees) against both public equity markets and strategies of direct investment into private equity funds. They also examine the types of portfolios private equity FOFs create when they pool investor capital. After accounting for fees, primary FOFs provide returns equal to or above public market indices for both buyout and venture capital. While FOFs focusing on buyouts outperform public markets, they underperform direct fund investment strategies in buyout. In contrast, the average performance of FOFs in venture capital is on a par with results from direct venture fund investing. This suggests that FOFs in venture capital (but not in buyouts) are able to identify and access superior performing funds.


Are investors better off with small hedge funds in times of crisis?
Andrew Clare, Dirk Nitzsche and Nick Motson,

available at


With the benefit of a more comprehensive dataset than previous authors in this area, in this paper the authors revisit the relationship between hedge fund performance and size. Their results indicate that there is a strong, negative relationship between hedge fund performance and size. But, in addition, they also find that rather than dissipating during the two recent periods of financial crisis, other things equal, investors would have been better off with smaller hedge funds than with large ones during these crisis periods. Finally, they also document clear cross-sectional variation in this relationship by broad hedge fund strategy.

Hedge fund flows chase alpha, yet they also follow returns attributable to traditional and exotic risk exposures. Investors appear more cognizant of exotic risks over time, with flows increasing their relative emphasis on returns from exotic betas in recent years. Investors also discriminate between which risks warrant high fees, with flows into high-fee funds being more likely to emphasize returns arising from exotic risks.

Although the authors find strong evidence of persistence for alpha, persistence in hedge fund returns attributable to traditional and exotic risk exposures is modest, which suggests investors would benefit from employing more sophisticated risk models when evaluating fund performance.


Alternatives to Silicon Valley: Building your global business anywhere
Mark Fenwick and Eric P.M. Vermeulen,


Lex Research Topics in Corporate Law & Economics Working Paper No. 2015-2 available at


Entrepreneurs who are driven, ambitious and dream of building a global business that will change the world are going to have to survive the difficult period in the early stage of the life cycle of a company known as the “Valley of Death.” In order to be successful in this challenging task ─ after all, many businesses will fail at this early stage ─ they will need to raise a significant amount of money. But this need for money raises a series of daunting questions: “Who should they turn to for investment?”; “What kind of money do they want to attract?”; “When is the right moment to seek investment?”; and “Where should they locate their company, if their dream is to build a global business?”

This last question ─ the authors refer to it as the “Where question” ─ is perhaps the most important of all, not least because it will determine the available options for answering the other questions. Research has consistently shown that over the last three decades Silicon Valley has been the place to go. Over recent years, however, this picture has become somewhat blurred. If deal growth is examined, for example, it is clear that more and more high risk venture capital deals are being put together far from California and that the correct answer to the “Where question” is becoming much less obvious. A global business really can begin anywhere.

An important new development is the emergence of a global or “virtual” innovation eco-system. A metaphor for understanding various features of this new phenomenon is that of the Cloud.

CFR comment:

Tupitsyn and Lajbcygier’s provocative paper reviews the data on hedge funds and proposes a data-driven means of testing how active fund management is, and whether that is a good thing to be. Clare, et al, offer some intriguing findings on fund size and performance, finding differences between cries and non-crisis periods. Harris, et al, offer some intriguing results on the efficacy of funds of funds, finding an advantage to them in venture capital but not buyout funds. Agarwal, et al, find that there are types of risk which appear to not be compensated for by returns, suggesting investors can improve returns by getting a better grip on the more “exotic” risks to which funds expose them. Fenwick and Vermeulen offer intriguing data on the increasing shift of investment opportunities to less traditional locales. 

Several other recent papers use data to examine the offshore financial sector:

Offshore schemes and tax evasion: The role of banks
Lucy Chernykh & Sergey Mityakov

available at


The authors use official Russian banks’ reports to the central bank to construct a novel measure of offshore banking activity over the period 2000-2003. Individual bank involvement in offshore schemes is calculated as a fraction of total annual transactions with foreign countries that goes through offshore zones. They find that offshore banking is closely connected with other forms of bank malfeasance: tax evasion, money laundering and accounting fraud. At the same time, banks engaged in offshore transactions tend to be less actively involved in traditional financial intermediation, such as lending and deposit-taking. They further document the positive relation between offshore activities of banks and tax evasion of non-financial companies doing business with those banks.

Finally, the authors find that the central bank seems to detect such bank malfeasance over time and sanction involved banks through bank license revocation and/or criminal chargers against top managers. Collectively, the results of this study provide first systematic empirical evidence on the role of banks and bank-firm relationships in offshore-tax evasion schemes.


The effect of ‘check the box’ on U.S. multinational tax rates
Amy E. Dunbar & Andrew Duxbury,


available at


This paper examines changes in current foreign effective tax rates for U.S. versus foreign multinational corporations (MNCs) after a U.S. tax change known as check-the-box (CTB) became effective. The authors find that U.S. MNCs reported current foreign effective tax rates that declined approximately 9 percentage points more than foreign MNCs in the post-CTB period, suggesting that CTB allowed these U.S. firms to engage in more effective foreign tax planning. Because the U.S. taxes foreign income up to the U.S. tax rate when repatriated, the authors examine whether these foreign tax savings were maintained, or whether they were offset by additional U.S. tax. The authors find no significant change in U.S. tax rates on foreign income in the post-CTB period suggesting that more foreign earnings were retained offshore after CTB became effective. Thus, CTB likely played a role in maintaining the competitive balance between U.S. and foreign MNCs worldwide effective tax rates as found in prior studies. Finally, given the significant change in foreign effective tax rates, the authors examine whether investors reacted to CTB announcements, but they do not find a stock price response.

CFR comment:

These are welcome additions to the literature, since they bring some precision to debates that have been historically driven by passion and wild guesses. 


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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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