Investment funds: What next?

Investment funds provide a low cost method of sharing in the rewards from capitalism. Recently “alternative investments” such as hedge funds have grown rapidly and the trading strategies open to hedge funds are now becoming available to mutual funds and even to ordinary retail investors. In this paper we analyze problems in assessing fund performance and the prospects for investment fund sectors. Choosing genuine outperformers among top funds requires a careful assessment of non-normality, order statistics and the possibility of false discoveries. The risk adjusted performance of the average hedge fund over the last 10-15 is actually not that impressive, although the “top” funds do appear to have statistically significant positive alphas.

Pairs trading in the UK equity market: risk and return

In this paper, we provide the first comprehensive UK evidence on the profitability of the pairs trading strategy. Evidence suggests that the strategy performs well in crisis periods, so we control for both risk and liquidity to assess performance. To evaluate the effect of market frictions on the strategy, we use several estimates of transaction costs. We also present evidence on the performance of the strategy in different economic and market states. Our results show that pairs trading portfolios typically have little exposure to known equity risk factors such as market, size, value, momentum and reversal. However, a model controlling for risk and liquidity explains a far larger proportion of returns. Incorporating different assumptions about bid-ask spreads leads to reductions in performance estimates. When we allow for time-varying risk exposures, conditioned on the contemporaneous equity market return, risk-adjusted returns are generally not significantly different from zero.