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  • NAA301

    Bachelor Thesis Business 15 hp

    Tutor: Johan Lindn

    Mlardalens Hgskola

    2011-06-08

    Hedge Funds Strategies

    Research on market correlation, market

    neutrality and portfolio performance

    improvements

    Oluwayinka Ogunniyi

    Ekpenmhene Ojeabulu

    Nelson Tabe Arrey

  • Acknowledgement

    Firstly, we would like to give thanks to The Almighty God for a spiritual insight and a sound

    mind in the realization of this work. It would have never been a wonderful piece without

    inspiration from above. Special gratitude goes to our supervisor, Johan Lindn whose

    ingenuity and guidance made this project a dream come true. His endless support both in and

    out of class provided us with all the necessary academic ingredients for any present and

    future engagements.

    ______________________________ _____________________________

    Oluwayinka Ogunniyi Ekpenmhene Ojeabulu

    _________________________________

    Nelson Tabe Arrey

    Vsters, 2011

  • Abstract

    Date: 2011-06-08

    Level: Bachelor Thesis in Economics, 15hp

    Authors: Oluwayinka Ogunniyi, Ekpenmhene Ojeabulu and Nelson Tabe Arrey

    Tutor: Johan Lindn

    Aim: This study analyze the market neutrality of market neutral hedge funds

    strategies given that hedge funds seeks to provide positive returns completely

    free of market conditions and also consider their performance against the

    market. We begin this study with a look into the hedge fund world and a

    description of the hedge funds is given so as to provide to the reader a clearer

    view of the hedge fund strategies. Then an analysis is made using monthly

    data from Barclay hedge fund database, S&P500 and T-bills from the period

    of January 2006 to March 2011 to evaluate if market neutral hedge funds can

    eliminate market risks using financial theories as a guide.

    Conclusion: In conclusion, using a correlation coefficient, the assumption that market

    neutral hedge fund strategies can eliminate market risk has to be rejected for

    all of the market neutral hedge fund strategies since the result goes against the

    relative value strategy theory that hedge fund strategies are expected to be

    market neutral.

  • Table of Contents 1 INTRODUCTION ............................................................................................................................... 5

    1.1 BACKGROUND INTRODUCTION .............................................................................................. 1

    1.2 PROBLEM DISCUSSION ............................................................................................................ 2

    1.3 RESEARCH QUESTION ............................................................................................................. 2

    1.4 RESEARCH PURPOSE ............................................................................................................... 2

    1.5 DELIMITATION OF THE STUDY ................................................................................................ 2

    1.6 METHODOLOGY ...................................................................................................................... 3

    1.7 STRUCTURE OF THE THESIS ..................................................................................................... 4

    2 FINANCIAL THEORIES ...................................................................................................................... 5

    2.1 UNDERLYING MARKET THEORIES ........................................................................................... 5

    2.1.1 EFFICIENT MARKET HYPOTHESIS (EMH) ............................................................................. 5

    2.1.2 BEHAVIORAL FINANCE ........................................................................................................ 5

    2.2 HEDGE FUND THEORY ............................................................................................................. 7

    2.2.1 DESCRIPTION OF HEDGE FUND STRATEGIES AND STYLES .................................................. 8

    2.2.1.1 MARKET NEUTRAL STRATEGIES (RELATIVE VALUE STRATEGIES) ........................................ 8

    2.2.1.2 EVENT DRIVEN HEDGE FUNDS ............................................................................................ 9

    2.2.1.3 TACTICAL/DIRECTIONAL HEDGE FUNDS ........................................................................... 11

    2.2.1.3 HYBRID HEDGE FUND ........................................................................................................ 13

    2.3 CORRELATION AND MARKET NEUTRALITY ........................................................................... 14

    2.4 MODERN PORTFOLIO THEORY .............................................................................................. 16

    2.4.1 MARKOWITZ PORTFOLIO SELECTION THEORY AND EFFICIENT PORTFOLIO ..................... 16

    2.4.2 CAPITAL ASSET PRICING MODEL (CAPM) .......................................................................... 19

    2.4.3 RISK -ADJUSTED PERFORMANCE MEASUREMENT OF PORTFOLIO ................................... 21

    2.4.3.1 SHARPE RATIO ................................................................................................................... 22

    2.4.3.2 TREYNOR RATIO ................................................................................................................ 22

    2.4.4 SKEWNESS AND KURTOSIS ................................................................................................ 23

    3 ANALYSIS ................................................................................................................................... 25

    3.1 CHOICE OF TIME PERIOD ...................................................................................................... 25

    3.2 DESCRIPTION OF HEDGE FUND DATA ................................................................................... 26

    3.3 RETURN AND STANDARD DEVIATION ................................................................................... 26

    3.4 MARKET NEUTRALITY ............................................................................................................ 27

    3.4.1 CORRELATION NEUTRALITY HYPOTHESIS ......................................................................... 27

    4 RESULTS......................................................................................................................................... 29

  • 4.1 RESULTS REGARDING THE RESEARCH QUESTION ................................................................. 29

    4.1.1 CORRELATION COEFFICIENT ANALYSIS OF HF SAMPLES OVER THE WHOLE PERIOD ....... 29

    4.1.2 RESULTS OF CORRELATION MARKET NEUTRALITY BASED ON CORRELATION MATRICES

    29

    4.1.3 CORRELATION MATRIX REGARDING THE WHOLE TIME PERIOD FROM 2006 to MARCH

    2011 29

    4.1.4 BETA VALUES REGARDING THE WHOLE TIME PERIOD FROM 2006 to MARCH 2011 ....... 30

    4.1.5 ASSESSMENT OF CORRELATION/BETA MARKET NEUTRALITY BASED ON A PERFORMANCE

    RANKING 31

    CONCLUSION ......................................................................................................................................... 34

    REFERENCE ............................................................................................................................................ 35

    APPENDIX ................................................................................................................................................ 1

    List of Figures

    Figure 1: Minimum-Variance Frontier and Set of Risky Assets. 18

    Figure2: Expected Return - Beta Relationship (SML) 20

    Figure3: Positive and Negative skewness. . 23

    Figure 4: showing the kurtosis 24

    List of Tables

    Table1: summary of the number of strategies considered under HF.. 26

    Table 2: Performance ranking using Treynor Ratio 33

  • Hedge Funds Strategies - Research on Market correlation, Market

    neutrality and portfolio performance improvements

    1

    1 INTRODUCTION

    This chapter introduces the topic and provides background information about the history and

    development of the hedge fund industry. It also presents the research question, purpose and

    an outline of the delimitation.

    1.1 BACKGROUND INTRODUCTION

    Over the years, there has been a growing awareness of hedge funds amongst both investment

    professionals and the general public. They are a prominent feature on the investment

    landscape as over two trillion dollars in assets worldwide are managed by hedge funds. The

    size of the hedge fund market has grown dramatically in both size and number over the last

    few years. Industry experts estimate around 8,000 hedge funds operating globally, mainly in

    the USA, with hundreds based in the UK primarily in the West End. This is without a doubt

    due to the stable financial environment witnessed in the 1900s, characterized by the soaring

    financial market asset values and increased wealth generated by a rising stock market. There

    was an estimated 70 hedge funds in 1990 compared to today with over 50,000 (Lavinio,

    Stefano, 1999).

    Hedge funds are aggressively managed portfolio of investments that uses advanced

    investment strategies such as long-short positions, leveraged and derivative positions in both

    domestic and international markets aimed at reducing volatility and