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Hedge Fund Essays

Serigy Gorovyy, 2012
Faculty Advisor: Andrew Ang
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This dissertation analyzes hedge fund leverage and its determinants, investigates optimal hedge fund manager behavior induced by hedge fund contracts, and uncovers an evidence of a hedge fund transparency risk premium. The first essay investigates the leverage of hedge funds in the time series and cross-section. Hedge fund leverage is found to be counter-cyclical to the leverage of listed financial intermediaries. Changes in hedge fund leverage tend to be more predictable by economy-wide factors than by fund-specific characteristics. In particular, decreases in funding costs and increases in market values both forecast increases in hedge fund leverage. Decreases in fund return volatilities predict future increases in leverage. In the second essay, I investigate hedge fund compensation from an investor's point of view in a model with a risk neutral fund manager who can continuously rebalance the fund's holdings. I solve for the optimal leverage level in a fund that has a compensation contract with a high-water mark and hurdle rate provisions where management and performance fees are paid at discrete time moments. The compensation contract induces risk-loving behavior with managers often choosing the maximum leverage. Third essay investigates risk premia associated with hedge fund transparency, liquidity, complexity, and concentration over the period from April 2006 to March 2009. Consistent with factor models of risk, we find that during normal times low-transparency, low-liquidity, and high-concentration funds delivered a return premium, with economic magnitudes of 5% to 10% per year, while during bad states of the economy, these funds experienced significantly lower returns. We also offer a novel explanation for why highly concentrated funds command a risk premium by revealing that the risk premium is mostly prevalent among non-transparent funds where investors are unaware about the exact risks they are facing and hence cannot diversify them away.

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