Eficiência Negociação Estratégias Na Presença Do Mercado Frictions

Guofu é Frederick Bierman e James E. Spears Professor de Finanças da Olin Business School (OBS), Universidade de Washington em St. Louis. Seus interesses de ensino e pesquisa incluem testes de preços de ativos, alocação de ativos, otimização de carteiras, aprendizado Bayesiano e avaliações de modelos, métodos econométricos em finanças, futuros, opções, derivativos, estrutura de prazo das taxas de juros e avaliação de opções reais de projetos corporativos. Antes de ingressar na OBS em 1990, estudou na Duke University para seu doutorado em economia e MA em matemática, na Academia Sinica para seu MS em análise numérica e em Chengdu University of Technology para o seu BS. Ele cresceu em Chengdu, capital da província sudoeste de Sichuan. Chengdu tem sido o centro cultural da província mais populosa de Chinas desde 400 aC, e é uma das cidades mais bonitas da China. Nas imediações de Chengdu, é possível beber água fresca diretamente do rio Yangtze, que é o rio mais longo do mundo. Um pode também olhar acima no palácio azul do boi onde o Lao Tse, de acordo com a legenda, voou ao céu em 500 BC após ter escrito seu livro Tao Te Ching (ensinos da filosofia e do Taoism, a maneira). Além disso, pode-se caminhar nos corredores em ziguezague do Parque Du Fu (nomeado após o poeta do Realismo da Grande Chines, 712-770 dC, que escreveu mais de 200 poemas lá) em torno de árvores florescentes antigas, ameixas e lagoas de lotus. Pode-se até mesmo ter um partido de 10 pessoas na ponta de uma estátua de Buda gigantesco supervisionando a fusão de três rios ou subir ao longo de um caminho de 40 quilômetros de pedra extenuante (tendo normalmente 3 dias) para Budistas Golden Summit no topo do Monte. Emei maravilha-se e pondera o halo de Buddhas, que ocorre quando os raios do sol refletiram fora das nuvens que criam um círculo do brilho cintilante, multi-hued. Outras atividades incluem meditar sobre o Caminho do Monte Taoísta Qing Chen, ou explorar o único lugar no mundo onde existem pandas selvagens. Finalmente, pode-se recarregar com alimentos picantes Sichuan, panelas quentes e pequenos pratos (um conjunto de 40 tipos diferentes não é incomum para uma única pessoa). Algumas fotos em torno de Chengdu E-mail: zhouwustl. edu Escritório: Sala 207, Simon Hall Telefone Fax: 314-935-6384 314-935-6359 Endereço para correspondência: Professor Guofu Zhou, Olin Business School, Washington University, 1 Brookings Dr. St Louis, MO 63130 Graus: Ph. D. 1990 M. A. 1987, Duke University M. S. Academia Sinica, 1985 B. S. Faculdade de Geologia de Chengdu, China, 1982 Curriculum Vita: Arquivo PDF Opções Futuros, Derivados (BSBA, MBA e PMBA) Avaliação Real de Opções (MBA e PMBA) Tópicos Avançados em Finanças (EMBA) Análise de Dados para Investimentos (MBA, implementando estratégias avançadas de alocação de ativos) e Matemática Financeira (MS em Finanças, derivativos de precificação em processos de difusão e salto). Seleção de portfólio, alocação de ativos, análise técnica, bolhas e falhas, anomalias, informações assimétricas, testes de preços de ativos, aprendizado bayesiano, seleção de modelos, métodos econométricos em finanças e opção real. Editora Associada: Revista de Análise Financeira e Quantitativa, 2000-presente Revista de Finanças Empíricas, 2016-presente Conselho Editorial: Revista de Gestão de Portfólio, 2008-presente e Revista Internacional de Análise de Portfólio Diretor: Associação Asiática de Finanças, 2008--2010 Co-Presidente do Programa: 2007 e 2008 Conferência Internacional da China em Programa Financeiro Presidente Associado: Reuniões da Sociedade de Pesquisa de Intermediação Financeira, 2002 Western Finance Association Comité do Programa: Western Finance Association Reuniões Anuais, 1999--2015 China International Conference in Finance, 2002 - 2015. Árbitro para mais de 50 revistas. Principais Contribuições Acadêmicas: (um resumo dos trabalhos publicados e futuros) CAPM e APT. Harvey e Zhou (1990) fornecem os primeiros testes Bayesianos multivariados do CAPM e acham que a probabilidade de que o mercado seja média-variância eficiente é bastante pequena para uma série de prioridades plausíveis Zhou (1991) fornece a primeira O teste exato do CAPM zero-beta que permite taxas de empréstimo ser maior do que as taxas de empréstimo (mais complexo do que o habitual CAPM, mas mais realista) e encontra mesmo esta extensão não vai explicar a ineficiência do mercado. Geweke e Zhou (1994) fornecem uma estrutura Bayesiana exata para analisar a teoria de preços de arbitragem (APT) e encontrar os erros de preços são pouco alterados com a inclusão de mais fatores além do primeiro (os erros de preços pode ser melhor ponderada usando o inverso de ativos Matriz de covariância para que sejam invariantes ao reencaminhamento de portfólio). GMM. Zhou (1994) fornece os primeiros testes GMM para matrizes de ponderação padronizadas que permitem analiticamente soluções em muitas aplicações financeiras (citado por Matyas (1999) em seu livro GMM Cochrane (2001) apresenta um teste GMM similar em seu livro de preços de ativos). SDF. Kan e Zhou (1999) mostram que a abordagem SDF (estocástica desconto factor) usual fornece estimativa de prémio de risco pouco fiável, estudos posteriores resolver este problema através da adição de condições factor momento para o qual não mais soluções analíticas disponíveis. Kan e Zhou (2006) fornecem o limite mínimo mais apertado no SDF até à data, mostrando que modelos de ativos bem conhecidos não têm volatilidade suficiente no SDF para passar esse limite. Regressões de duas passagens. Shanken e Zhou (2007) fornecem testes de misppecificação de modelos formais, além de um amplo estudo teórico e de pequena amostra do procedimento amplamente utilizado de duas passagens de Fama e MacBeth (1973), que é fundamental para entender até que ponto os valores de retornos esperados transversais são explicados Por certos atributos fatoriais. Jagannathan, Schaumburg e Zhou (2010) levantam a literatura. Bai e Zhou (2015) fornecem tanto a teoria assintótica para Fama e MacBeth (1973) regressões de duas passagens e novos estimadores de OLS e GLS ajustados de modo tendencioso no caso da NT comum. Previsibilidade. Lamoureux e Zhou (1996) mostram que uma decomposição permanente e temporária dos retornos dificulta as previsões. Rapach e Strauss e Zhou (2010) fornecem a primeira evidência empírica de que o prêmio de risco do mercado norte-americano é consistentemente previsível fora da amostra com variáveis ​​macroeconômicas por meio de uma abordagem de previsão combinada. Neely, Rapach, Tu e Zhou (2014) mostram ainda que o poder preditivo dos indicadores técnicos é igual ou superior ao das variáveis ​​macroeconômicas (note que indicadores técnicos, como médias móveis de preços, também podem captar informações fundamentais como a estabilidade política mundial , Que se reflectem nos preços e não se reflectem nas macro variáveis ​​comuns). Kong, Rapach, Strauss e Zhou (2011) analisam a previsibilidade dos componentes do mercado. Rapach e Strauss e Zhou (2013) acham que o mercado de ações dos EUA lidera os mercados mundiais mesmo na freqüência mensal. Rapach e Zhou (2013) levantam a literatura. Huang, Jiang, Tu e Zhou (2015) acham que o sentimento do investidor é um poderoso preditor do mercado de ações, e Rapach, Ringgenberg e Zhou (2015) mostram que o interesse curto agregado é outro poderoso preditor. Lin, Wu e Zhou (2016) fornecem um novo método iterado de previsão de combinação (do qual o PLS é um caso especial) e, com este novo método, eles acham que a previsibilidade de títulos corporativos é economicamente e estatisticamente significativa. Huang e Zhou (2015) fornecem limites substancialmente mais apertados e acham que os principais modelos de precificação de ativos não explicam a previsibilidade empírica nos dados devido a variáveis ​​de estado inadequadas. MomentumTechnical Analysis. Zhu e Zhou (2010) fornecem o primeiro estudo teórico para mostrar que a análise técnica, especificamente as médias móveis amplamente utilizadas, pode agregar valor à alocação de ativos sob incerteza sobre previsibilidade ou incerteza sobre o verdadeiro modelo que governa o preço das ações. Han e Yang e Zhou (2013) descobrem que a análise técnica, aplicada a carteiras classificadas por volatilidade ou outros proxies de informações, pode superar substancialmente a estratégia de compra e retenção e render retornos anormais acima de 20, o que não pode ser explicado pelo timing de mercado Capacidade, sentimento do investidor, riscos de inadimplência e de liquidez. Han, Zhou e Zhu (2016) fornecem talvez o primeiro modelo de equilíbrio geral sobre as médias móveis de preço para entender os papéis dos comerciantes técnicos e para justificar sua previsibilidade e propor um fator de tendência que captura simultaneamente todas as três tendências de preços das ações Curto, médio e longo prazo) e supera fatores substancialmente existentes, como o impulso, ao dobrar mais do que seus rácios de Sharpe. Testes de assimetria. Hong, Tu e Zhou (2007) fornecem o primeiro teste livre de modelo para correlações assimétricas (e betas) para ver se os estoques se movem mais frequentemente com o mercado quando o mercado cai do que quando ele sobe. Escolha da Carteira. Tu e Zhou (2009) mostram como selecionar uma carteira de média-variância ótima sob a distribuição t realística com priores do modelo de precificação de ativos e encontram grandes diferenças em pesos em relação ao caso normal. Kan e Zhou (2007) resolvem analiticamente, pela primeira vez, a perda de rendimento esperada no risco de estimação de parâmetro. Fabozzi, Huang e Zhou (2010) fornecem uma pesquisa. Tu e Zhou (2011) propõem estratégias de portfólio que superam a regra 1N em quase todos os cenários, exceto nos casos em que os pesos reais estão próximos de 1N. Escolha da carteira Bayesiana. Zhou (2009) fornece uma extensão do popular modelo Black-Litterman, e Tu e Zhou (2010) mostram como os objetivos econômicos podem servir como priores úteis que produzem portfólios superiores. Avramov e Zhou (2010) levantam a literatura. Riscos de volatilidade. Zhou e Zhu (2010) mostram como selecionar carteiras sob riscos de volatilidade de curto e longo prazo e encontrar grandes impactos contra o modelo de fator de volatilidade comumente usado. Zhou e Zhu (2015) estendem o modelo de riscos de longo prazo de Bansal e Yaron (2004), permitindo componentes de volatilidade de longo e curto prazo na evolução dos fundamentos econômicos. Com a extensão, o novo modelo não é apenas consistente com a literatura volatilidade que o mercado de ações é impulsionado por dois, em vez de um, fatores de volatilidade, mas também fornece melhorias significativas na explicação de vários quebra-cabeças de dados de equidade e opções. Gerenciamento ativo da carteira. Zhou (2008a, b) estende a lei fundamental da gestão de carteira ativa pioneira por Grinold (1989) ao caso dos erros de estimação e ao caso do desempenho condicional. Zhou (2009) fornece uma extensão do popular modelo Black-Litterman, incorporando informações dos dados (como a dinâmica de como o mercado se move) além de combinar visões com o equilíbrio. Comportamento Financeiro. Huang, Jiang, Tu e Zhou (2015) fornecem um novo índice de sentimento do investidor que está alinhado com a finalidade de prever o mercado de ações agregado. Ao eliminar um componente de ruído comum em proxies de sentimento, o novo índice tem um poder preditivo muito maior do que os índices de sentimento existentes, dentro e fora da amostra, supera variáveis ​​macroeconômicas bem reconhecidas e também pode prever retornos de estoque transversais classificados por setor, Tamanho, valor e momentum. Finanças Domésticas. Gormley, Liu e Zhou (2010) mostram teórica e empiricamente que o seguro (de grandes choques de riqueza) desempenha um papel importante nas decisões de investimento e de poupança das famílias. Mercados de Acções e Obrigações Chineses. Jiang, Rapach, Strauss, Tu e Zhou (2011) acham que o mercado acionário chinês é duas vezes mais previsível do que os EUA. Han, Wang, Zhou e Zou (2014) mostram que a dinâmica existe na China, mas apenas a curto prazo. Para o mercado de títulos chinês, Fan, Li e Zhou (2013) analisam seu fator de oferta, e Fan, Jiang e Zhou (2014) fornecem uma introdução geral. Este artigo apresenta algoritmos eficientes para a computação de projeções de séries temporais, a função de máxima verossimilhança e seu gradiente em modelos de séries vetoriais eventualmente não-estacionárias (VARMA). Journal of Time Series Analysis, 13, 1991, 171-188. INVESTIGAÇÃO DE TERCEIROS Para acessar os artigos abaixo, verifique primeiro se você está logado como membro e, em seguida, clique nos links abaixo. A adesão é gratuita, clique aqui para se cadastrar. Gambling ou De-risking: Tomada de Risco de Fundo de Cobertura vs. Remuneração de Gestores As opções de risco de gestão de fundos de hedge são determinadas pela sua compensação. Os gerentes de-risco quando a taxa de gestão se torna mais importante na compensação total, potencialmente para proteger seus ativos existentes e os rendimentos de taxa. Quando os fundos estão abaixo de suas margens altas, os gerentes aumentam a tomada de risco para recuperar perdas passadas. Os gerentes também assumem mais riscos quando os fundos estão acima de suas margens altas, possivelmente para aumentar ainda mais sua compensação. Durante a recente crise financeira, os gerentes pastorearam mais com seus estilos e reduziram o risco específico do fundo. Finalmente, quando os gestores de fundos assumem mais riscos, não geram um melhor desempenho futuro e, portanto, não beneficiam os investidores. Chengdong Yin, Escola de Administração de Krannert, Universidade de Purdue Xiaoyan Zhang, Escola de Administração de Krannert, Universidade de Purdue, e Escola de Finanças de PBC, Universidade de Tsinghua Risco de Liquidez de Financiamento e Dinâmica de Bloqueios de Fundos de Hedge Nós exploramos a natureza expirante de Lockups de fundos de hedge para criar um proxy dinâmico, fundo-nível de risco de liquidez de financiamento. Em contraste com a literatura anterior, a nossa medida permite identificar como as mudanças dentro do fundo no risco de liquidez de financiamento estão associadas ao desempenho e à tomada de riscos. Os fundos de lockup com menor risco de liquidez de financiamento assumem mais risco de cauda e têm um melhor desempenho ajustado ao risco, o que sugere que o risco de liquidez de financiamento reduzido permite que os fundos capitalizem melhor os preços de risco arriscados. Surpreendentemente, os fundos de lockup superam os fundos sem lockup mesmo quando se controla o capital restrito, sugerindo que uma parte do prêmio de lockup é atribuível a um efeito fixo de lockup. Clique aqui para ver o artigo completo Adam L. Aiken, PhD, Professor Assistente de Finanças - Universidade Elon Christopher P. Clifford, PhD, Phillip Morris Professor Associado de Finanças - Gatton College of Business and Economics, Universidade de Kentucky Jesse A. Ellis, PhD, Professora Associada de Finanças Faculdade de Administração de Poole, Universidade Estadual da Carolina do Norte Qiping Huang, PhD Faculdade de Administração de Gatton, Universidade de Kentucky Profissionais do setor financeiro não devem ser afetados pelo discurso político, e Os investidores não podem realizar retornos anormais em informações publicamente disponíveis. Eventos raros, entretanto, podem silenciar a racionalidade e potencializar a dissonância cognitiva em um espectro de agentes. Nós montamos um conjunto de dados abrangente de desempenho de fundo de hedge e correspondência de fundos de hedge de capital afiliação política por suas contribuições partidárias. Documentamos maiores retornos de fundos de hedge de ações administrados por democratas por 10 meses subseqüentes - de dezembro de 2008 a setembro de 2009. Esse resultado é único e robusto para janelas de tempo de placebo e aleatoriedade de afiliação aleatória aleatória. Conjeturamos que a conjunção da crise financeira, a eleição de Obama e a interpretação politicamente polarizada da política do banco central dos EUA durante esse período tiveram um impacto assimétrico na percepção dos gestores de fundos de hedge. Em outros períodos, quando o discurso político não envolveu a política do banco central, não houve diferença estatisticamente significativa entre o desempenho dos gestores de fundos de hedge de ações, dependendo de suas convicções políticas. Este artigo estuda o nível, os determinantes e a persistência dos gestores de fundos de hedge. O objetivo deste estudo é estudar o nível, os determinantes e a persistência dos gestores de fundos de hedge. A capacidade de cronometragem de fatores de hedge gestores de fundos. Encontramos fortes evidências a favor da capacidade de cronometragem de fatores no nível agregado, embora encontremos ampla variação nas habilidades de cronometragem em estilos de investimento e fatores no nível do fundo. Nossa análise transversal mostra que as melhores habilidades de timing de fatores estão relacionadas a fundos que são mais jovens, menores, têm taxas de incentivo mais altas, têm um período de restrição menor e fazem uso da alavancagem. Um teste fora da amostra mostra que o tempo do fator é persistente. Especificamente, os fundos de tempo de fator de topo superam os fundos de tempo de fator de fundo com um 1 significativo por ano. Isso constitui 13% da persistência geral do desempenho em hedge funds. Os resultados são robustos ao uso de um modelo alternativo, fatores alternativos, e controle para o uso de derivados, informação pública e tamanho do fundo. Clique aqui para ver o artigo completo Albert Jakob Osinga, Banco KAS Marc BJ Schauten, VU Amsterdã Remco CJ Zwinkels, VU Amsterdã e Instituto Tinbergen Lobos na Porta: Um olhar mais atento sobre o ativismo do fundo de hedge Alguns comentaristas atribuem o sucesso do ativismo dos fundos de hedge ao apoio Oferecidos por outros investidores, muitos dos quais são pensados ​​para acumular participações nas empresas-alvo antes de as campanhas de ativistas são divulgadas publicamente. Esse fenômeno é comumente referido como ativismo de lobos. Este artigo explora três questões de pesquisa: Existe alguma evidência de formação de lobos? A manada de lobos é formada intencionalmente (pelo ativista líder) ou é resultado de uma atividade independente de outros investidores A presença de uma manada de lobos melhora o resultado Campanha de ativistas Primeiro, consistente com a formação de lobos, acho que investidores além do ativista principal acumulam participações significativas antes da divulgação pública. Em segundo lugar, essas acumulações de ações são mais susceptíveis de serem reunidas pelo ativista principal do que ocorrer espontaneamente. Nomeadamente, por exemplo, os outros investidores são mais susceptíveis de ser aqueles que tinham uma relação comercial anterior com o ativista principal. Em terceiro lugar, a presença de uma matilha de lobo está associada a uma maior probabilidade de que o ativista alcance seus objetivos declarados (por exemplo, obterá assentos na diretoria) e maiores retornos de estoque futuros ao longo da campanha. Oportunidades de trabalho recentes sobre a coordenação de acionistas A coordenação de acionistas pode contribuir para o sucesso do ativismo de fundos de hedge. Examinamos as ações que as empresas visam tomar para limitar a coordenação entre os acionistas, obstruindo assim a capacidade de coordenar. Metas mais freqüentemente obstruir a coordenação quando o potencial de coordenação dos acionistas titulares é maior e quando o estoque da empresa-alvo experimenta um volume de negócios anormal antes do anúncio do ativismo. As empresas que obstruem a coordenação sofrem pior estoque e desempenho operacional a longo prazo e uma menor probabilidade de fusões, pagamentos, vendas de ativos e mudanças de gestão após o ativismo. Nossos resultados são robustos para a correspondência de propensidade e uma análise de variáveis ​​instrumentais. Nós analisamos se a exposição ao risco do sentimento ajuda a explicar a variação transversal dos retornos dos fundos de hedge . Descobrimos que os fundos com o beta do sentimento no décile superior subseqüentemente superam aqueles no decil inferior por 0.67 por o mês em uma base risk-adjusted. Além disso, mostramos que alguns fundos de hedge têm a capacidade de cronometrar sentimento por ter alta exposição a um fator de sentimento quando o prêmio de fator é alto, e timing sentimento também contribui para o desempenho do fundo. Nossos resultados são robustos para controlar as características do fundo e outros fatores de risco conhecidos por afetar os retornos dos fundos de hedge e manter as medidas de risco do sentimento alternativo. Em geral, essas descobertas destacam o risco do sentimento como uma fonte de limites à arbitragem enfrentada pelos fundos hedge. Clique aqui para o artigo completo Yong Chen, Mays Business School, Texas AM University Bing Han, Rotman Escola de Administração, Universidade de Toronto Jing Pan, Universidade de Utah, Eccles Escola de Negócios Benchmarking Benchmarks: Muito barulho por nada Comparamos o desempenho de um Ampla variedade de benchmarks: tradicional, baseada em fundamentos e baseada na otimização. Descobrimos que, para um conjunto de todas as ações do índice SP500 durante o período de fevereiro de 1989 a dezembro de 2011, as carteiras tradicionais e as novas carteiras de referência operam de forma semelhante de acordo com uma variedade de métricas de retorno, risco, volume de negócios e diversificação. Além disso, a diferença entre o valor de referência tradicional ponderado pelo valor ou igual e as novas carteiras de referência não é estatisticamente significativa. Identificamos um conjunto de benchmarks de base, que abrangem tanto o conjunto de novos como o conjunto de benchmarks tradicionais. A primeira base de referência explica três quartos da variação de todas as carteiras de referência correlação entre esta base de referência e fator de mercado sistemático é de 96 para o último período de 10 anos. Concluímos que a força motriz mais forte de todas as carteiras de referência consideradas é o fator de mercado. Independentemente da carteira de referência, os gestores seguem principalmente o mercado e o fazem de forma estatisticamente suficiente durante os últimos 23 anos. A diferença no desempenho de vários benchmarks pode ser atribuída à habilidade de superar o mercado. A longo prazo, essas habilidades são lavadas. Nosso trabalho tem implicações para grandes fundos mútuos, de pensões e de hedge com um número bastante grande de ações em suas carteiras e um longo horizonte de tempo de investimento. Para estes fundos, a escolha do parâmetro de referência não é importante. A abordagem atual para a avaliação de desempenho é executar regressões de equação por equação para calcular alphas. Há pelo menos três questões que surgem: 1) a estimativa não leva em conta qualquer informação transversal (ou seja, como bem outros fundos estão fazendo) 2) não há tolerância para a incerteza parâmetro e 3) os alphas estimados fazer um pobre Trabalho de prever futuros alfas. Harvey e Liu (2015) propõem um novo método que usa informações transversais. Eles realizam simulações extensas no papel e mostram que seu método é superior à abordagem OLS usual. Eles também argumentam que sua técnica tem vantagens em relação a uma abordagem bayesiana, porque nenhum prior precisa ser especificado. Os últimos documentos de pesquisa concluem que nem um único MF supera significativamente (há alguns que significativamente underperform). Aplicando sua técnica, dramaticamente muda a inferência. Aproveitando as informações transversais, eles acham que 26 superam. Embora eles tenham aplicado apenas o seu método de fundos mútuos, o documento indica que a próxima são os fundos de hedge. Clique aqui para ver o artigo completo Campbell R. Harvey, Universidade Duke - Fuqua School of Business Instituto Nacional de Pesquisa Econômica (NBER) Duke Inovação Iniciativa Empreendedorismo Yan Liu, Texas AM University, Departamento de Finanças Slow Trading e Previsibilidade Retornos anormais em ações pequenas e ilíquidas, o que implica estratégias de investimento dinâmicas atraentes para investidores que investem no prêmio de tamanho ou em ações pequenas e ilíquidas, diretamente ou através de fundos negociados em bolsa. Nós fornecemos evidências de que essa previsibilidade de retorno é devido aos padrões de negociação dos investidores institucionais: Ao reequilíbrio de suas carteiras, os investidores institucionais inicialmente compram (vendem) relativamente mais as ações grandes e líquidas. No caso de ações ilíquidas, eles dividiram suas ordens ao longo de vários dias para evitar um impacto excessivo nos preços, induzindo assim previsibilidade nos retornos das ações. Fornecemos evidências de que alguns hedge funds exploram essa previsibilidade de retorno. Clique aqui para ver o artigo completo Matthijs Lof, Escola de Negócios da Universidade Aalto Matti Suominen, Escola de Negócios da Universidade Aalto Aquisição e Negociação em Informações Complementares: Como os Fundos de Hedge utilizam a Lei da Liberdade de Informação Food and Drug Administration sobre novas aprovações de produtos, inspeções de fábrica e reclamações. Usamos o recebimento de fundos dessa informação para testar empiricamente implicações de teorias sobre investidores com racionalidade limitada adquirindo informações complexas para fins de negociação. Em consonância com a teoria, encontramos evidências de que a magnitude dos negócios de hedge funds está positivamente relacionada ao conhecimento prévio dos fundos sobre a empresa-alvo eo processo FOIA e aos retornos anormais de ações de curto prazo derivados da negociação. Clique aqui para ler o artigo completo April Klein, Professor de Contabilidade, Escola Stern de Negócios - Universidade de Nova York Tao Li, Universidade de Warwick - Warwick Business School Governança Corporativa e Hedge Fund Activismo Nos últimos 25 anos, ativismo de hedge fund emergiu como nova forma Do mecanismo de governança corporativa que traz reformas operacionais, financeiras e de governança a uma corporação. Muitos executivos de negócios proeminentes e estudiosos do direito estão convencidos de que toda a economia americana sofrerá, a menos que o ativismo dos fundos de hedge com sua agenda de curto prazo percebida seja significativamente restrito. Os ativistas de acionistas e seus proponentes alegam que eles funcionam como um mecanismo disciplinar para monitorar a administração e são instrumentais na mitigação do conflito de agência entre gerentes e acionistas. Eu encontro evidências empíricas estatisticamente significativas para rejeitar a sabedoria convencional anedótica de que o ativismo de fundos hedge é prejudicial aos interesses de longo prazo das empresas e seus acionistas de longo prazo. Além disso, minhas descobertas sugerem que os fundos de hedge geram valor substancial a longo prazo para as empresas-alvo e seus acionistas de longo prazo quando eles funcionam como um advogado de acionistas para monitorar a administração através do engajamento ativo da diretoria para reduzir o custo da agência. Clique aqui para ver o artigo completo Shane C. Goodwin, Professor Adjunto (Finanças e Economia Gerencial), Universidade do Texas Dallas Intermediação Financeira em Private Equity: Como os Fundos de Fundos Realizam Este artigo concentra-se em fundos de fundos (FOFs) como uma forma de Intermediação financeira em private equity (aquisição e capital de risco). Em comparação com os investimentos em fundos de hedge ou ações negociadas publicamente, os investimentos de private equity em fundos diretos são menos líquidos, menos facilmente escaláveis ​​e têm maiores custos de busca e monitoramento. Como conseqüência, as FOFs em private equity podem fornecer intermediação valiosa para investidores que desejam exposição à classe de ativos. Nós comparamos o desempenho do FOF (líquido de suas taxas) em relação aos mercados de ações públicos e às estratégias de investimento direto em fundos de private equity. Examinamos também os tipos de carteiras que os FFs de private equity criam quando agrupam o capital investidor. Após a contabilização das taxas, as FOFs primárias fornecem retornos iguais ou acima dos índices do mercado público para aquisição e capital de risco. Enquanto as FOFs focadas em aquisições superam os mercados públicos, elas superam as estratégias de investimento de fundos diretos na compra. Em contrapartida, o desempenho médio dos FOFs em capital de risco está em pé de igualdade com os resultados do investimento directo em fundos de risco. Isto sugere que as FOFs em capital de risco (mas não em aquisições) são capazes de identificar e aceder a fundos de desempenho superior. Clique aqui para ver o artigo completo Robert S. Harris, Universidade de Virginia Darden Escola de Negócios Tim Jenkinson, Said Business School, Universidade de Oxford e CEPR Steven N. Kaplan, Universidade de Chicago Booth School of Business e NBER Ruediger Stucke, Warburg Pincus The Case Por e Contra os Fundos de Hedge Ativista Um subconjunto dos chamados fundos de hedge, doravante conhecidos como ativistas, se agarrou à idéia de que muitas corporações não são administradas ou governadas de forma a maximizar o valor para os acionistas. Com o capital que obtiveram de fundos de pensão e outros investidores institucionais, eles assumem uma pequena posição no patrimônio de companhias abertas e empurram, com um grau variável de agressividade, por medidas que considerem prováveis ​​impulsionar o preço das ações direcionadas às empresas. Este é um negócio em rápido crescimento. O número de intervenções activistas, cerca de 27 em 2000, atingiu 345 em 2014, de acordo com o WSJ-FactSet Activism Scorecard. Os fundos de hedge ativistas já acumulam cerca de 200 bilhões de ativos gerenciados. Para obter mais alavancagem nas empresas, os fundos de hedge menores podem se integrar no que foi apropriadamente chamado de pacotes de lobos. Em um cenário agora familiar, o fundo de hedge ativista convida a empresa visada a nomear para seu conselho algumas pessoas de sua escolha (ameaçando uma briga por procuração se a empresa não está disponível). Isso é apenas um primeiro passo, às vezes totalmente ignorado. A menos que a empresa ceda prontamente às suas exigências, o fundo de hedge produzirá um documento, ou uma carta longa, crítico da administração da empresa e da diretoria e delineando as ações corretivas que, em sua opinião, beneficiariam os acionistas. Esse documento será difundido amplamente para reunir o apoio dos acionistas institucionais da empresa, mesmo que seja tácito. No momento oportuno, se as questões vierem a uma briga proxy, o fundo de hedge tentará persuadir os conselheiros proxy (ISS e Glass Lewis) para sair em favor dos nominados fundos hedge para o conselho. Eficiência de restrições regulatórias no desempenho do fundo: Novas evidências de fundos de hedge de OICVM Motivamos economicamente e, em seguida, testamos uma série de hipóteses sobre desempenho e diferenças de risco entre Em conformidade com o OICVM e outros hedge funds. Estes últimos apresentam padrões de retorno mais suspeitos do que os OICVs de retorno absoluto (ARU), mas as ARUs apresentam níveis mais elevados de risco operacional. Encontramos evidências de um forte prêmio de liquidez: os fundos de hedge oferecem aos investidores menos liquidez do que as ARUs, mas exibem um melhor desempenho ajustado ao risco. Nossos resultados são substancialmente inalterados sob vários testes de robustez e ajustes para possíveis viés de seleção. O prémio de liquidez das ARUs e a sua falta de persistência no desempenho têm implicações tanto para os investidores como para os decisores políticos. Clique aqui para ver o artigo completo Juha Joenvr, Universidade de Oulu, Laboratório de Gestão de Risco, Imperial College Business School Robert Kosowski, Imperial College Business School, CEPR, Oxford-Man Instituto de Finanças Quantitativas e EDHEC As Consequências Económicas das Relações com Investidores: Oferecem novas evidências sobre o valor econômico da atividade de relações com investidores (IR), usando os resultados de uma pesquisa global de 2012 sobre os funcionários de RI e suas atividades em mais de 800 empresas de 59 países. More active IR programs, as measured by a firms involvement in broker-sponsored conferences, in facilitating one-on-one meetings with institutional investors, through global outreach, and with formal disclosure, media and governance policies, are associated with a statistically significant and economically large 8-12 higher Tobins q valuation. The findings are resilient to concerns about potential reverse-causality as we instrument the level of IR activity with firm-level constraints, or of their peers, on IR personnel, salaries, and budget. The channels through which IR activity increases market value is through greater analyst following, improved analyst forecast accuracy, and a reduced cost of capital. More IR activity is also associated with higher institutional and hedge fund ownership, and more equity issuance. Click here for full article G. Andrew Karolyi, Professor of Finance and Economics and Alumni Professor in Asset Management at the Johnson Graduate School of Management, Cornell University Rose C. Liao, Assistant Professor, Rutgers Business School, Rutgers University Asset Bubbles: Re-thinking Policy for the Age of Asset Management In distilling a vast literature spanning the rational irrational divide, this paper offers reflections on why asset bubbles continue to threaten economic stability despite financial markets becoming more informationally-efficient, more complete, and more heavily influenced by sophisticated (i. e. presumably rational) institutional investors. Candidate explanations for bubble persistencesuch as limits to learning, frictional limits to arbitrage, and behavioral errorsseem unsatisfactory as they are inconsistent with the aforementioned trends impacting global capital markets. In lieu of the short-term nature of the asset ownermanager relationship, and the momentum bias inherent in financial benchmarks, I argue that the business risk of asset managers acts as strong motivation for institutional herding and rational bubble-riding. Two key policy implications follow. First, procyclicality could intensify as institutional assets under management continue to grow. Second, remedial policies should extend beyond the standard suite of macroprudential and monetary measures to include time-invariant policies targeted at the cause (not just symptom) of the problem. Prominent among these should be reforms addressing principal-agent contract design and the implementation of financial benchmarks. Click here for full article Brad Jones, International Monetary Fund Hedge Fund Flows and Performance Streaks: How Investors Weigh Information We examine the relative weights hedge fund investors attach to past information in the fund selection process. The weighting scheme appears inconsistent with econometric forecasting models that predict fund returns, alphas or Sharpe ratios. In particular, investor flows are highly sensitive to performance streaks despite their limited predictive power regarding fund performance. Further, allocations based on forecast models out-of-sample predictions beat investor allocations by a significant margin, which suggests that the latter are suboptimal and reflect overreaction to certain types of information. Our findings do not support the notion that sophisticated investors have superior information or superior information processing abilities. Click here for full article Guillermo Baquero, European School of Management and Technology Marno Verbeek, Rotterdam School of Management, Erasmus University Duration of Poor Performance, Fund Flows and Risk-Shifting by Hedge Fund Managers A typical hedge fund manager receives greater compensation when the fund has a strong absolute or relative performance. Asymmetric performance fees and fund flow-performance relationship may create incentives for risk-shifting, estimated in our study by the change in fund return volatility in the middle of the year. However, hedge funds that cannot attract new funds or have had poor performance for a long period may face different incentives. The combination of these two observations confronts hedge fund managers with a complex strategic decision regarding the optimal level of their funds return volatility. While an increase in return volatility generally increases the expected payoff of the compensation contract, excessive volatility is not sustainable. This paper empirically examines the factors that affect hedge fund managers decisions to risk-shifting. We show that (1) if the fund has had prior poor performance, the magnitude of risk-shifting is larger (2) as the duration of poor performance increases, risk-shifting is reduced (3) if the fund is experiencing capital outflows, the magnitude of risk-shifting is smaller and (4) funds that have outflows and also use leverage or have short redemption notice periods display a smaller degree of risk-shifting. Click here for full article Ying Li, Asst. Professor of Business, Univ. of Washington Bothell A. Steven Holland, Professor of Business, Univ. of Washington Bothell Hossein B. Kazemi, Professor of Finance, Univ. of Massachusetts Amherst Best Ideas of Hedge Funds We provide new compelling evidence that hedge funds possess investment skill. Using the longest-in-literature unbiased sample of hedge funds, we show that large holdings of past winners earn 7 annual benchmark-adjusted return. This remarkable performance is consistent with the notion that large holdings represent managers best ideas. Our sample goes back to 1980 and does not miss non-surviving hedge funds, or those that do not voluntarily report to commercial databases. It consists of all investment managers that must report to the SEC, except those that we identify as managers other than hedge funds. While publicly available data is not sufficient to identify hedge funds directly, our reverse identification method achieves both high sensitivity and specificity. We also find weaker yet significant evidence of investment skill in standard indicators such as average fund performance and performance persistence. Click here for full article Sergey Maslennikovy, Ph. D. student and Parker Hund, undergraduate student both at Department of Finance, McCombs School of Business, University of Texas at Austin Chasing Winners: The Appeal and the Risk For the large majority of hedge fund investors, frequent and repeated manager turnover is neither a practical nor desirable approach to managing a hedge fund portfolio. However, experiments simulating such an approach can be useful in that they can illustrate potential long-term consequences of different selection strategies. In this paper, we present results of one such experiment that offer a strong caution against the practice of chasing winners, or hiring managers that have had the highest returns. The experiment results also suggest that alpha in this case, return not accounted for by beta to the broad equity market, including from manager skill consistently outperforms absolute return as a selection criterion. Amid a prolonged bull market, there may be a natural tendency for hedge fund investors to gravitate toward managers that have captured a significant share of the markets upside however, since such equity upside capture is statistically a relative rarity among hedge fund strategies, such a selection criterion may lead to adverse selection. Click here for full article Kristofer Kwait, Managing Director, Head of Hedge Fund Research and John Delano, Director Commonfund Hedge Fund Strategies Group Do Incentive Fees Signal Skill Evidence from the Hedge Fund Industry We examine whether fee structure acts as a reliable signal of hedge fund performance. Recent theoretical work suggests that, given the unique information asymmetries faced by hedge fund investors, managers will use performance-based incentive fees to signal skill. We test this hypothesis empirically and find little support for the notion that high incentive fee funds generate superior risk-adjusted returns during normal market conditions rather, increases in incentive fee level are accompanied by an increased proclivity to take on risk and increased leverage. Consequently, higher incentive fee funds suffer higher rates of attrition. Higher incentive fee funds do demonstrate lower market correlations and thus provide enhanced diversification benefits. As a result, high fee funds exhibited remarkable outperformance during the recent global financial crisis. Click here for full article Paul Lajbcygier, Department of Banking Finance, Monash University Joe Rich, Department of Accounting and Finance, Monash University Why Complementarity Matters for Stability 8212 Hong Kong SAR and Singapore as Asian Financial Centers There is much speculation regarding a race for dominance among financial centers in Asia, arising from the anticipated financial opening up of China. This frame of reference is, to an extent, a predilection that results from a traditional understanding of financial centers as possessing historical, geographic, and scale economy advantages. This paper, however, suggests that there is an alternative prism through which the evolution of financial centers in Asia needs to be viewed. It underscores the importance of complementarity rather than dominance to better serve regional and global financial stability. We posit that such complementarity is vital, through network analysis of the roles of Hong Kong SAR and Singapore as the current leading financial centers in the region. This analysis suggests that a competition for dominance can result in de-stabilizing levels of interconnectivity that render the global network as a whole more susceptible to rapid propagation of shocks. We then examine the regulatory and policy challenges that may be encountered in furthering such complementary coexistence. Click here for full article Minsuk Kim, Vanessa Le Lesl, Franziska Ohnsorge, and Srikant Seshadri International Monetary Fund (IMF) Do Alternative UCITS Deliver What They Promise A comparison of alternative UCITS and hedge funds We study the performance of alternative UCITS funds and account for potential survivorship biases in our sample in the best possible manner. Alternative UCITS funds offer similar raw returns but a lower volatility compared to offshore hedge funds. Single-index models show that alternative UCITS funds provide only marginal exposure to variations in hedge fund returns. Multifactor models indicate that the most important risk factors for both alternative UCITS funds and their matched hedge funds strategies are related to stock market risks, but alternative UCITS funds exhibit a lower exposure to these factors than hedge funds. Moreover, we find factor loadings on different risk factors, suggesting that alternative UCITS and hedge funds pursue different strategies. Finally, we assess the degree of the value added for an investor in terms of enhanced diversification benefits by implementing a spanning test and find that both groups are different asset classes with time-varying diversification properties. Click here for full article Michael Busack, Absolut Research GmbH Wolfgang Drobetz, School of Business, University of Hamburg Jan Tille, Absolut Research GmbH Evaluating and Predicting the Failure Probabilities of Hedge Funds Hedge funds have the most sophisticated risk management practices however, hedge funds also appear to have a short lifetime relative to other managed funds. In this study, we investigate the failure probabilities of hedge fundsparticularly the failures due to financial distress. We forecast the failure probabilities of hedge funds using both a proportional hazard model and a logistic model. By utilizing a signal detection model and a relative operating characteristic curve as the prediction accuracy metrics, we found that both of the models have predictive power in the out-of-sample test. The proportional hazard model, in particular, has stronger predictive power, on average. Click here for full article Hee Soo Lee, School of Business, Yonsei University Juan Yao, The University of Sydney Business School, The University of Sydney Sentiment and the Effectiveness of Technical Analysis: Evidence from the Hedge Fund Industry This paper presents a unique test of the effectiveness of technical analysis in different sentiment environments by focusing on its usage by the most sophisticated and astute investors, hedge fund managers. We document that during high-sentiment periods, hedge funds using technical analysis exhibit higher returns, lower risk, and superior market-timing ability than those non-users. The advantages for hedge funds of using technical analysis disappear in low-sentiment periods. These findings are consistent with the view that technical analysis performs relatively better in high-sentiment periods with larger mispricing, which cannot be fully exploited by arbitrage activities due to short-sale impediments. Click here for full article David M. Smith, State University of New York at Albany Na Wang, Hofstra University Ying Wang, State University of New York at Albany Edward J. Zychowicz, Hofstra University Hedge Fund Holdings and Stock Market Efficiency We examine the relation between changes in hedge fund stock holdings and measures of informational efficiency of equity prices derived from transactions data, and find that, on average, increased hedge fund ownership leads to significant improvements in the informational efficiency of equity prices. The contribution of hedge funds to price efficiency is greater than the contributions of other types of institutional investors, such as mutual funds or banks. However, stocks held by hedge funds experienced extreme declines in price efficiency during liquidity crises, most notably in the last quarter of 2008, and the declines were most severe in stocks held by hedge funds connected to Lehman Brothers and hedge funds using leverage. Click here for full article Charles Cao, Smeal College of Business, Penn State University Bing Liang, Isenberg School of Management, University of Massachusetts Andrew W. Lo, MIT Sloan School of Management Lubomir Petrasek, Board of Governors of the Federal Reserve System CTAs 8211 Which trend is your friend The occurrence of trends within financial markets is inconsistent with the assumptions of classical financial theory. Nevertheless, it can be empirically validated that market prices can be subject to trends. But - which trends should you measure Which trend is your friend Click here for full article Fabian Dori, Manuel Krieger, and Urs Schubiger 1741 Asset Management Ltd. In Search of Missing Risk Factors: Hedge Fund Return Replication with ETFs Properly considering all potential risk factors through tradable liquid portfolios in the context of a risk based factor model is paramount to quantifying the benefits of investing in hedge funds. We attempt to span the space of potential risk factors with exchange traded funds (ETFs). We develop a methodology of hedge fund return replication with ETFs based on cluster analysis and LASSO factor selection that overcomes multicollinearity among ETFs and the data mining bias. We find that the overall out-of-sample accuracy of hedge fund replication with ETFs increases with the number of ETFs available. This is consistent with our interpretation of ETF returns as proxies to a multitude of alternative risk factors that could be driving hedge fund returns. We further consider portfolios of cloneable and non-cloneable hedge funds, defined as top and bottom in-sample R2 matches. We find superior risk-adjusted performance for non-cloneable funds, while cloneable funds fail to deliver significantly positive risk-adjusted performance. We conclude that our methodology provides value in both identifying skilled managers of non-cloneable hedge funds, and also successfully replicating out-of-sample returns that are due to alternative risk exposures of cloneable hedge funds, thus providing a transparent and liquid alternative to investors who may find these return patterns attractive. Click here for full article Jun Duanmu, Yongjia Li, and Alexey Malakhov Sam M. Walton College of Business, University of Arkansas The Effect of Investment Constraints on Hedge Fund Investor Returns The aim of this paper is to examine the effect of frictions and real-world investment constraints on the returns that investors can earn from investing in hedge funds. We contribute to the existing literature by accounting for share restrictions, minimum diversification requirements and fund size restrictions that are commonly used by institutional investors. We show that the size-performance relationship is positive (negative) when past (future) performance is used. Evidence of performance persistence is reduced significantly when fund size and share restrictions such as notice, redemption and lockup period are incorporated into rebalancing rules. We test several hypotheses regarding the economic mechanism that underlies the size-performance relationship. We find empirical support for theoretical models based on decreasing returns to scale as well as managers responding optimally to fee incentives. The findings have significant implications for hedge fund investors since they caution against chasing performance in hedge funds and within the billion dollar club of hedge funds, in particular. Click here for full article Juha Joenvr, University of Oulu and Imperial College Business School Robert Kosowski, Imperial College Business School and Oxford-Man Institute of Quantitative Finance Pekka Tolonen, University of Oulu Equity Hedge Fund Performance, Cross8211Sectional Return Dispersion, and Active Share This study examines several aspects of active portfolio management by equity hedge funds between 1996-2013. Consistent with the idea that cross-sectional return dispersion is a proxy for the markets available alpha, our results show that equity hedge funds achieve their strongest performance during periods of elevated dispersion. The performance advantage is robust to numerous risk adjustments. Portfolio managers may use the current months dispersion to plan the extent to which the following months investment approach will be active or passive. We also estimate the active share for equity hedge funds and find an average of 53. We further document the average annual expense ratio for managing hedge funds active share to be about 7. This figure is remarkably close to active expense ratios reported previously for equity mutual funds, which may be interpreted as evidence of uniform pricing for active portfolio management services. Click here for full article David M. Smith, Department of Finance and Center for Institutional Investment Management, University at Albany Crystallization 8211 the Hidden Dimension of Hedge Funds Fee Structure We investigate the implications of variations in the frequency with which hedge funds update their high-water mark on fees paid by hedge fund investors. Using data on Commodity Trading Advisors (CTAs), we perform simulations to analyse the effect. We find a statistically and economically significant effect of the crystallization frequency on total fee load. Funds total fee load increases significantly as the crystallization frequency increases. As such, our findings indicate that the total fee load depends not only on the management fee and incentive fee, but also on the crystallization frequency set by the manager. Click here for full article Gert Elaut, Ghent University, Belgium Michael Frmmel, Ghent University, Belgium John Sjdin, Ghent University, Belgium, and RPM Risk Portfolio Management AB, Sweden Governance Under the Gun: Spillover Effects of Hedge Fund Activism This paper empirically studies the spillover effects of hedge fund activism. Activism threat, defined as a heightened rate of recent activism in an industry, predicts a higher probability that a firm in that industry will be targeted. Using institutional trading in stocks outside of the industry as an instrument, we identify the effects of activism threat from those of product market competition and time-varying industry structure. The threat of being targeted has a disciplining effect on peer firms, which respond by reducing agency costs and improving performance along the same dimensions as actual targets. These changes lead to substantial positive abnormal returns and lower the ex-post probability of becoming a target, suggesting the presence of a partial feedback effect. Overall, our results provide new evidence that shareholder activism, as a monitoring mechanism, reaches beyond the firms being targeted. Click here for full article Nickolay Gantchev, Finance Area, Univ. of North Carolina at Chapel Hill Oleg Gredil, Kenan-Flagler Business School, Univ. of North Carolina at Chapel Hill Chotibhak Jotikasthira, Kenan-Flagler Business School, Univ. of North Carolina at Chapel Hill Evaluating Absolute Return Managers One traditional measure of investment performance, the Information Ratio (IR), is defined as the active return (alpha) divided by the tracking error (the standard deviation of the active return). Calculating an IR is straightforward when the benchmark for performance is a buy-and-hold standard like the SP 500. For absolute return managers, however, the typical benchmark we observe is zero meaning that any excess return is classified as alpha and deemed to represent the return from active management or skill. In this paper, we argue that this standard approach confuses beta returns and alpha returns. The former can be earned by following generic strategies that can be easily implemented and are often replicated by ETFs while the later are associated with more original or complex strategies that more genuinely reflect unique skills or expertise. We propose a new performance metric that strips out beta returns associated with investment style factors. This approach leads to a new statistic, the alpha ratio, which can dramatically impact the relative performance rankings of managers and provide a clearer signal of manager skill. Click here for full article Momtchil Pojarliev, Hathersage Capital Management LLC Richard M. Levich, New York University Stern School of Business, Finance Department CTAs: Shedding light on the black box In their paper they explore a number of the features they consider important when assessing Commodity Trading Advisors (CTAs), from the perspective of an investor in the asset class as well as issues of a more technical nature which will inform further those considering making an allocation to the sector. Throughout the paper they have tried to visit topics which are pertinent to this quest, and in so doing, limit re-visiting themes which are already much discussed instead illustrating our assertions (where possible and appropriate) with technical data and examples of the techniques we have developed for finding, managing and monitoring managers in the space. We have covered a lot of ground: indeed this was the aim of their first paper on the sector and there exist many areas which may be the subject of dedicated papers in the future. Finally, they examine some traditionally held assertions with regards to CTAs and in turn assert that some hold true under analysis while others are likely not fully informed. Click here for full article Tommaso Sanzin, Partner, Risk Manager, Head of Quantitative Research Hermes BPK Partners Larry Kissko, Head of CTA, Macro RV Strategies Hermes BPK Partners How Do Hedge Fund 8216Stars8217 Create Value Evidence from Their Daily Trades I use transaction-level data to investigate the magnitude and source of hedge funds equity trading profits. Bootstrap simulations indicate that the trading profits of the top 10 of hedge funds cannot be explained by luck. Similarly, superior performance persists. Outperforming hedge funds tend to be short-term contrarians with small price impacts, and their profits are concentrated over short holding periods and in their more contrarian trades. Further, I find that performance persistence is significantly stronger for contrarian funds with small price impacts. My findings suggest that liquidity provision is an important channel through which outperforming hedge funds persistently create value. Click here for full article Russell Jame, Gatton College of Business and Economics, University of Kentucky Did Long-Short Investors Destabilize Commodity Markets This paper contributes to the debate on the effects of the financialization of commodity futures markets by studying the conditional volatility of long-short commodity portfolios and their conditional correlation with traditional assets (stocks and bonds). Using several groups of trading strategies that hedge fund managers are known to implement, we show that long-short speculators do not cause changes in the volatilities of the portfolios they hold or changes in the conditional correlations between these portfolios and traditional assets. Thus calls for increased regulation of commodity money managers might at this stage be premature. Click here for full article Jolle Miffre, PhD, Professor of Finance, EDHEC Business School Chris Brooks, Professor of Finance and Director of Research, ICMA Centre, Reading Quantitative Trend Following Strategies and Equity Risk: From Diversifier to Hedge The goal of this paper is to analyze the equity risk hedging capabilities of CTA Trend Following (TF) strategies and to evaluate enhancements that would stabilize their hedging characteristics to equities. With real yields on US treasuries below zero, institutions are pushing the envelope to find new sources of return, Alpha and risk. More complex, but less liquid and less transparent, new investment conduits such as hedge funds have hidden the usually apparent equity market risk, as measured by volatility, by converting it in the form of tail risk and negative skew. Fixed Income has been extremely stable in the past 30 years and not many worry or care to hedge exposure to it yet. Equities, on the other side, have had some large cycles and drawdowns, which include some over 50. Although it is now in the form of tail risk, rather than old fashioned volatility, most investors would still like to hedge the residual equity risk that is now the core risk in almost every portfolio including hedge funds and fund of hedge funds. The DJCS HFI Dedicated Short Bias (Short Biased Index) has been extremely costly with a negative true Alpha of around -5.5 a year to the SP500. Timing the overall equity market on a discretionary or fundamental basis has not worked for most. Put option buying is extremely costly despite the low implied volatility of the equity markets and it only rewards sporadically due to the negative skew of equities. A profitable or at least cheaper hedge would be most welcome and there still seems to be some hope that TF can effectively hold this responsibility. We will offer some enhancements that will make the correlation of TF to equities significantly negative in order to stabilize this relationship. Despite strong performance during equity drawdowns, TF has been used (and sized) only as a diversifier in portfolios, not as a hedge. This could be due to: 1) A lack of model transparency and understanding, 2) High volatility that sometimes correlates to equities, and 3) Neutral rather than negative long term correlation to equities. In this paper, we will: 1) Analyze the ability of TF to improve a hedge fund portfolios risk adjusted returns and drawdowns, 2) Explore the increase in correlation of TF managers to equities and the reduction in their equity hedging characteristics over time, 3) Specifically analyze the impact of Fixed Income in TF portfolios and its role in TF hedging of equities, 4) Estimate the ability of TF ex-Fixed Income to hedge equity drawdowns across trading time frames and trading styles, 5) Explore the use of TF as a timing filter for equity indices, and 6) Enhance a diversified TF portfolio with covariance filtering to stabilize its ability to hedge equity risk. Click here for full article Nigol Koulajian, Quest Partners LLC Paul Czkwianianc, Quest Partners LLC Do Hedge Funds Provide Liquidity Evidence from Their Trades The paper provides significant evidence of limits of arbitrage in the hedge fund sector. Using unique data on institutional transactions, we show that the price impact of hedge fund trades increases when aggregate conditions deteriorate. The peak in trading impatience is reached during the financial crisis. The finding is consistent with arbitrageurs withdrawal from liquidity provision following a tightening in funding liquidity. Compared to other institutions in our data, hedge funds display the largest sensitivity of trading costs to aggregate conditions. We pin down this effect to a subset of hedge funds whose leverage, lack of share restrictions, asset illiquidity, and low reputational capital make them particularly exposed to funding constraints. These characteristics appear to negatively impact hedge funds trading performance when times get worse. Click here for full article Francesco Franzoni, Professor of Finance, University of Lugano Institute of Finance Alberto Plazzi, Assistant Professor, University of Lugano - Institute of Finance The Returns to Carry and Momentum Strategies We find that global time series carry strategies (across bonds, commodities, currencies, equities and metals) can be explained by a set of lagged macroeconomic variables. The payoffs to carry strategies disappear once futures returns are adjusted for their predictability based on these macroeconomic variables. On the other hand, momentum strategies are only weakly affected by lagged macroeconomic variables but are significantly related to measures of hedge fund capital flow. When studying these two findings together and over time we find that while momentum strategies were highly co-moving with carry strategies and therefore business cycle predictors between 1994 and 2002, when Hedge Fund AUM was low, correlation has since decreased. The decrease in correlation has coincided with significant increases in hedge fund AUM, and limits to arbitrage have become more relevant in explaining momentum returns. We embed these findings within a broad empirical investigation of time series carry and momentum strategies across 55 futures contracts spanning the asset classes bonds, currencies, commodities, equities and metals. Our results provide a possible avenue for identification strategies to disentangle the role of limited arbitrage effects on futures returns and systematic risks that are associated with time-varying expected returns in explaining momentum returns. Click here for full article Jan Danilo Ahmerkamp, Imperial College Business School James Grant, Imperial College Business School Crises, Liquidity Shocks, and Fire Sales at Hedge Funds We investigate hedge fund stock trading from 1998-2010 to test for fire sales. While funds with high capital outflows sell large amounts of stock during crises, these funds also buy stock, rather than using all the proceeds to fulfill redemptions. Further, funds with large outflows rarely sell the same stocks at the same time. For the relatively few stocks that are sold en masse, there is no evidence of price pressure, largely because hedge funds overwhelmingly choose to sell their most liquid, largest, and best-performing stocks. We provide new and compelling evidence that hedge funds neither engage in nor induce fire sales, since their well-diversified portfolios allow them to cherry-pick the most appropriate stocks to sell during crises. Click here for full article Nicole Boyson, Northeastern University Jean Helwege, University of South Carolina Jan Jindra, Ohio State University Drawdown-Based Stop-Outs and the Triple Penance Rule We develop a framework for informing the decision of stopping a portfolio manager or investment strategy once it has reached the drawdown or time under water limit associated with a certain confidence level. Under standard portfolio theory assumptions, we show that it takes three times longer to recover from the maximum drawdown than the time it took to produce it, with the same confidence level (triple penance rule). We provide a theoretical justification to why hedge funds typically set less strict stop-out rules to portfolio managers with higher Sharpe ratios, despite the fact that they should be expected to deliver superior performance. We generalize this framework to the case of first-order serially-correlated investment outcomes, and conclude that ignoring the effect of serial correlation leads to a gross underestimation of the downside potential of hedge fund strategies, by as much as 70. We also estimate that some hedge funds may be firing more than three times the number of skillful portfolio managers, compared to the number that they were willing to accept, as a result of evaluating their performance through traditional metrics, such as the Sharpe ratio. We believe that our closed-formula compact expression for the estimation of drawdown potential, without having to assume IID cashflows, will open new practical applications in risk management, portfolio optimization and capital allocation. The Python code included confirms the accuracy of our solution. Click here for full article David H. Bailey, Complex Systems Group Leader, Lawrence Berkeley National Laboratory Marcos Lpez de Prado, Head of Global Quantitative Research, Tudor Investment Corporation and Research Affiliate, Lawrence Berkeley National Laboratory The Value of Funds of Hedge Funds: Evidence from their Holdings We examine the value of Funds-of-Hedge-Funds (FoFs) using a hand-collected database of the funds hedge fund holdings. This holdings level data allows us to examine the determinants of hedge fund selection by FoFs, as well the ability to gauge the FoFs skill at hiring and firing managers. We find that FoFs hire hedge funds that are more difficult for individual investors to access, all else equal. FoFs hire larger, younger hedge funds with more restrictive share liquidity and higher minimum investments. Contrary to the previous literature, we do not find that FoFs perform worse than their single manager peers. Rather, we find evidence that a primary source of FoF value comes via skillful monitoring of their underlying hedge fund investments after the hire date. Specifically, we find that hedge funds that are held by FoFs are less likely to fail. The hazard rate for hedge funds held by FoFs is 57 lower than comparable hedge funds. Further, funds fired by FoFs are more likely to underperform and subsequently fail more often indicating FoFs have skill in their firing decisions. Click here for full article Adam L. Aiken, Quinnipiac University Christopher P. Clifford, University of Kentucky Jesse Ellis, University of Alabama Trading Losses: A Little Perspective on a Large Problem Big losses by traders are back in the news. In September the trial of former Union Bank of Switzerland (UBS) derivatives trader Kweku Adoboli opened in London with jury selection. Adoboli stands accused of four counts of fraud and false accounting in connection with losses of 2.3 billion on apparently unauthorized equity derivatives trades in 2011. The trial comes not long after JPMorgan Chases credit derivatives tradersincluding Bruno Iksil, known as the London Whale due to the size of his positions lost an estimated 7.5 billion (5.8 billion in realized losses in addition to 1.7 billion yet to come) on apparently authorized credit default swap trades. Since 1990, there have been 15 instances when traders lost at least 1 billion (in 2011 dollars). Trading losses of this size are uncommon but matter when they occur. Shareholders suffer losses, counterparties are exposed to potential settlement failure in over-the-counter markets, bank regulators face the prospect of individual bank insolvencies or even systemic problems in the financial markets, and the public is always on the hook when a bailout is deemed necessary. Click here for full article James R. Barth, Senior Finance Fellow, Milken Institute Donald McCarthy, Consultant, Econ One Research Exploring Uncharted Territories of the Hedge Fund Industry: Empirical Characteristics of Mega Hedge Fund Firms This paper investigates mega hedge fund management companies that manage over 50 of the industrys assets, incorporating previously unavailable data from those that do not report to commercial databases. We document similarities among mega firms that report performance to commercial databases compared to those that do not. We show that the largest divergences between the performance reporting and non-reporting can be traced to differential exposure to credit markets. Thus the performance of hard-to-observe mega firms can be inferred from observable data. This conclusion is robust to delisting bias and the presence of serially correlated returns. Click here for full article Daniel Edelman, Head of Quantitative RD, Alternative Investment Solutions William Fung, Visiting Research Professor, London Business School David A. Hsieh, Professor, Fuqua School of Business, Duke University Revisiting Kats Managed Futures and Hedge Funds: A Match Made in Heaven In November 2002, Cass Business School Professor Harry M. Kat, Ph. D. began to circulate a Working Paper entitled Managed Futures and Hedge Funds: A Match Made In Heaven. The Journal of Investment Management subsequently published the paper in the First Quarter of 2004. In the paper, Kat noted that while adding hedge fund exposure to traditional portfolios of stocks and bonds increased returns and reduced volatility, it also produced an undesired side effect - increased tail risk (lower skew and higher kurtosis). He went on to analyze the effects of adding managed futures to the traditional portfolios, and then of combining hedge funds and managed futures, and finally the effect of adding both hedge funds and managed futures to the traditional portfolios. He found that managed futures were better diversifiers than hedge funds that they reduced the portfolios volatility to a greater degree and more quickly than did hedge funds, and without the undesirable side effects. He concluded that the most desirable results were obtained by combining both managed futures and hedge funds with the traditional portfolios. Kats original period of study was June 1994-May 2001. In this paper, we revisit and update Kats original work. Using similar data for the period June 2001-December 2011, we find that his observations continue to hold true more than 10 years later. During the subsequent 10.5 years, a highly volatile period that included separate stock market drawdowns of 36 and 56, managed futures have continued to provide more effective and more valuable diversification for portfolios of stocks and bonds than have hedge funds. Click here for full article Thomas N. Rollinger, Director of New Strategies Development, Sunrise Capital Partners Segmenting Supply Chain Risk Using ECTRM Systems: Unifying Theory of Commodity Hedging and Arbitrage The complexity of managing physical and financial risk throughout the commodity production, processing and merchandising chain presents numerous challenges. To solve this problem commercials are increasingly turning to Energy and Commodity Transaction Risk Management (ECTRM) systems. Still, risk management functionality within these systems is reported as falling short of requirements. Our discussion, in response, provides an economic framework for developing commodity risk policy and evaluation tools. In doing so, we unify the theory of normal backwardation with theory of storage, macroeconomic general equilibrium with multiple equilibria and microeconomic agents, basis trading with arbitrage strategies, and the hedging response function with elasticinelastic supply-demand economics. After establishing axioms and rules of inference, we investigate the agribusiness supply chain to help illustrate application. Click here for full article Michael Frankfurter, Partner, IQ3 Solutions Group Send in the Clones Hedge Fund Replication Using Futures Contracts Replication products strive to offer investors some of the benefits of hedge funds while avoiding their high fees, illiquidity, and opacity. We test whether a replication algorithm can deliver the diversification and high Sharpe ratio that investors seek. Our procedure constructs monthly clone returns out-of-sample using fully collateralized futures positions held for one-month, with position sizes determined using rolling window regressions. Clone returns have high correlation with their hedge fund targets, indicating replication is possible. Clones also have high correlation with a buy-and-hold investment in stocks, however, and neither the targets nor their clones demonstrate successful time variation in factor loadings. Click here for full article Nicolas P. B. Bollen, Owen Graduate School of Management - Vanderbilt University Gregg S. Fisher, President and Chief Investment Officer, Gerstein Fisher The Life Cycle of Hedge Funds: Fund Flows, Size, Competition, and Performance This paper analyzes the life cycles of hedge funds. Using the Lipper TASS database it provides category and fund specific factors that affect the survival probability of hedge funds. The findings show that in general, investors chasing individual fund performance, thus increasing fund flows, decrease probabilities of hedge funds liquidating. However, if investors chase a category of hedge funds that has performed well (favorably positioned), then the probability of hedge funds liquidating in this category increases. We interpret this finding as a result of competition among hedge funds in a category. As competition increases, marginal funds are more likely to be liquidated than funds that deliver superior risk-adjusted returns. We also find that there is a concave relationship between performance and lagged assets under management. The implication of this study is that an optimal asset size can be obtained by balancing out the effects of past returns, fund flows, competition, market impact, and favorable category positioning that are modeled in the paper. Hedge funds in capacity constrained and illiquid categories are subject to high market impact, have limited investment opportunities, and are likely to exhibit an optimal size behavior. Click here for full article Mila Getmansky, Ph. D. Assistant Professor, Isenberg School of Management, University of Massachusetts Managed Futures and Volatility: Decoupling a Convex Relationship with Volatility Cycles 2011 was a period fraught with turbulence in financial markets. Managed Futures strategies, despite their common association with long volatility, did not fare as well as some might have expected amidst this turbulence. A closer look at volatility, what it means to be long or short volatility, and Managed Futures performance across different regimes in volatility can provide insights into the strategys complex or convex relationship with volatility. A closer look at the cycles of volatility demonstrates that Managed Futures is able to capture crisis alpha for investors over negative volatility cycles, while in certain turbulent periods they also face some of the same short volatility risks that plague many hedge fund strategies. Click here for full article Kathryn M. Kaminski, PhD. CIO and Founder, Alpha K Capital LLC Lessons from the MF Global Collapse In her paper, Ms. Till presents an organized series of events leading up to the downfall of MF Global and subsequently the eighth largest filing of bankruptcy in U. S. history. Click here for full article Hilary Till, Principal, Premia Risk Consultancy Contrarian Hedge Funds and Momentum Mutual Funds We study how hedge fund performance is related to the presence of mutual funds operating in the same asset class. We argue that hedge funds are able to exploit the constraints of the mutual funds related to both the high correlation between flows and value of investment and their tendency to cater to investors by invest in stocks that are hot. Hedge funds exploit these features of the mutual funds, especially the domestic ones. We show that the performance of the hedge funds is significantly higher when mutual fund market coverage is higher. This effect is mostly concentrated among domestic mutual funds and is stronger the higher investment horizon of the hedge funds. A high presence of the mutual fund industry helps to explain 28 of the yearly hedge fund performance. Hedge funds are more likely to be alpha in the presence of a high degree of mutual fund market coverage and their probability of survival is higher. Hedge funds employ contrarian strategies at the very moment in which mutual funds ride market expectations. The degree by which hedge funds react to changes in public information is directly related to the degree of mutual fund market coverage. Click here for full article Massimo Massa, Rothschild Chaired Professor of Banking, Professor of Finance at INSEAD Andrei Simonov, Associate Professor Finance, Eli Broad Graduate School of Mgmt. MSU and CEPR and Shan Yan, Eli Broad Graduate School of Mgmt. MSU Revisiting Stylized Facts About Hedge Funds - Insights from a Novel Aggregation of the Main Hedge Fund Databases This paper presents new stylized facts about hedge fund performance and data biases based on a novel database aggregation. Our aim is to improve the ability of researchers in this literature to compare results across different studies by highlighting differences between databases and their effect on previously documented results. Using a comprehensive hedge fund database, we document economically important positive risk-adjusted performance of the average fund while differences in magnitude are due to differences in fund size and data biases, but not differences in fund risk exposures. However, this performance does not persist in any of databases when using value-weighted returns a finding which we show to be linked to fund size and more pronounced biases in certain databases. Hedge funds with greater managerial incentives, smaller funds and younger funds outperform while hedge funds with strict share restrictions are not associated with higher risk-adjusted returns. Overall we find that several stylized facts are sensitive to the choice of the database. To avoid biases, it is therefore important to use a high quality consolidated database such as the one used in this paper. Click here for full article Juha Joenvr, University of Oulu, Robert Kosowski, Imperial College Business School, Imperial College, and Pekka Tolonen, University of Oulu and GSF Regulated Alternative Funds: The New Conventional In what is beginning to seem like the distant past, a clear line had once separated traditional and alternative investment products. But as investors faced multiple market crises and rising volatility, fund managers responded with a range of innovative products designed to better manage volatility and offer alternatives to long-only investing in traditional markets. As investor segments and products converge, alternative strategies are increasingly being packaged within registered fund structures originally designed for retail buyers, but also used by institutions and other fund selectors. A growing number of alternative funds are being launched as UCITS (Undertaking for Collective Investment in Transferable Securities), a fund vehicle accepted for sale in countries throughout the European Union and many other nations. Alternatives also are becoming more prominent within U. S. mutual funds (registered under the Investment Company Act of 1940 or, in some cases, under the Securities Act of 1933). The growing popularity of these funds is clearly evident in strong asset flows, product proliferation, and a growing presence in Asian markets. One factor driving the popularity of alternative UCITS and mutual funds is the detailed requirements around risk measurement and management, liquidity, counterparty diversification, and limits on leverage. However, the increased use of derivatives and their associated counterparty and operational risks continue to concern investors and regulators alike. The regulatory environment remains in flux as new rules on hedge funds take shape in Europe, and as the framework around UCITS gets reviewed amidst the expansion of more complex products. Yet this too is encouraging further innovation. Meanwhile, new frontiers are emerging. Europe and the U. S. have led the way in the adoption of alternative strategies, but other markets are developing a taste for non-correlated funds. One of the biggest retail fund launches in Japan this year was an alternative managed futures strategy. Demand for alternatives is growing among sovereign wealth funds and national pension funds in Asia, Latin America and the Middle East. Wealthy individual investors around the world are also expected to consider alternatives more seriously after their recent experiences with traditional asset classes. Although U. S. institutions and high net worth individuals (HNWIs) can access hedge funds and alternatives directly, they may see the benefits of sourcing such strategies through regulated structures, just as their European counterparts have done. Click here for full article contributed by SEI Global Services, Inc. - Investment Manager Services division Investor Behavior, Hedge Fund Returns and Strategies We quantify risks associated with investor behavior using several asset pricing models and hedge fund data. After finding that irrational sentiments play a role in hedge fund returns, our multi-beta CAPM estimations reveal that beta belonging to irrational component varies around .037 for risky hedge funds and .018 for relatively less risky ones. Investors can use this irrational beta to gauge the extent of irrational sentiments prevailing in markets and compare the values in turbulent periods with more tranquil periods to re-adjust their portfolios and use these betas as an early warning sign. It can also guide investors in avoiding those funds that display greater irrational behavior. Our approach offers investors a solid quantitative rather than subjective approach in assessing the oncoming of a financial downturn and in doing so better protect against unpredicted losses that may result from irrational trading. Click here for full article Andres Bello, University of Texas-Pan American, Gke Soydemir, California State University Stanislaus, and Jan Smolarski, University of Texas-Pan American A Review of the G20 Meeting on Agriculture: Addressing Price Volatility in the Food Markets Food price volatility has spiked to levels last seen in the 1970s. For low-income countries, food price hikes, such as have occurred recently, tend to significantly increase the incidence of intra-state conflicts, according to IMF research. Therefore, it was fitting and proper that the G20 meeting of agricultural ministers, which was hosted by France at the end of June, put food insecurity squarely at the top of the 2011 G20 agenda. The June G20 agricultural meeting resulted in an action plan that will be carried forward at the Cannes Summit of G20 leaders in November. The 2007-2008 food crisis, and the resumption of more recent food price spikes, clearly have a number of causes, which will require a great deal of political courage to address and ameliorate. That said, in reviewing over a century of commodity price volatility, there are episodes of low volatility and high volatility, which would indicate that this may be a pattern of recurrent phenomena. As a result, it may be wise to focus on how to manage price volatility rather than believe that this phenomenon can be eradicated, as noted by Dr. Pierre Jacquet of the Agence Franaise de Dveloppement. The World Bank, for example, has launched a program that will assist and encourage companies in developing countries to buy insurance in the derivative markets against sudden changes in food prices, according to the Financial Times. Notably, the action plan, agreed to by the G20 agricultural ministers in June, largely embraces marketbased solutions to the problems of food insecurity and food volatility, amongst its many action items. In contrast to the benign view of commodity derivatives trading, French president Nicolas Sarkozy stated at the opening of the June G20 agricultural meeting that the financialization of agriculture markets. is a contributory factor in price volatility and that this was a priority issue for regulators to address. Ultimately, whether commodity derivatives trading (and speculation) increases price volatility is an empirical question. Assuming that one has access to transparent marketparticipant, position, and price data, one can carry out empirical studies to confirm or challenge this assumption. In reviewing the evidence so far regarding the impact of commodity trading, speculation, and index investment on price volatility, this report finds that the evidence for the prosecution does not seem sufficiently compelling at this point. That said, given the disastrous performance of financial institutions in 2007 and especially, in 2008, it is fully appropriate to revisit ones assumptions regarding the economic usefulness of all manner of financial instruments, including commodity derivatives contracts. This papers conclusion is to agree with the World Bank president who has said, the answer to food price volatility is not to prosecute or block markets, but to use them better. And one sensible use of financial engineering is for hedging volatile food price risk with appropriate commodity derivatives contracts. Click here for full article Hilary Till, Research Associate, EDHEC-Risk Institute, Principal, Premia Capital Management, LLC Beware of Stranger Originated Life Insurance This issue summarizes two recent Delaware court decisions determining the validity of life insurance policies under a stranger originated life insurance program. These decisions are relevant to hedge funds and other investors that purchase life insurance policies for investment purposes. Click here for full article Christopher Machera, Hedge Funds Returns Hedge Fund Performance and Liquidity Risk This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important predictor of hedge fund performance. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6.5 annually, on average, over the period 1994-2009, while negative performance is observed during liquidity crises. The returns are independent of share restriction, pointing to a possible imbalance between the liquidity a fund offers its investors and the liquidity of its underlying positions. Liquidity risk seems to account for a substantial part of hedge fund performance. The results suggest several practical implications for risk management and manager selection. Click here for full article Ronnie Sadka, Boston College, Carroll School of Management The Importance of Business Process Maturity and Automation in Running a Hedge Fund: Know Your Score and Get to the 8220Sweet Spot8221 Over the past two years, Merlin has published several white papers that are designed to highlight and help managers implement industry best practices - from shoring up their business model to identifying their target investors based on the development stage of their fund. In continuing with this theme, our latest white paper discusses the importance of business process automation within an asset management firm at all stages of development and how these organizations can measure their current processes versus investor expectations. It is critical that business process maturity and automation evolve over the life of a fund in a disciplined and forward-looking manner as they are key components to maintaining a scalable business. As a firm grows, processes that are maintained manually or with home-grown spreadsheets will stress and may break, adding business risk and overhead to a firms operations. This concept is especially important for fund managers because they cannot afford distractions and errors caused by broken or manual processes that affect the viability of the fund. Click here for full article This paper proposes a new methodology to evaluate the prevalence of skilled fund managers. We as-sume that each funds alpha is drawn from one of several distributions based on its skill level (e. g. good, neutral, or bad). For a sample of funds, the composite distribution of alpha is thus a mixture of the underlying distributions. We use the Expectation-Maximization algorithm to infer the proportion of funds of different skill levels and estimate the conditional probability each fund is of a skill type given estimated alpha. Applying our approach to hedge funds over 1994-2009, we find that about 50 of funds have positive skill. Funds identified by our approach as superior persistently deliver high out-of-sample alpha over the next three years. While investors chase past performance, inflows do not reduce fund performance in the near future. Click here for full article Yong Chen, Assistant Professor of Finance, Virginia Tech Michael Cliff, Vice President, Analysis Group Haibei Zhao, PhD student, Georgia State University Diversification in Funds of Hedge Funds: Is It Possible to Overdiversify Many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FoHFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance-reducing effects of diversification diminish once FoHFs hold more than 20 underlying hedge funds. This excess diversification actually increases their left-tail risk exposure once we account for return smoothing. Furthermore, the average FoHF in our sample is more exposed to left-tail risk than are nave 1N randomly chosen portfolios. This increase in tail risk is accompanied by lower returns, which we attribute to the cost of necessary due diligence that increases with the number of hedge funds. Click here for full article Stephen J. Brown, New York University Stern School of Business Greg N. Gregoriou, State University of New York (Plattsburgh) Razvan Pascalau, State University of New York (Plattsburgh) The Market Timing Skills of Hedge Funds During the Financial Crisis The performance of a market timer can be measured through the Treynor and Mazuy (1966) model, provided the regression alpha is properly adjusted by using the cost of an option-based replicating portfolio, as shown by Hubner (2010). We adapt this approach to the case of multi-factor models with positive, negative or neutral betas. This new approach is applied on a sample of hedge funds whose managers are likely to exhibit market timing skills. We stick to funds that post weekly returns, and analyze three hedge fund strategies in particular: long-short equity, managed futures, and funds of hedge funds. We analyse a particular period during which the managers of these funds are likely to magnify their presumed skills, namely around the financial and banking crisis of 2008. Some funds adopt a positive convexity as a response to the US market index, while others have a concave sensitivity to the returns of an emerging market index. Thus, we identify positive, mixed and negative market timers. A number of signs indicate that only positive market timers manage to acquire options below their cost, and deliver economic significant performance, even in the midst of the financial crisis. Negative market timers, by contrast, behave as if they were forced to sell options without getting the associated premium. We interpret this behavior as a possible result of fire sales, leading them to liquidate positions under the pressure of repemption orders, and inducing negative performance adjusted for marketing timing. Click here for full article Over the past forty years or so, actively managed quantitative equity strategies have become a growing presence within the asset management industry, with numerous competing firms offering a relatively standardized set of products. The vast majority of managers in the benchmark-relative quantitative equity space, which has the largest pool of quant equity assets, relies on what this paper terms the generic paradigm: valuation and momentum alpha forecasts, highly standardized and often commercially available risk models, and mean-variance portfolio optimization tools. This paper argues that each element in this generic approach to quantitative equity management has become vulnerable to competitive pressure and changes in the nature of global equity trading. As a result, the performance of quant equity strategies in the benchmark-relative space has suffered over the past three years, and generic quant managers are likely to face considerable challenges in attracting additional assets going forward. Managers that eschew the generic approach by deploying more diversified sources of alpha, proprietary risk tools, and innovative approaches to dynamic portfolio optimization are likely to fare better, but to the extent they do, it will likely be on a far smaller scale in terms of aggregate assets under management. Click here for full article The investment community has heard and is following the siren call of Alternative Investments. Their seductive return properties and the mystique surrounding how they make money has tantalized investors resulting in exponential growth of assets under management. The key issue remains that dynamic strategies in Alternative Investments perform differently and are exposed to a different set of underlying risks than traditional investment vehicles. By taking a closer look into times when markets are stressed or in crisis (often called tail risk events), this investment primer will explain how some Alternative Investment strategies provide crisis alpha opportunities while others suffer substantial losses during times of market stress. Crisis alpha opportunities are profits which are gained by exploiting the persistent trends that occur across markets during crisis. By gaining a better understanding of what happens during crisis, the underlying risks in Alternative Investment strategies can be divided into three key groups: price risk, credit risk, and liquidity risk. By understanding and classifying Alternative Investments according to their underlying risks, performance metrics commonly used in this industry can be explained in simpler terms helping investors to use them more effectively as part of a larger investment portfolio strategy or philosophy. Click here for full article Using the hedge fund industry as our laboratory, we examine whether bank bailout programs initiated in seven countries during the 2007-2009 global financial crisis reduced contagion risk in the financial system. We test for the likely channel of achieving any such benefits. Reduced fund liquidation probabilities followed bailouts of financial firms offering prime brokerage, custodial and investment advisory services to hedge funds in the short term. However, bailouts did not lead to increased capital levels in bank-related hedge funds. Collectively, our evidence suggests that bailouts helped stem the propagation of contagion through information channels rather than directly through counterparty funding. Click here for full article Robert W. Faff, University of Queensland Jerry T. Parwada and Kian M. Tan, University of New South Wales The Business of Running a Hedge Fund - Best Practices for Getting to the 8216Green Zone8217 2010 was a transformative year for the hedge fund industry and served as a strong reminder that managing money is not the same as running a business. The significant number of small, mid-size and large fund closures already in 2011 provides continuing evidence of the material, multifaceted challenges facing operators of hedge fund businesses. Managers who understand the distinction between managing money and running a business and who execute both effectively are best positioned to maintain a sustainable and prosperous business - to achieve not only investment alpha, but also enterprise alpha. This paper examines the hedge fund business model and is based on our observations and numerous conversations with hedge fund managers, investors and industry experts. Our goal is to share the best practices we have witnessed among green zone hedge funds that are well positioned for sustainability across a variety of economic and market conditions. Click here for full article This paper introduces the portfolio construction technique of OverlayUnderlay Alternatives Blend of CTAs (overlay) and Hedge Funds (underlay). The well-established result, in both industry literature and practice, that adding alternatives to a traditional-only portfolio leads to superior risk-adjusted returns is re-established in this paper. Additionally, it is demonstrated that invoking an overlayunderlay of with CTAs and hedge funds-attainable due to the cash efficiency of futures-is better than investing in either hedge funds or CTAs alone. This finding helps to establish that a hedge funds versus CTAs attitude should be replaced by hedge funds and CTAs. Different nuances of how to blend hedge funds with CTAs are explored. Click here for full article Hedge funds are in a better position than mutual funds in timing systematic risk factors because they are less regulated and thus have more freedom to use leverage and short sales. To examine whether factor timing is a source of hedge fund alpha, this paper decomposes excess return generated by hedge funds during 1994 - 2008 into security selection, factor timing, and risk premium using the new measure of performance developed by Lo (2008). I find that security selection on average explains most of the excess return generated by hedge funds, and the contributions of factor timing and risk premium are trivial. In the U. S. equity market, hedge funds on average show negative timing ability especially in recent years that include the financial crisis period of 2007-08. Click here for full article In this paper we study the drawdown status of hedge funds as a hedge fund characteristic related to performance. A hedge funds drawdown status is the decile to which the fund belongs in the industrys drawdown distribution (at a given point in time). Economic reasoning suggests that both the current level and the past evolution of a funds drawdown status are informative of key fund aspects, including the managers 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 In this paper, we examine the hypothesis that hedge fund managers obtain an informational advantage in securities trading through their connections with lobbyists. Using datasets on hedge fund long-equity holdings and lobbying expenses from 1999 to 2008, we show that hedge funds that are connected to lobbyists tend to trade more heavily in politically sensitive stocks than those that do not. We further show that connected hedge funds perform significantly better on their holdings of politically sensitive stocks. Using a difference-in-differences approach, we find that connected hedge funds, relative to non-connected ones, outperform by 1.6 to 2.5 percent per month in politically sensitive stocks, relative to non-political stocks. These results suggest that hedge fund managers exploit private information, which can be an important source of their superior performance. Our study provides evidence for the ongoing debate about regulatory reform governing informed trading based on private political information. Click here for full article Meng Gao, Risk Management Institute, National University of Singapore Jiekun Huang, Department of Finance, NUS Business School Are All Currency Managers Equal We present a post-sample study of currency fund managers showing that alpha hunters and especially alpha generators are more effective in providing diversification benefits for a global equity portfolio than currency managers who earn beta returns from popular style strategies or managers with high total returns regardless of their source. Our study is unusual in that we measure the alpha from currency investing using a simple factor model rather than based on total excess returns, that we use rankings of currency managers from an earlier published study and examine their performance truly out-of-sample, and finally that our data reflect actual trades and returns earned by these managers, so the data are not contaminated by the usual biases in hedge fund databases. Our results suggest that a factor model approach to analyzing currency fund returns, coupled with the revealed degree of alpha and beta persistence in our data, offer institutional investors with large equity exposure a useful tool for improving their performance. Click here for full article In spite of a somewhat disappointing performance throughout the crisis, and a series of high profile scandals, investors are showing interest in hedge funds. Still, funds of hedge funds keep on experiencing out-flows. Can this phenomenon be explained by the failure of funds of hedge funds managers to deliver on their promise to add value through active management, or is it symptomatic of a move toward greater disintermediation in the hedge fund industry Little attention has been paid so far to the added-value, and the sources of the added-value, of funds of hedge funds. The lack of transparency that is characteristic of the hedge funds arena and makes the performance attribution exercise particularly challenging is probably an explanation. The objective of this article is to fill in the gap. We introduce to this end a return-based attribution model allowing for a full decomposition of funds of hedge funds performance. The results of our empirical study suggest that funds of hedge funds are funds of funds like others. Strategic Allocation turns out to be a crucial step in the investment process, in that it not only adds value over the long-term, but most importantly, it brings resilience precisely when investors need it the most. Fund Picking, on the other hand, turns out to be a double-edged sword. Overall, funds of hedge funds appear to succeed in overcoming their double fee structure, and add value across market regimes, although to varying degrees and in different forms. Click here for full article Serge Darolles, Ph. D. Research Fellow, CREST and Deputy Head RD, Lyxor Asset Management Mathieu Vaissi, Ph. D. Research Associate, EDHEC-Risk Institute and Senior Portfolio Manager, Lyxor Asset Management Hedge Fund Leverage We investigate the leverage of hedge funds using both time-series and cross-sectional analysis. Hedge fund leverage is counter-cyclical to the leverage of listed financial intermediaries and decreases prior to the start of the financial crisis in mid-2007. Hedge fund leverage is lowest in early 2009 when the market leverage of investment banks is highest. 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 also increase leverage. Click here for full article Andrew Angy, Columbia University and NBER Sergiy Gorovyyz, Columbia University Gregory B. van Inwegenx, Citi Private Bank Regular(ized) Hedge Fund Clones This article addresses the problem of portfolio construction in the context of efficient hedge fund investments replication. We propose a modification to the standard la Sharpe style analysis where we augment the objective function with a penalty proportional to the sum of the absolute values of the replicating asset weights, i. e. the norm of the asset weights vector. This penalty regularizes the optimization problem, with significant impacts on the stability of the resulting asset mix and the risk and return characteristics of the replicating portfolio. Our results suggest that the norm-constrained replicating portfolios exhibit significant correlations with their benchmarks, often higher than 0.9, have a fraction, i. e. about 12 to 23, of active positions relative to those determined through the standard method, and are obtained with turnover which is in some instances about 14 of that for the standard method. Moreover, the extreme risk of the replicating portfolios obtained through the regularization method is always lower than that exhibited by currently available commercial hedge fund investment replication products. Click here for full article Daniel Giamouridis, Dept. of Accounting Finance, Athens University of Economics and Business Sandra Paterlini, Center for Quantitative Risk Analysis, Dept. of Statistics, LMU, Munich, Germany Dedicated Short Bias Hedge Funds - Just a one trick pony During the recent period of significant market unrest in 2007 and 2008 dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This study, prompted by this recent episode, investigates the DSB hedge funds performance over an extended sample period, from January 1994 to December 2008. Performance evaluation is carried out both initially at the individual fund level and then on an equally weighted dedicated short bias hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. We conclude that DSB hedge funds are indeed more than a one trick pony. They are a significant source of diversification for investors and produce statistically significant levels of alpha. Our findings are robust to the specification of traditional and alternative risk factors, nonlinearity and the omission of the flattering credit crisis period. Click here for full article Ciara Connolly, Dept. of Accounting, Finance Information Systems Mark C. Hutchinson, Dept. of Accounting, Finance Information Systems and Centre for Investment Research University College Cork Replicating Hedge Fund Indices with Optimization Heuristics Hedge funds offer desirable risk-return profiles but we also find high management fees, lack of transparency and worse, very limited liquidity (they are often closed to new investors and disinvestment fees can be prohibitive). This creates an incentive to replicate the attractive features of hedge funds using liquid assets. We investigate this replication problem using monthly data of CS Tremont for the period of 1999 to 2009. Our model uses historical observations and combines tracking accuracy, excess return, and portfolio correlation with the index and the market. Performance is evaluated considering empirical distributions of excess return, final wealth and correlations of the portfolio with the index and the market. The distributions are compiled from a set of portfolio trajectories computed by a resampling procedure. The nonconvex optimization problem arising from our model specification is solved with a heuristic optimization technique. Our preliminary results are encouraging as we can track the indices accurately and enhance performance (e. g. have lower correlation with equity markets). Click here for full article Manfred Gilli, University of Geneva and The Swiss Finance Institute Enrico Schumann, Gerda Cabej and Jonela Lula University of Geneva Absolute Returns Revisited The term absolute returns has been battered as well as misused by business and politics alike. We aim to clarify. The term stands for an investment philosophy that stands in stark contrast to financial orthodoxy. And thats a good thing. Market heterogeneity with moderately leveraged financial institutions reduces systemic risk. Market homogeneity with excessively leveraged institutions doesnt. After challenging some axioms of financial orthodoxy, we introduce PPMPT (Post-post-modern portfolio theory) as an alternative to mean-variance optimization. Click here for full article This paper attempts to determine whether exchange-listed hedge funds experience longer lifetimes than non-listed funds, even after factors known to affect survival, such as size and performance, are considered. The Kaplan-Meier estimator is used to compare survival times of listed and non-listed funds. The Cox proportional hazards model is used to make the same comparison, but by controlling for additional factors. The accelerated failure time (AFT) regression model is used to estimate the median survival time of hedge funds, based on values of explanatory variables. Listed hedge funds tend to be larger and adopt more conservative investment strategies than non-listed funds. Listed funds tend to survive roughly two years longer on average than non-listed funds, and this difference in longevity is persistent even after controlling for factors known to affect survival. Finally, we find that the failure rate of listed funds is substantially lower than that of non-listed funds, but only during the first five years of life. Click here for full article Greg N. Gregoriou, SUNY College at Plattsburgh - School of Business and Economics Franois-Serge Lhabitant, Kedge Capital Fund Management amp EDHEC Business School Fabrice Douglas Rouah, McGill University - Faculty of Management Merlins Necessary Nine: How to Raise and Retain Institutional Capital This article is based on a presentation by Ron Suber at the Feb. 18th event Hedge Funds: Getting to the Next Level By Ron Suber -- Not long ago, pre-2008, hedge fund managers held relative power over investors. Because demand for their products was so high across a range of strategies, they controlled the terms, often with little transparency and very favorable gating provisions. Recent market events and a general scarcity of investors has shifted the power to the investor. While raising and retaining institutional capital has always been challenging, in todays environment hedge fund managers must be more diligent than ever in clearly defining and explaining their process, controls and their differentiation. Worries about performance are now often eclipsed by other concerns such as volatility, liquidity, attribution, transparency and, of course, fraud. The following checklist - we call it the Merlin Necessary Nine - is designed to help hedge fund managers understand and articulate their edge to institutional investors. Click here for full article In the last 20 years, the amount of assets managed by quantitative and qualitative hedge funds have grown dramatically. We examine the difference between quantitative and qualitative hedge funds in a variety of ways, including management differences and performance differences. We find that both quantitative and qualitative hedge funds have positive risk-adjusted returns. We also find that overall, quantitative hedge funds as a group have higher s than qualitative hedge funds. The outperformance might be as high as 72 bps per year when considering all risk factors. We also suggest that this additional performance may be due to better timing ability. Click here for full article Ludwig Chincarini, CFA, Ph. D. Assistant Professor Department of Economics, Pomona College Lies of Capital Lines In this paper we examine in detail the qualitative effects caused by the investors sensitivity to mark-to-market and price of liquidity. This distorts CAPM-like portfolio construction causing the Capital Line to become curved and eventually inverted. We show that in the world of strongly concave and non-monotonous Capital Lines, pushing up return targets results in increasing risk but not in increasing return. This is due to the decreasing and eventually negative marginal returns per unit of risk. By chasing returns and prompting investment managers to deliver unsustainable performance, the investment community damages its own chances through a greedy search for yield. Besides negatively skewing the risk-return characteristics, this also amplifies destabilizing pro-cyclical dynamics and increases the component of volatility, which is not accompanied by corresponding return. The latter has profound consequences for investment management and economic policy making. We examine the influence of non-linearity of the Capital Line on the cyclical volatility of capital market and short optionality negative gamma) profile, implicitly embedded in classical investment approach. We show how to mitigate this negative effect by including long volatility funds in the investment portfolio. We also discuss adverse selection bias among investment managers, created by the investors demand for high unsustainable returns. Since one can only hope that the behaviour of either capital allocators or investment managers will change, we argue that it is left up to regulators to take measures to limit the use of credit and leverage, and to control the self-enforcing mechanism of market destabilization. Click here for full article Kirill Ilinski, Fusion Asset Management Alexis Pokrovski, Laboratory of Quantum Networks, Institute for Physics, St-Petersburg State University Detecting Crowded Trades in Currency Funds The financial crises in 2008 highlights the importance of detecting crowded trades due to the risks they pose to the stability of the financial system and to the global economy. However, there is a perception that crowded trades are difficult to identify. To date, no single measure to capture the crowdedness of a trade or a trading style has developed. We propose a methodology to measure crowded trades and apply it to professional currency managers. Our results suggest that carry became a crowded trading strategy towards the end of Q1 2008, shortly before a massive liquidation of carry trades. The timing suggests a possible adverse relationship between our measure of style crowdedness and the future performance of the trading style. Crowdedness in the trend following and value strategies confirm this hypothesis. We apply our approach to currencies but the methodology is general and could be used to measure the popularity or crowdedness of any trade with an identifiable time series return. Our methodology may offer useful insights regarding the popularity of certain trades - in currencies, gold, or other assets - among hedge funds. Further research in this area might be very relevant for investors, managers and regulators. Click here for full article Because many facets of the global oil markets have not been sufficiently transparent, it is unclear how much of the oil-price rally that peaked in July 2008 can be put down to speculation. This uncertainty has led to concerns that there was actually excessive speculation in the oil derivatives markets. In an effort to make the oil markets more transparent, the U. S. Commodity Futures Trading Commission has recently launched the Disaggregated Commitments of Traders report. This report includes three years of enhanced market-participant data for twenty-two commodity futures contracts. This report makes it possible to examine whether, over the last three years, speculative position-taking in the exchange-traded oil derivatives markets has been excessive relative to commercial hedging needs. We use a traditional metric for evaluating speculative position-taking and find that this position-taking does not appear to be excessive over the past three years when compared to the scale of commercial hedging at the time. Click here for full article The original Superstars versus teamwork (Nov. 8, 2007) was the first in a sequence of research pieces that have persuaded us that the best way to build portfolios of CTAs is to look for low correlation and place your bets there. Correlations appeared to be predictable, especially for portfolios, while Sharpe ratios did not. We found that choosing managers to maximize the portfolios Sharpe ratio yielded better results than did choosing managers based on their individual Sharpe ratios, and the difference was statistically significant. The teamwork portfolios in that research were constructed, however, using conventional mean variance analysis that was based on estimated means, volatilities and correlations. And, when we applied it to the construction of a teamwork index, we found out, quite by accident, that it was unusually sensitive to minor changes in the eligible set. Too sensitive, for that matter, which led us back to the question of just how one should approach the selection of managers for a teamwork portfolio. The flaw, we found, was not in giving past correlations a role in shaping our teamwork portfolios, but in allowing past returns to have any effect at all. As you will see on page 3 (Exhibit 3), past correlations for large enough portfolios of CTAs can be highly predictable while past returns and, by extension, past Sharpe ratios are not. In this new look at that research, we changed two things. First, we formed teamwork portfolios using three different rules. Second, we allowed ourselves to construct new portfolios each year without regard to the costs of dropping and adding managers. The three teamwork rules were these. One used the conventional meanvariance approach to maximize the Sharpe ratio of the portfolio. The other two used only correlations and gave no weight at all to past returns. The first of these, which is illustrated in Exhibit 1, simply calculated the probability that a CTA would have been in a low-average correlation portfolio and chose those with the highest probabilities of inclusion. The second ranked CTAs using each CTAs average return correlation with all others CTAs in the eligible set and chose those with the lowest average correlations. The superstar portfolios were formed by identifying those CTAs who had, over the previous three years, produced the highest individual Sharpe ratios. In a nutshell, what we found is this. First, the teamwork portfolios gave us an edge over the superstar portfolios. While the superstar portfolios delivered the highest Sharpe ratio in two of the eight years, they came in dead last the other six years. In contrast, the correlation-only teamwork portfolios came in first or second in five of the eight years, and came in last only once. Second, the correlation-only approaches gave us two benefits over the conventional meanvariance approach. For one thing, they are more robust. The removal of one or more managers from the eligible set does not materially affect the probability that the remaining low correlation CTAs will end up in the low correlation portfolio. For another, they are more economical and use the eligible CTA set far more sparingly. While the meanvariance portfolios performed almost as well as the correlation-only portfolios, they used 21 of the 42 CTAs over the eight years, while the correlation-only portfolios used only 14. Thus, the meanvariance approach would have dropped and added 11 CTAs, the correlation-only rules would have dropped and added only four. Given the high costs of dropping and adding CTAs, this kind of stability in ones choice of CTAs can be worth a great deal. In the remainder of this note, we review this reworking of our research and conclude with a discussion of how we have applied what weve learned to the construction and management of the AlternativeEdge Teamwork Index. In particular, we take a more complete look at which return statistics are persistent or predictable (volatilities and correlations) and which are not (means and Sharpe ratios) explore two empirical approaches to constructing low correlation portfolios explain why we volatility weight the CTAs in the AlternativeEdge indices. Click here for full article We believe the distinction between emerging markets and developed markets is no longer useful. The differences that justified the segregation of emerging and developed markets have disappeared or are in the process of disappearing. Emerging markets, because of their characteristics, should matter a great deal to investors today. Investors handicap themselves by limiting how much they invest in emerging markets. The term emerging markets is obsolete. The end of emerging markets has arrived, as the distinction between emerging markets and developed markets has run the course of its usefulness to investors. Distinctions are disappearing between emerging and developed markets. Emerging markets represent half of the worlds economy they are large and liquid with volatility similar to that of developed markets and their corporate governance and government policies are no worse than, and in some cases superior to, those of developed markets. There is one measure by which there is still a distinction between emerging markets and developed markets: Growth. We believe that, for the foreseeable future, this differentiation in growth will remain, leading to more attractive investment opportunities in emerging markets than in developed markets. For this reason, investors should focus more on emerging markets than developed markets. Click here for full article I study novel data from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. These value investors are not easily defined: they exploit traditional tangible asset valuation discrepancies such as buying high book-to-market stocks, but spend more time analyzing intrinsic value, growth measures, and special situation investments. Evidence suggests that the managers long recommendations earn economic and statistically significant long-term abnormal returns. Oddly enough, these managers share their profitable ideas with other skilled investors. This evidence is puzzling in a world where there is an efficient market for fund managers and asset prices. Click here for full article Based on the style analysis pioneered in Sharpe, W. F. (1992). Asset Allocation: Management Style and Performance Measurement, Journal of Portfolio Management, 7-19. I define a procedure to examine the consistency of hedge fund indexes across providers. The results of my investigation suggest that the competing indexes of the different providers are homogeneous. However, I also find two cases for which one provider differently allocates the funds between styles compared to its peers. Click here for full article Portfolio optimisation for a Fund of Hedge Funds (FoHF) has to address the asymmetric, non-Gaussian nature of the underlying returns distributions. Furthermore, the objective functions and constraints are not necessarily convex or even smooth. Therefore traditional portfolio optimisation methods such as mean-variance optimisation are not appropriate for such problems and global search optimisation algorithms could serve better to address such problems. Also, in implementing such an approach the goal is to incorporate information as to the future expected outcomes to determine the optimised portfolio rather than optimise a portfolio on historic performance. In this paper, we consider the suitability of global search optimisation algorithms applied to FoHF portfolios, and using one of these algorithms to construct an optimal portfolio of investable hedge fund indices given forecast views of the future and our confidence in such views. Click here for full article B. Minsky, International Asset Management Ltd. M. Obradovic, School of Mathematical Physical Sciences, Sussex Univ. Q. Tang, School of Mathematical Physical Sciences, Sussex Univ. R. Thapar, International Asset Management Ltd. What is the Optimal Number of Managers in a Fund of Hedge Funds This paper investigates the level and the determinants of the optimal number of hedge fund managers in a Fund of Hedge Funds (FOFs). The paper also analyzes the impact that this level has on the performance and the volatility of returns of the typical FOF. Several important findings emerge. First, we find that the number of underlying hedge funds (HFs) included into a FOF has a negative and significant impact on the volatility of returns but less of an impact on the actual returns. However, if we properly classify the FOFs into several larger categories of interest, we find evidence that the FOFs having between 6 and 10 hedge fund managers perform the best. On average this group of FOFs has assets under management of around 200 million. Second, further evidence shows that there is a positive relationship between the size of the FOF portfolio and the lifetime of the fund. Third, several factors that influence the number of HF managers into a FOF include, but are not limited to the amount of leverage, the redemption frequency, the size of the fund, the total number of assets managed by the FOF manager, whether the fund issues a K-1 schedule for tax purposes, the currency in which the fund trades, the geographical focus, and the strategy pursued. Click here for full article Greg N. Gregoriou, Professor of Finance, State University of New York Razvan Pascalau, Assistant Professor of Economics, State University of New York Investor Irrationality and Closed-End Hedge Funds This study questions the rationality of people investing in HFs. I use a sample of London listed closed-end hedge funds to evaluate two criteria that imply irrational behavior. I nd that the rationality of investors can not be rejected for the majority of time. However, the results also imply that investors react irrationally when facing the worsening economic conditions in the second half of 2008. Click here for full article Oliver Dietiker, University of Basel Skill, Luck and the Multi-Product Firm: Evidence from Hedge Funds We propose that higher skilled firms diversify in equilibrium even though managers exploit idiosyncratic performance shocks to time diversification moves. We formalize this intuition in a mistakefree equilibrium and test our predictions using a large panel dataset on the hedge fund industry 1977- 2006. The results show that returns fall following new fund launches, but are 13 basis points per month higher in diversified firms compared to a matched control sample of focused firms. Consistent with the theory, the evidence suggests that both idiosyncratic performance shocks and systematic differences in skill influence diversification decisions. Click here for full article Rui J. P. de Figueiredo, Jr. University of California, Berkeley Evan Rawley, University of Pennsylvania Crowded Chickens Farm Fewer Eggs - Capacity Constraints in the Hedge Fund Industry Revisited We revisit the question of capacity constraints in the hedge fund industry by looking at over 2,000 individual funds operating within ten different strategy segments over the years 1994 to 2006. By first looking at fund specific determinants of alpha returns, we demonstrate that the negative effect of inflows on performance is dominated by a concave size effect and thus nonlinear. Secondly, we investigate how competitive dynamics within a strategy segment influence alpha returns. The finding of a concave relationship between the total size of a segment and individual fund performance supports the notion of limiting capacity constraints on strategy level. While fund specific determinants only apply to funds that generated alpha in the past, strategy segment effects apply to all funds. Click here for full article Oliver Weidenmller and Marno Verbeek Rotterdam School of Management, Erasmus University The Good, the Bad or the Expensive Which Mutual Fund Managers Join Hedge Funds Does the mutual fund industry lose its best managers to hedge funds We find that a mutual fund manager with superior past performance is more likely to start managing an in-house hedge fund while continuing to manage mutual funds. However, a mutual fund manager with poor past performance is more likely to leave the mutual fund industry to manage a hedge fund. Thus, mutual funds appear to use in-house hedge funds to retain the best-performing managers in the face of competition from hedge funds. In addition, the managers of mutual funds with greater expenses are more likely to enter the hedge fund industry. The magnitude of such expenses is negatively related to subsequent performance in the hedge fund industry. Hence, hedge funds do not acquire superior performance for their investors by hiring these expensive managers. Click here for full article Prachi Deuskar, University of Illinois at Urbana Joshua M. Pollet, Goizueta Business School, Emory University Z. Jay Wang, University of Illinois at Urbana Lu Zheng, Paul Merage School of Business, University of California Irvine Performance Bias from Strategic Asset Allocation: The Case of Funds of Hedge Funds Evaluating the performance of portfolio managers has received wide attention in the finance literature. The common practice is to divide performance, which is attributable to active management, into two main components, security selection and market timing. However, the Brinson et al. studies and the controversial debate on the relative importance of asset allocation and security selection reveal that the strategic asset allocation has a significant impact on the performance of an actively managed portfolio. Nevertheless, up to now neither an empirical study has taken that portfolio decisions into account in the performance evaluation nor has anyone previously discussed a possible performance bias which could arise from the strategic asset allocation decisions. Beside its direct influence on the performance of funds of hedge funds, the strategic asset allocation induces a performance bias similar to the timing bias, which results from actively changing the beta of the portfolio of hedge funds by the portfolio manager. Unfortunately, normally the historical portfolio holdings of funds of hedge funds are not available due to their low transparency. In order to estimate the strategic asset allocation of each fund of hedge funds we use Sharpes 1988, 1992 returns-based style analysis (RBSA), which requires only the monthly performance. By comparing the selectivity and timing performance of 2638 funds of hedge funds, 2095 live funds and 543 dead funds, estimated with Jensens 1968 model and the timing model of Treynor and Mazuy 1966 using fund specific benchmark portfolios - which reflect the funds strategic asset allocations - against the selectivity and timing performance estimates generated with traditional hedge fund and fund of hedge funds indices, we document a performance bias which is clearly induced by the strategic asset allocation decision. This bias causes an overestimation of the true selectivity and timing performance of funds of hedge funds. In order to avoid these biases, both academics and practitioners should evaluate the performance of funds of hedge funds against benchmark portfolios which reflect the fund specific strategic asset allocation. Over the period from 1994 - 2006, we find that funds of hedge funds exhibit a negative monthly selectivity performance of -0.1648 and a monthly timing performance of -0.0263. Click here for full article Dr. Oliver A. Schwindler, Department of Finance, Bamberg University Lintner Revisited: The Benefits of Managed Futures 25 Years Later In this paper we attempt to update Professor Lintners work by demonstrating that the beneficial correlative properties of managed futures presented in his research persist today. Click here for full article Ryan Abrams, AlphaMetrix Alternative Investment Advisors, LLC Ranjan Bhaduri, AlphaMetrix Alternative Investment Advisors, LLC Elizabeth Flores, CME Group Selectivity and Timing Performance of Funds of Hedge Funds: A Time-Varying Approach This paper empirically examines the time variation of the selectivity and timing performance of funds of hedge funds by employing rolling versions of the performance regression models of Jensen (1968) and Treynor and Mazuy (1966). The analysis is based on a sample of 1,207 funds of hedge funds during January 1994 until December 2006. We propose for the first time a cross-sectional regression method similar to those used by Fama and McBeth (1973) for the analysis of the determinants of the performance of funds of hedge funds. Moreover, we use fund specific style benchmarks, which reflect the performance of the individual strategic asset allocation decision of each fund. Our results show that positive selectivity performance has faded away over the sample period and has become negative in recent years while the timing performance erratically fluctuates around zero. The cross-sectional regression reveals that the importance of the selectivity and timing seems to rotate over time, as both variables show considerable variation over time and different magnitudes in the cross-section. Summing up, we present profound and robust evidence that selectivity performance can be regarded as a good discriminating factor for superior funds of hedge funds. Click here for full article Dr. Marco Rummer, Saiumld Business School, Oxford University Dr. Oliver A. Schwindler, Department of Finance, Bamberg University Recovering Delisting Returns of Hedge Funds Numerous hedge funds stop reporting to commercial databases each year. An issue for hedgefund performance estimation is: what delisting return to attribute to such funds This would be particularly problematic if delisting returns are typically very different from continuing funds returns. In this paper, we use estimated portfolio holdings for funds-of-funds with reported returns to back out maximum likelihood estimates for hedge-fund delisting returns. The estimated mean delisting return for all exiting funds is small, although statistically significantly different from the average observed returns for all reporting hedge funds. These findings are robust to relaxing several underlying assumptions. Click here for full article James E. Hodder, Professor - Finance, University of Wisconsin-Madison Dr. Jens Jackwerth, Head Dept of Economics, University of Konstanz Olga Kolokolova, Research Asst. University of Konstanz The Impact of Hedge Fund Family Membership on Performance and Market Share We study the impact that hedge fund family membership has on performance and market share. Hedge funds from small fund families outperform those from large families by a statistically significant 4.4 per year on a risk-adjusted basis. We investigate the possible causes for this outperformance, and find that regardless of family size, fund families that focus on their core competencies have core competency funds with superior performance, while the familys non-core competency funds underperform. We next examine the determinants of hedge fund family market share. A familys market share is positively related to the number and diversity of funds offered, and is also positively related to past fund performance. Finally, we examine the determinants of fund family market share at the fund stylestrategy level. Families that focus on their core competencies attract positive and significant market share to these core-competency funds. Hence, by starting new funds only in their familys core competencies, fund managers can enjoy increased market share while their investors enjoy good performance. Click here for full article The paper assesses the extent to which the Group of Seven (G7) has been successful in its management of major currencies since the 1970s. Using an event-study approach, the paper finds evidence that the G7 has been overall effective in moving the US dollar, yen and euro in the intended direction at horizons of up to three months after G7 meetings, but not at longer horizons. While the success of the G7 is partly dependent on the market environment, it is also to a significant degree endogenous to the policy process itself. The findings indicate that the reputation and credibility of the G7, as well as its ability to form and communicate a consensus among individual G7 members, are important determinants for the G7s ability to manage major currencies. The paper concludes by analyzing the factors that help the G7 build reputation and consensus, and by discussing the implications for global economic governance. Click here for full article This paper is the first to use quantile regression to analyze the impact of experience and size of funds of hedge funds (FHFs) on performance. In comparison to OLS regression, quantile regression provides a more detailed picture of the influence of size and experience on FHF return behaviour. Hence, it allows us to study the relevance of these factors for various return and risk levels instead of average return and risk, as is the case with OLS regression. Because FHF size and age (as a proxy for experience) are available in a panel setting, we can perform estimations in an unbalanced stacked panel framework. This study analyzes time series and descriptive variables of 649 FHFs drawn from the Lipper TASS Hedge Fund database for the time period January 1996 to August 2007. Our empirical results suggest that experience and size have a negative effect on performance, with a positive curvature at the higher quantiles. At the lower quantiles, however, size has a positive effect with a negative curvature. Both factors show no significant effect at the median. Click here for full article We make use of a new database on daily currency fund manager returns over a threeyear period, 2005-08. This higher frequency data allows us to estimate both alpha measures of performance and beta style factors on a yearly basis, which in turn allows us to test for persistence. We find no evidence to support alpha persistence a managers alpha in one year is not significantly related to his alpha in the prior year. On the other hand, there is substantial evidence for style persistence funds that rely on carry, trend or value trading or with a longshort bias toward currency volatility are likely to maintain that style in the following year. In addition, we are able to examine the performance of managers that survive through the entire sample period, versus those that drop out. We find significant differences in both the investment styles of living versus deceased funds, as well as their realized alpha performance measures. We conjecture that both style differences and ineffective market timing, rather than market conditions, have impacted performance outcomes and induced some managers to close their funds. Click here for full article Momtchil Pojarliev, Hermes Investment Management Limited Richard M. Levich, New York Universitys Leonard N. Stern School of Business The Rising Costs of Low U. S. Interest Rates The Federal Open Market Committees (FOMC) decision to drastically reduce interest rates over the past year may be viewed positively in hindsight because it prevented a collapse of the U. S. credit markets. But it is more likely that this decision will be remembered for the toll it exacted on the U. S. economy and global markets. After tightening monetary policy for two years, from June 2004 to June 2006, the decision by the FOMC in the autumn of last year to reverse course seems to have provided some short-term relief to U. S. financial institutions and credit markets. But it also has significantly raised the long-term costs and challenges of restoring price stability in the consumer goods and financial markets. Click here for full article This paper provides a discussion about some recent issues related to the transfer of credit risk (CRT) from the perspective of global liquidity. The CRT market is enormously growing and exhibits major structural shifts in terms of buyers and sellers of protection. I try to address these issues from an options perspective by suggesting that liquidity providing can be understood, in economic terms, as selling put options. The overall conclusion of the paper is that it is not the extent of CRT per se, as often claimed, which causes liquidity related systemic risk, but rather the potential coordination failures of the behavior market participants in adverse market environments. In this context, I critically address the role of investments banks in providing liquidity to hedge funds, and finally, the (limited) access of global banks to central bank liquidity through cross-border collateral trading. Since coordination failures, seen as the major issue of a potential liquidity crisis, is to a large extent a matter of market structure, regulatory actions to improve liquidity should focus on the architecture of the financial system in the first place, not so much on the behavior of individual agents. Market stabilization should therefore be understood as a process of establishing informative markets and adequate infrastructure. Click here for full article We study the effect of financial crises on hedge fund risk. Using a regime-switching beta model, we separate systematic and idiosyncratic components of hedge fund exposure. The systematic exposure to various risk factors is conditional on market volatility conditions. We find that in the high-volatility regime (when the market is rolling-down and is likely to be in a crisis state) most strategies are negatively and significantly exposed to the Large-Small and Credit Spread risk factors. This suggests that liquidity risk and credit risk are potentially common factors for different hedge fund strategies in the down-state of the market, when volatility is high and returns are very low. We further explore the possibility that all hedge fund strategies exhibit a high volatility regime of the idiosyncratic risk, which could be attributed to contagion among hedge fund strategies. In our sample this event happened only during the Long-Term Capital Management (LTCM) crisis of 1998. Other crises including the recent subprime mortgage crisis affected hedge funds only through systematic risk factors, and did not cause contagion among hedge funds. Click here for full article Monica Billio, University of Venice - Department of Economics Mila Getmansky, University of Massachusetts at Amherst Loriana Pelizzon, University of Venice - Department of Economics A Portrait of Hedge Fund Investors: Flows, Performance and Smart Money We explore the flow-performance interrelation of hedge funds by separating the investment and divestment decisions of investors. We report three main results. First, we find a weak inflow-performance relation at quarterly horizons together with a very steep outflow-performance relation. At annual horizons, these patterns revert. We attribute this differential response time of inflows and outflows to the combined effect of liquidity restrictions, high searching costs and active investors monitoring. Second, consistent with the theory that performance persistence is more pronounced where money flows are the least responsive, we find remarkable differences in persistence levels across horizons for the subsets of funds experiencing inflows and outflows. Third, we show that investors limited response capacity precludes them from investing into the subsequent good performers. Conversely, investors appear to be fast and successful in de-allocating from the subsequent poor performers. Click here for full article Studies dealing with the classification of CTAs have not effectively examined the distinction between the time frame these managers trade and the strategies they employ. Nor have such studies examined the information that rigorous due diligence adds to the process of classifying CTA s. This paper utilizes a set of CTA managers screened from the Barclay CTA (Managed Futures) Data Feeder database. Returns of these managers are analyzed using variables in this database as well as information collected in an extensive due diligence review. The results suggest that time frame and strategy are distinct factors in the classification of CTA managers. Furthermore, with ratings derived from the due diligence review, research quality is identified as a separate factor affecting CTA returns. Click here for full article We investigate an index of returns on professionally managed currency funds and a subset of returns from 34 individual currency fund managers. Over the period 1990-2006, excess returns earned by currency fund managers have averaged 25 basis points per month. We examine the relationship of these returns to four factors representing returns based on carry trading, trend-following, value trading and currency volatility. These four factors explain a substantial portion of the variability in index returns in the entire period and in sub-periods. We perform similar regressions for the 34 individual funds, and find many funds where returns are significantly related to these four factors. Our approach impacts the definition of alpha returns from currency speculation, modifying it from the excess return earned by the fund, to only that portion of the excess returns not explained by the four factors. While the impact on measured alpha is substantial, we find that some currency fund managers continued to generate alpha returns in the most recent sample period. Click here for full article This paper investigates potential sources of return to speculators in the commodity futures market. Initially, we focus on the classic arbitrage model based on the theories of Keynes (1930), Kaldor (1939), Hicks (1939, 1946), Working (1948) and Brennan (1958). Next our study examines the simplified arbitrage model which references the term structure of the futures price curve and provides rationale for a structural risk premium known as the roll return. We then introduce our theory of roll yield permutations which is derived from integrating the futures price curve with the expected future spot price variable. Last, we investigate Spurgins (2000) hedging response model from which asymmetric hedging response functions transfer risk premia to speculators. Our research indicates that these models have inherent shortcomings in being able to pinpoint a definitive source of structural risk premium within the complexity of the commodity futures markets. We hypothesize that the classic arbitrage pricing theory contains circular logic, and as a consequence, its natural state is disequilibrium, not equilibrium. We extend this hypothesis to suggest that the term structure of the futures price curve, while indicative of a potential roll return benefit, in fact implies a complex series of roll yield permutations. Similarly, the hedging response function elicits a behavioral risk management mechanisms, and therefore, corroborates social reflexivity. Such models are inter-related and each reflects certain qualities and dynamics within the overall futures market paradigm. With respect to managed futures, it is an observable materialization of behavioral finance, where risk, return, leverage and skill operate un-tethered from the anchor of an accurate representation of beta. In other words, it defies rational expectations equilibrium, the efficient market hypothesis and allied models - the CAPM, arbitrage pricing theory or otherwise - to single-handedly isolate a persistent source of return without that source eventually slipping away. Click here for full article Davide Accomazzo, Adjunct Professor of Finance, Pepperdine University Michael Frankfurter, Managed Account Research, Inc. Principals, Cervino Capital Management, LLC What Happened to the Quants In August 2007 During the week of August 6, 2007, a number of quantitative longshort equity hedge funds experienced unprecedented losses. Based on TASS hedge-fund data and simulations of a specific longshort equity strategy, we hypothesize that the losses were initiated by the rapid unwind of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to a margin call or a risk reduction. These initial losses then put pressure on a broader set of longshort and long-only equity portfolios, causing further losses by triggering stoploss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the unwind hypothesis. This dislocation was apparently caused by forces outside the longshort equity sector in a completely unrelated set of markets and instruments suggesting that systemic risk in the hedge-fund industry may have increased in recent years. Click here for full article Natural-resource managers make or lose their bread-and-butter by structuring active bets in the commodity markets in a variety of ways. Active managers may try to call the market direction correctly make relative-value bets in the derivatives markets take on basis risk invest in natural-resources equities, particularly in emerging markets or they may trade physical commodities. Active natural-resource managers need to be clearly differentiated from Commodity Trading Advisors (CTAs) and index funds. CTAs (or systematic trend followers) exploit trends in the financial and commodity markets. Indexed commodity funds, in turn, offer the investor pure commodity exposure. The case for institutional investors to include both passive commodities portfolio exposure as well as active commodities management has been made by a variety of industry observers. Until now, however, the subset of active natural-resource managers has not seen the growth in assets that the commodity index funds have seen. Clearly, active natural-resource investing is not nearly as well understood by institutional investors. As such, an institutional investor considering an investment with a naturalresources manager needs to understand the trading strategies, risks, and potential returns in this investment category. This article will focus on the due-diligence process as it applies to investment strategies commonly used by active natural-resource managers. Click here for full article Since the publication of our first paper on hedge fund replication in 2005, our FundCreator methodology has met with many positive reactions. There have also been some negative responses though. Until now we have not responded to the criticism launched against FundCreator, other than the occasional remark when asked for comments. However, with a number of high profile conferences on the subject coming up this year and early next year and investors clearly becoming confused as a result of the amount of disinformation that is being circulated, in this short paper we will address the 10 most common points of criticism. We will argue that most of these are largely unjustified and fairly trivial at best and no reason whatsoever to doubt the capability of FundCreator to deliver exactly what it promises: returns with predefined statistical properties. Here we go. Click here for full article We examine whether hedge funds are more likely to experience extremely poor returns when equity, fixed income, and currency markets or other hedge funds have extremely poor performance than would be predicted by correlations of hedge fund returns with returns on these markets or with returns of other hedge funds (contagion). First, we consider whether extreme movements in these markets are contagious to Arbitrage, Directional, and Event Driven hedge fund indices. Second, we investigate whether extreme adverse returns in one hedge fund index are contagious to other hedge fund indices. To conduct these examinations, we estimate Poisson regressions using both monthly and daily returns on hedge fund style indices. We find no systematic evidence of contagion from equity, fixed income, and currency markets to hedge fund indices, although the Arbitrage index exhibits evidence of contagion from the equity and currency markets for monthly data. In contrast, we find systematic evidence of contagion across hedge fund styles for both monthly and daily data. Our results provide a new perspective on the systemic risks of hedge funds and suggest that diversification across hedge funds may not help as much as correlations would imply in reducing the probability of very poor returns. Click here for full article Nicole M Boyson, Northeastern University Christof W. Stahel, George Mason University Ren M. Stulz, Ohio State University A Subprimer on Risk Early in 2007, there were concerns about two issues that could wind up causing significant havoc. One was the potential unwind of the yen carry trade, which we covered in our last issue. The other was the weakness in subprime mortgages in the US. At the risk of further cursing the market, it is fair to say that the yen carry trade scenario has not come about as yet. But clearly, the subprime issue has come to a head, and by now has impacted markets directly linked to subprime, such as securitized products and the equity of mortgage lenders, and others where the link is at best indirect, such as corporate credit, leveraged buyouts, and global equities. A postmortem analysis of these market events is premature, since the situation is still quite fluid. A comprehensive analysis of subprime mortgages, the catalyst of our current excitement, is beyond the scope of our efforts here. Still, it is not a market we can ignore, and so we offer some thoughts here on what is particular about subprime, and what we might be able to learn after this storm has blown over. Click here for full article When I recently co-edited the book, Intelligent Commodity Investing (Risk Books, 2007), a risk-management professional asked me if the title of the book is an oxymoron. This question was posed soon after the Amaranth debacle so perhaps the question is an appropriate one. This article will argue that one can indeed intelligently invest in the commodity markets and will briefly touch on three approaches, which in turn are drawn from the Intelligent Commodity Investing book. The first two sections of this article will discuss two historically profitable approaches that take into consideration the largely mean-reverting properties of commodity prices. The final section of the article will argue that we are in the midst of a rare trend shift in prices for some commodity markets and will provide some ideas on how to benefit from this shift. Click here for full article Dubbed the Trade of the Decade by at least one website, it is difficult to imagine a single trading strategy getting more popular attention than the carry trade has over the last eighteen months. Headlines in early 2006 included Japans Boom May Explode Yen-Carry Trade and Yen Carry Trade to Unwind-Market Crash Alert. Fears rose again in early 2007: in What keeps bankers awake at night the Economist made the carry trade first on its list. But the fears seem to have subsided, with the Economist acknowledging more recently that the carry trade may have gone Out With a Whimper. Click here for full article In this article, we provide the busy reader with a survey of articles that were written over the past four years on hedge funds. Specifically, we review the economic basis for hedge fund returns and then discuss some of the logical consequences of these observations. Next, we summarize the general statistical properties of hedge fund strategies. We then examine what the appropriate performance measurement and risk management techniques are for these investments. And lastly, we briefly cover ways that investors can consider incorporating hedge funds within their overall portfolios. Click here for full article Never has an industry so extensively studied by experts produced such a surplus of myths, misunderstandings, and half-truths. Many of these myths could easily be clarified with a call or two to knowledgeable industry professionals. Too often, a seemingly logical statement that sounds-good-when-you-say-it-fast becomes accepted conventional wisdom despite the reams of evidence weighted against it. Although many of these experts are well-intentioned, they may not be sufficiently well-informed. The solution lies in enhanced collaboration between academia, industry, and the press. Click here for full article The interest in commodity trading advisers (CTAs) and hedge funds trading purely currency has increased significantly in recent times this has both been with respect to the number of participants involved and the money-under-management allocated to the sector, Middleton (2006). Performance has suffered over the past couple of years and this has led many to question how sustainable this popularity in currency will be. The purpose of this paper is to investigate the downturn in performance experienced by currency programmes over the past couple of years. Active currency indices are used, together with transparent proxies for style, to highlight the importance of assessing performance over as long a period as possible prior to making investment decisions. The paper puts forward some possible explanations for the recent difficulties investigates whether the investors appetite for currency as an asset class still remains and concludes with thoughts on the ways in which participants may have to change in order to adapt to the new environment. Click here for full article In this paper we use the hedge fund return replication technique recently introduced in Kat and Palaro (2005) to evaluate the net-of-fee performance of 875 funds of hedge funds and 2073 individual hedge funds, up to an including November 2006. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 18.6 of the funds of funds and 22.5 of the individual hedge funds in our sample convincingly beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading a diversified basket of liquid futures contracts. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time. This supports the hypothesis that increased assets under management tend to endanger future performance. Click here for full article One of the more notable trends in the hedge fund industry over the past few years is the migration toward more stringent liquidity terms. That is, managers are requiring lock ups of one year or longer and are also lengthening notice periods for redemptions. Numerous reasons exist for this shift including potential SEC registration that may be skirted by employing a lock up of two years or more, a trend toward lesser-liquid underlying investments in an attempt to generate favorable returns and, for lack of a better term, manager greed. The SEC regulation rationale appears moot for the time being given that the mandatory registration requirement has been indefinitely tabled (see Goldstein, et al v. SEC, 2006). The most legitimate argument appears to be the utilization of more strict liquidity terms in order to better match fund assets and liabilities as managers migrate toward lesser-liquid underlying investments. Manager greed on the other hand continues to exemplify a straight forward supply and demand issue: the highest quality managers with the best performance are likely to be more in demand and will best be in a position to dictate lock up requirements. Notwithstanding the aforementioned arguments, the question remains as to what longterm value is being added by managers employing more inflexible liquidity terms. In this study we revisit, albeit with a different set of data, the observations of Liang (1999) pertaining to fund lock ups and performance. We then delve further into the data on a sub-strategy basis to determine the extent of value added and to discuss the necessity of lock ups given the nature of the underlying securities employed within each sub-strategy. Click here for full article One of the most powerful tensions in the world of money management is in the pull between assets that perform well on their own and portfolios that perform well. Even the most casual students of finance know about the importance of diversification. But as soon as any one asset turns in a bad performance, the temptation to dump that asset and replace it with something that performed better is nearly irresistible. What we found in this research is that team players outperformed superstars. We found that the difference was statistically significant. We found that in most cases replacing underperforming managers with someone who would have been better did little or nothing to improve overall portfolio performance. We did find, though, that firing team players for poor individual performance and replacing them with managers with higher Sharpe ratios seriously degraded the performance of the portfolio. Click here for full article We examine how Amaranth, a respected, diversified multi-strategy hedge fund, could have lost 65 of its 9.2 billion assets in a little over a week. To do so, we take the publicly reported information on the funds Natural Gas positions as well as its recent gains and losses to infer the sizing of the funds energy strategies. We find that as of the end of August, the funds likely daily volatility due to energy trading was about 2. The funds losses on 91506 were likely a 9-standard-devation event. We discuss how the funds strategies were economically defensible in providing liquidity to physical Natural Gas producers and merchants, but find that like Long Term Capital Management, the magnitude of Amaranths energy position-taking was inappropriate relative to its capital base. Click here for full article Although commodity markets have been around for centuries, investors interest in them has always been quite limited. Over the last few years, however, this has changed completely. Commodities have very quickly become very popular and investment in commodities is growing at an unprecedented rate. It is estimated that over the past few years (institutional) investors have poured 75 billion into commodities and according to a recent institutional investor survey by Barclays Capital, many institutions expect to significantly increase their commodity exposure further over the next three years1. After initially taking a somewhat reserved view on the commodity investment boom, the supply side is rolling out a whole range of commodity-linked products funds, ETFs, trackers, and all kinds of structured products. Given investors appetite for and the very healthy profit margins earned on these products, the end of the boom may not be in sight yet. Click here for full article New research by CISDM and the Barclay Group examines the early reporting habits of hedge funds and CTAs. In the article, Early Reporting Effects on Hedge Fund and CTA Returns, published in the Journal of Alternative Investments, Fall 2006 issue, it is shown that hedge funds and to a lesser extent CTAs who delay reporting returns often report lower performance than those who report early. Hedge fund and CTA indices published by the Barclay Group are used to demonstrate the differences between early estimates and final numbers. Each month, Barclays provides an early estimate (usually within the first week of the month) of the previous months returns by strategy based on reporting managers. Typically within weeks following the early estimate, Barclays provides a final estimate for the previous months hedge fund andor CTA index returns. Note that hedge fund and CTA fundmanager returns are reported in the month following the actual month of performance. This provides enough time for firms to properly calculate returns using various administrative reporting services and report them (if desired) to several of the existing hedge fund databases. The Barclay group is one of several firms or organizations currently reporting hedge fund and CTA returns on the industry. Other major hedge fund and CTA index reporting organizations include CISDM and HFR. While some overlap exists among databases managed by various firms and organizations, past research (Jones, 2005) has shown that each database differs as to reporting managers (approximately 50). Click here for full article In this paper we study the multivariate return properties of a large variety of commodity futures. We find that between commodity groupings (such as metals, energy, etc.) correlations are very low and mostly insignificant whereas within groups they tend to be much stronger. In addition, commodity futures are roughly uncorrelated with stocks and bonds. Still, correlations may vary somewhat over the different phases of the business cycle, suggesting that not all commodities make equally good diversifiers at all times. Copula-based tests do not indicate any deviant behaviour in the tails of the joint return distribution of commodity futures and stocks or bonds. Contrary to equities and bonds, we show that commodity futures returns are positively correlated with unexpected inflation (i. e. 25 on average with CPI inflation as opposed to 30 for equities and 50 for bonds). There are significant differences between the various commodities, however, with energy, metals, cattle, and sugar offering the best hedging potential. Altogether, assuming that the observed regularities will persist, our results confirm that a well-balanced commodity futures portfolio could offer a worthwhile diversification service to the typical traditional investment portfolio. Click here for full article In this chapter, we introduce readers to commodity (natural resource) futures programs. We begin the chapter by describing the present investment landscape as one where return compression in a number of popular hedge fund strategies has led absolute-return investors to investigate other promising return sources. This includes the highly volatile natural-resource markets, which Lammey (2004) describes as a paradise for speculators. The second section of the chapter discusses how (real) spot commodity prices have been in a long-term secular decline, which has meant that in the past, most arguments for investing in commodities have had to rely on one of the two following rationales. An investment in a commodity futures program has had to (1) capture cyclical opportunities, or (2) provide an inherent risk premium that has only been available in certain futures markets. This latter concept is admittedly esoteric and will be explained later in this chapter. In the chapters third section we will argue that current commodity investment programs, which are designed to either capture cyclical opportunities or monetize risk premia, are still valid in the current environment. But we will further note that one can also make a plausible case for investing in commodities based on increases in spot commodity prices. The 1990s were marked by a series of unusually favorable supply shocks, which may not be the case going forward, as ONeill of Goldman Sachs et al. (2004) have warned. In the concluding section of the article, we will outline the risk management requirements for a commodity investment program, given that absolute-return investors require that hedge funds control downside risk rather than just capture the premium of the asset class, as Ineichen of UBS (2003) has explained. Click here for full article Optimizing fund growth maximizes fund value. We argue that growth in fund size results from managerial skill. To test this argument, we estimate a model that links fund growth to performance characteristics. We use the model to isolate significant performance characteristics, and then confirm that the model has predictive power out-of-sample. This predictive ability suggests that a manger can employ strategies to optimize his funds size and hence maximize overall fund value, thus demonstrating skill. In November, we discussed risk modeling of credit spreads. We raised two broad questions. First, we asked which market should we look to for information. And when credit is traded in more than one market, should we choose the one with the greatest liquidity, or the one that most closely matches our position Second, we asked what made a time series useful as a risk factor, and whether we could choose among a variety of definitions of spread to obtain the best properties for forecasting purposes. A third question we could have asked, but did not, was how we should model the volatility once we had obtained a useful time series. We picked up that question in our December note. In this note, we ask the first two questions again, but for futures contracts rather than credit spreads. As we will discuss, there are modeling choices we have applied for a long time which, while serving us well broadly, are in fact questionable in specific cases. Moreover, it is never a bad thing to return to models that have been around a while, and revisit the thinking that led us to those choices in the past. We examine the role of backwardation in the performance of passive long positions in soybeans, corn and wheat futures over the period, 1950 to 2004. We find that over this period, backwardation has been highly predictive of the return of a passive long futures position when measured over long investment horizons. The share of return variance explained by backwardation rises from 24 at a one-year horizon to 64 using five-year time periods. A historical examination of soybean production and trading suggests that the profitability of a passive long soybean position during the early part of our sample may have resulted from inadequate inventories and storage facilities at the time. These conditions created the conditions for demand-driven price spikes. Further, the thin margins of soybean processors likely increased hedging demand. The implications for commodity investing are considered. Click here for full article In this paper we study the univariate return properties of a large variety of commodity futures. Our analysis shows that the volatility of commodity futures is comparable to that of US large cap stocks. Yet, with the exception of energy, a consistently positive risk premium is lacking in commodity futures. We also find that for many commodities, futures returns and volatility can vary considerably over different phases of the business cycle, under different monetary conditions as well as with the shape of the futures curve. Skewness in commodity futures returns is largely insignificant, whereas kurtosis is significantly positive and comparable to that of US large cap stocks. In almost all commodities we find significant degrees of autocorrelation, which affects the properties of longer horizon returns. Click here for full article In this paper we use the hedge fund return replication technique recently introduced by Kat and Palaro (2005) to evaluate the net-of-fee performance of 1917 individual hedge funds. Comparing fund returns with the returns on dynamic futures trading strategies with the same risk and dependence characteristics, we find that no more than 17.7 of the hedge funds in our sample beat the benchmark. In other words, the majority of hedge funds have not provided their investors with returns, which they could not have generated themselves by mechanically trading SP 500, T-bond and Eurodollar futures. Over time, we observe a substantial deterioration in overall hedge fund performance. In addition, we find a tendency for the performance of successful funds to deteriorate over time. This supports the hypothesis that increased assets under management endanger future performance. Click here for full article January 5, 2006 - NEW YORK - Strategic Financial Solutions, LLC, (SFS) creator of the worlds leading asset allocation and investment analysis software, the PerTrac Desktop Analytical Platform, is pleased to present the aggregate results of the 2005 SFS Hedge Fund Database Study, an annual report that aims to shed additional light on the hedge fund industry. Click here for full article The risk-adjusted returns since inception of most hedge fund indices have been enhanced by a favorable environment and could be susceptible to a decrease in market risk appetite. However, this vulnerability is not uniform managed futures strategies have proven more robust than other hedge fund strategies, yielding positive returns under both risk-seeking and risk-averse conditions. Risk-averse periods tend to cluster and therefore the current state of market risk appetite provides information about the future state of market risk appetite. These effects in combination mean that it is possible to enhance portfolio performance by combining a measure of risk aversion with allocations to the managed futures space. Click here for full article In this paper, we attempt to fill this gap by developing a fundamental framework to project future market volatility. We then apply it to current conditions, expecting in 2006 a rebound in market volatility from depressed levels, but with high volatility delayed to 2007-08. We draw implication for asset returns, active returns, and for what policy markets should be looking out for. We come up with some expected results, but also with quite a few surprises (at least to us). Among these are that leverage by investors tends to lag, rather than lead market volatility that corporate leverage and macroeconomic volatility are more causally related to market volatility that hedge funds seem very reluctant to raise leverage, in contrast to banks and that active investors tend to do poorly when volatility rises unexpectedly. Click here for full article The Sharpe ratio is a statistic which aims to sum up the desirability of a risky investment strategy or instrument by dividing the average period return in excess of the risk-free rate by the standard deviation of the return generating process. Devised in 1966 as a measure of performance for mutual funds, it undoubtedly has some value as a measure of strategy quality, but it also has several crucial limitations (see Sharpe 1994 for a recent restatement and review of its principles). Furthermore, its widespread and often indiscriminate adoption as a quality measure is leading to distortion of proper investment priorities, as investment firms manipulate strategies and data to maximise it. Click here for full article Over 1,000 representatives from 650 firms completed the 2005 Deutsche Bank Alternative Investment Survey. These 650 investors represent 645 billion dollars in direct hedge fund assets, which we estimate is nearly two-thirds of all assets in the hedge fund industry. We asked each respondent to categorize themselves as a fund of funds, bank, corporation, consultant, insurance company, pension, endowment, foundation, family office or high net worth individual. We received responses from all these investor types, with a particularly strong showing from pensions, endowments and foundations, comprising 18 of respondents. Family offices and high net worth individuals are also well represented, at 15. Funds of funds represent the largest group, with 43 of all responses. We polled investors from all over the world, with roughly half from the United States and more than a third from Europe. Click here for full article Two studies, by Watson Wyatt and UBS (both from March 2005), give a pessimistic view of the hedge fund industrys capacity to generate long-term returns, due to its increasing size. Unfortunately, these studies focus almost exclusively on alpha. In the present paper, we show the importance of considering not only the exposure to the market (the traditional beta), but also the other exposures (the alternative betas) to cover all the sources of hedge fund returns. To do so, we examine the real extent to which the variability and level of hedge fund returns are affected by (static) betas, dynamic betas (i. e. factor timing), and pure alpha (i. e. security selection). Click here for full article Over the last 10 years hedge funds have become very popular with high net worth investors and are currently well on their way to acquire a significant allocation from many institutional investors as well. The growing popularity of hedge funds and the availability of various hedge fund databases have spawned several hundreds of academic research papers on various aspects of the hedge fund industry and especially the risk-return performance of hedge funds and fund of funds. Many of these papers apply methods, like standard mean-variance and Sharpe ratio analysis for example, which are ill-suited for the analysis of hedge funds returns and have, as a result, produced incorrect conclusions. Fortunately, some studies have taken a more sophisticated approach and have made it clear that hedge fund returns are not really superior to the returns on traditional asset classes, but primarily just different. With hedge fund performance getting worse every year, the hedge fund industry has come to more or less the same conclusion. Unlike in the early days, hedge funds are no longer sold on the promise of superior performance, but more and more on the back of a diversification argument: due to their low correlation with stocks and bonds, hedge funds can significantly reduce the risk (as measured by the standard deviation) of a traditional investment portfolio without giving up expected return. Once we accept that hedge fund returns are not superior, but just different, the obvious next question is: is it possible to generate hedge fund-like returns ourselves by mechanically trading stocks and bonds (either in the cash or futures markets) Although hedge fund managers typically put a lot of effort into generating their returns, maybe it is possible to generate very similar returns in a much more mechanical way and with a lot less effort. If it is, we may be able to do without expensive hedge fund managers and all the hassle, including the due diligence, the lack of liquidity, the lack of transparency, the lack of capacity, and the fear for style drift, which comes with investing in hedge funds. There might well be more than one road leading to Rome. Based on earlier work into hedge fund return replication by Amin and Kat (2003), we have done a lot of research in this area, which has lead to the development of a 3 general procedure that allows us to design simple trading strategies in stock index, bond, currency and interest rate futures that generate returns with statistical properties that are very similar to those of hedge funds, or any other type of managed fund for that matter. In what follows, we briefly describe this procedure as well as provide some examples of the procedures amazing results. Click here for full article U. S. stock market from 1986 through 2002. While the falling knives we identified did post a relatively high bankruptcy rate over the three-year period following their initial drop, they also outperformed the SP 500 by wide margins. We followed up our study of U. S.-based falling knives by extending our falling knife analysis to markets outside the United States - and we concluded that non-U. S. knives also tended to outdistance their benchmarks. Whats new in this paper First, we study both U. S. and non-U. S. falling knives over a synchronized time period: 1980 through the end of 2003. As a result, our analysis now includes many falling knives that were generated in 2000, when the generally high valuation levels of the late 1990s began to wind down amid the collapse of the technology stock bubble. We also take an in-depth look at falling knives over time, by sector, and - for non-U. S. knives - on a country-by-country basis. In addition, we test market capitalization and enterprise-value-to-sales ratios as possible predictors of falling knife performance. Click here for full article Demographics, climate change, debt problems, deficit worries: the list of potential life changing events goes on. Yet there is one other decision that could overwhelm all these. If Asia - from Japan to China - formally begins to use the US dollar as their standard of value it will change the outlook for asset prices for decades to come. The idea is not fantasy. Chinas latest infusion of cash into State banks suggests that floating the RMB may not be as high on the political agenda as some hope. Moreover, the long-term Yen outlook looks far from assured. A simple pan-Asian dollar fix would drive Asian asset prices sky-high. And its happened before: Japan fixed to the US dollar in 1949 at Y360 and Hong Kong fixed in 1983 at HK7.80. Both markets subsequently enjoyed sharp increases in asset prices. Click here for full article Hedge funds have become increasingly popular among institutional investors due to their potential for generating positive returns in any market environment. The recent growth in the number, style, and complexity of these investments has increased the importance of the fund-offunds service provider. More recently, investable hedge fund indices have emerged to represent a quasi-passive low-cost beta approach to hedge fund investing. On the other hand, fund-of-funds are being relied upon to provide manager selection, due diligence, asset allocation, and riskmonitoring advice to institutional investors who are resource-constrained they are viewed as an active alpha-producing investment when compared with rules-based hedge fund indices. In this paper, we outline the theoretical and practical challenges of applying an investable index-based approach to an actively managed hedge fund industry, and seek to identify the potential value that fund-of-funds may provide. Click here for full article In February 2004, Everest Capital authored a White Paper titled The Continuing Case for Emerging Markets highlighting our positive outlook for emerging markets equities. We revisit our thesis below, and reiterate our favorable view for the performance of the asset class. Click here for full article In this article, we describe the reasons traditional performance evaluation approaches do not work-for traditional investments as well as hedge funds. However, unlike previous articles that have simply documented the problems, we offer a solution: Namely, performance evaluation in general, and hedge fund performance evaluation in particular, should be viewed as a hypothesis test where we assess the validity of the hypothesis Performance is good. To accept or reject this hypothesis, the textbooks say you should construct all of the possible outcomes and see where the actual performance result falls. If the observed performance is toward the top of all of the possibilities, the hypothesis is correct, and performance is good. Otherwise, it is not. In other words, the hypothesis test gives us a chance to determine if a manager truly has the skill to outperform a group of monkeys randomly playing the same game. Click here for full article The two most remarkable features in financial markets in recent years have been the plunge in stock market volatility and the bull market in credits. Together they have helped to sustain high valuation levels across world equity markets. Yet the two features are closely linked: their common factor being monetary policy, or more accurately monetary stability. In short, low currency market volatility has led to low stock market volatility, which, in turn, has fuelled the appetite for credit. We argue in this report that the world economy is operating two monetary standards. One looks rock steady the other appears close to change. The bottom line is that financial markets may be nearer to the fault line than most investors believe. Volatility could jump and credits blow out. Click here for full article Hedge funds do not easily fit into the current way institutions go about investing. Based on a survey of recent academic and practitioner research, this article reviews six competing frameworks for how to incorporate hedge funds in institutional portfolios. Each framework has very different implications for institutional asset allocation, manager selection, and benchmarking. Click here for full article Investable Hedge Fund Indices (IHFIs) have grown in numbers since the first meaningful introduction of these during 2003. While making their presence wide spread through a number of main providers, investors have been left with the task of considering whether or not IHFIs achieve in practice a better if not outright alternative to established Hedge Funds of Funds (HFOFs ). What the assessments provided by this report show is that IHFIs are not very different to HFOFs and in many ways HFOFs remain a more viable alternative. Large dispersions are shown to exist for the same types of Hedge Fund Strategies amongst the different IHFI providers. The subscription and redemption costs, notice periods and annual fees make the actual performance which investors can expect to realise from Buy and Hold investing, substantially less than that reported for the underlying indices on which the IHFIs are based. In summary, many practical challenges remain open with investing in IHFIs and will require considerable time and resources to shift the vote towards IHFIs away from HFOFs if at all. Click here for full article Longshort equity hedge funds have historically outperformed traditional long equity exposure with lower risk. This is a result of a demonstrated capability by longshort managers to generate alpha via stock selection, rotation in and out of cash and timely shifts in market exposures (e. g. large vs. small capitalization, sector, geography, etc). As a consequence, longshort managers have tended to generate a highly favorable characteristic: a higher correlation to equity markets in rising markets and lower correlation in falling markets (sometimes referred to as an asymmetrical riskreturn profile). Over the past decade, assets under management by longshort equity hedge funds have grown more than 20 annually. This expansion was the most rapid of any hedge fund strategy and longshort managers have displaced global macro funds to claim the largest share of industry assets. Although a portion of this growth in longshort assets was attributable to market appreciation, the demonstrated ability of the managers themselves was also a key factor stimulating inflows. In my view, the optimum portfolio allocation should include adequate doses of unconstrained longshort managers in lieu of passive or active long equity exposure. Indeed, if one relies solely on the historical performance record, longshort managers would entirely displace traditional long-only managers. This view holds up even when longshort manager returns are liberally adjusted downward to reflect possible survivor bias. And while there is no guarantee that longshort manager performance will hold up in the future, it would take a severe deterioration in manager capabilities to justify no allocation, in my opinion. There is no one preeminent asset allocation scheme for delineating the role of longshort hedge funds in portfolios-it depends on an investors current positions and portfolio management structure. Approaches include allocating to an aggregate longshort category and populating the space with generalist managers that invest broadly. Alternatively, one can distinguish between geographic markets (developed, emerging, etc) or invest in styles (valuegrowth) as part of the overall equity allocation. In this article, I make the case for incorporating the alpha-generating capabilities and the implicit beta exposure of longshort managers explicitly in the asset allocation process. The first section reviews the evolution of longshort hedge funds. The performance characteristics of the longshort managers are then reviewed in the second section. The third section describes the basic determinants of longshort manager returns. This is followed by an analysis of what allocations to longshort managers might make sense. The final section discusses the attributes of various longshort managers who specialize in sectors. The key conclusion is that longshort managers have a demonstrated ability to outperform on a risk-adjusted basis compared to most long-only vehicles. I believe substantial allocations to these managers are appropriate regardless of whether one views them as a substitute for active equity managers or as a stand-alone hedge fund strategy. Click here for full article Anjilvel et al 2001 emphasize the alpha advantage of hedge fund managers. They write, Our research has shown that a significant proportion of the total return to hedge funds in the past has been alpha, in contrast with a small negative total alpha for mutual funds . They hypothesize, One possible explanation for an alpha advantage. is that. the active managers can forecast expected returns better than others. This means a significant ability to exploit market inefficiencies to outperform their benchmarks, presumably by virtue of skill, knowledge, and insight. This view of hedge fund management has a direct impact on the potential capacity of the hedge fund industry. To figure out the capacity of the hedge fund industry, we start by quoting from Cochrane 1999: . the average investor must hold the market so portfolio decisions must be driven by differences between an investor and the average investor. If hedge funds are exploiting market inefficiencies, this means that other investors are supplying those inefficiencies. This means that, unfortunately, we cant all profit from exploiting inefficiencies. Therefore, there is a natural cap on the potential size of the hedge fund industry, assuming that hedge funds are indeed exploiting inefficiencies rather than taking in risk premiums. Click here for full article We construct an equally-weighted index of commodity futures monthly returns over the period between July of 1959 and December of 2004 in order to study simple properties of commodity futures as an asset class. Fully-collateralized commodity futures have historically offered the same return and Sharpe ratio as equities. While the risk premium on commodity futures is essentially the same as equities, commodity futures returns are negatively correlated with equity returns and bond returns. The negative correlation between commodity futures and the other asset classes is due, in significant part, to different behavior over the business cycle. In addition, commodity futures are positively correlated with inflation, unexpected inflation, and changes in expected inflation. Click here for full article This paper incorporates investor preferences for return distributions higher moments into a Polynomial Goal Programming (PGP) optimisation model. This allows us to solve for multiple competing hedge fund allocation objectives within a mean-variance-skewness-kurtosis framework. Our empirical analysis underlines the existence of significant differences in the return behaviour of different hedge fund strategies. Irrespective of investor preferences, the PGP optimal portfolios contain hardly any allocation to longshort equity, distressed securities, and emerging markets funds. Equity market neutral and global macro funds on the other hand tend to receive very high allocations, primarily due to their low co-variance, high co-skewness and low co-kurtosis properties. More specifically, equity market neutral funds act as volatility and kurtosis reducers, while global macro funds act as portfolio skewness enhancers. In PGP optimal portfolios of stocks, bonds, and hedge funds, where equity exposure tends to be traded off for hedge fund exposure, we observe a similar preference for equity market neutral and global macro funds. Click here for full article Illiquidity is a common feature of alternative investments, but the diversity of hedge fund investments - including OTC derivatives - present special challenges. Hilary Till of Premia Capital Management reviews developments in quantitative techniques for evaluating the effect on performance. Click here for full article OneChicago, LLC has asked Gardner Carton Douglas LLP to summarize the regulatory implications for funds and their advisors of investing or trading in security futures products (SFPs). SFPs are unique in that they are both securities and futures. Funds and investment managers must understand how the use of SFPs may affect their existing registrations andor exemptions or trigger the need for new registrations or exemptions. To navigate the analysis, we have created separate links for each type of fund or advisor. To view a summary of the regulatory implications of using SFPs, click on to the link that corresponds to the situation that is relevant to you. Of course, if more than one situation is relevant to you, you should review each relevant link. The accompanying regulatory analysis is not intended to be exhaustive. It does not include an analysis of the implications of using SFPs under the Securities Act of 1933 or Securities Exchange Act of 1934. Further, this analysis is not legal advice, which may often turn on specific facts. Readers should seek specific legal advice from qualified counsel before acting with regard to the subjects mentioned here. Click here for full article Some investors who are unfamiliar with managed futures are nervous about the volatility of the asset class. Unbeknownst to them, they may be missing an opportunity to reduce the overall risk of loss in their investment portfolios. Historically, diversified investment portfolios perform better and are less volatile when they include managed futures investments. Considering that returns from managed futures tend to be highly volatile, these assertions are counterintuitive. A clearer understanding of how this happens is obtained by studying the nature of managed futures returns and their correlation to stocks and bonds, especially during times of stress for financial markets. Click here for full article The paper tests the performance of 2894 hedge funds in a time period that encompasses unambiguously bullish and bearish trends whose pivot is commonly set at March 2000. Our database proves to be fairly trustable with respect to the most important biases in hedge fund studies, despite the high attrition rate of funds observed in the down market. We apply an original ten-factor composite performance model that achieves very significance levels. The analysis of performance indicates that most hedge funds significantly out-performed the market during the whole test period, mostly thanks to the bullish sub-period. In contrast, no significant under-performance of individual hedge fund strategies is observed when markets headed south. The analysis of persistence yields very similar results, with most of the predictability being found among middle performers during the bullish period. However, the Market Neutral strategy represents a remarkable exception, as abnormal performance is sustained throughtout and significant persistence can be found between the 20 and 69 best performers in this category, probably thanks to an extreme adaptability and a very active investment behavior. Click here for full article Emerging markets have not yet fully made their way back onto investors radar screens. Those who have not looked at the asset class since the turmoil of the late 1990s may be surprised by what they find a mere five years later. Largely unnoticed, emerging markets have outperformed developed markets over the past one-, three - and five-year periods. Investment inflows into the asset class finally showed renewed signs of life in late 2003, following net outflows over the previous five years. This lack of investor interest was in stark contrast to the acceleration of foreign direct investment (FDI) during the same period. Click here for full article The paper highlights the inadequacies of the traditional RAPMs (Risk-Adjusted Performance Measures) and proposes AIRAP (Alternative Investments Risk Adjusted Performance), based on Expected Utility theory, as a RAPM better suited to Alternative Investments. AIRAP is the implied certain return that a risk-averse investor would trade off for holding risky assets. AIRAP captures the full distribution, penalizes for volatility and leverage, is customizable by risk aversion, works with negative mean returns, eschews moment estimation or convergence requirements and can dovetail with stressed scenarios or regime-switching models. A modified Sharpe Ratio is proposed. The results are contrasted with Sharpe, Treynor and Jensen rankings to show significant divergence. Evidence of non-normality and the tradeoff between mean-variance merits vis--vis high moment risks is noted. The dependence of optimal leverage on risk aversion and track record is noted. The results have implications for manager selection and fund of hedge funds portfolio construction. Click here for full article Milind Sharma, Merrill Lynch A Detailed Analysis of the Construction Methods and Management Principles of Hedge Fund Indices - Are All Hedge Fund Indices Created Equal His analysis highlights the strengths and weaknesses of the various hedge fund indices available in the market. Click here for full article Marc Goodman, Kenneth Shewer and Richard Horwitz make the case that the style-based tailwinds that equity hedge funds have enjoyed over the past few years will shift, and could become dangerous headwinds for the unaware investor. Click here for full article Marc Goodman, Kenneth Shewer and Richard Horwitz explore whether hedge funds and fund of funds provide risk-efficient diversification, and how institutional investors can best allocate assets to achieve a superior riskreturn relationship. Click here for full article Hedge Funds are seen as an alternative asset class, but what does this really mean We argue in this report that the long-run returns from hedge funds should differ little from other financial assets. However, their risk characteristics are significantly different, particularly when differentiated by their investment style. It is this characteristic that distinguishes them from conventional assets. Hedge funds are not higher risk and they are not necessarily lower risk: they simply have a different risk profile. As such they should be part of every asset allocation. Click here for full article There are two ways to make money in financial markets. Beta - One way to make money in financial markets is to take on a systematic risk for which the market compensates you. This type of risk is known as beta. For instance, equities have a higher expected return than cash over time for the simple reason that they are a more risky investment than cash. The same is true of long duration bonds versus cash, corporate bonds versus treasuries, mortgages versus treasuries, emerging market debt versus developed market debt, etc. At any given point in time, risky financial assets may be expensive or cheap, but over time, they should return more than less risky assets. Betas are easy to capture (i. e. nave investment strategies can capture betas). Over significant periods of time, betas have positive returns. However, they have low return to risk ratios (we estimate that, over long time-frames, betas have annual Sharpe ratios ranging from 0.2 to 0.3), and for the most part, they are correlated to one another (in part because risk itself is inherent in each of them). Alpha - The other way to make money in financial markets is by taking it away from other market participants. This is known as alpha. Alpha is zero-sum. For every buyer, there is a seller, and so for every alpha trade, there is both a winner and a loser. Examples of alpha strategies include market-timing and active security selection. Only investors who are smarter than the market will be able to reliably provide alpha. Click here for full article The recovery seen in the Japanese market over the last couple of months begs the question, is this the start of a new secular bull market or a cyclical uplift in the extraordinary oversold position we saw at the end of the fiscal year We do not have the definitive answer. Fortunately as a hedge fund of funds, we do not need to time our entry into the market but to be positioned to protect funds regardless of market direction and to make money where we can. We are, however, in a position to reflect on some of the prevalent views amongst our own managers and make some observations of our own. Click here for full article As the speculative bubble of 98-99 gave way to the bear market of 00-01, pension sponsors found that traditional diversification methods have not hedged as much of the market decline as hoped - providing little absolute return protection. In particular, pension surpluses have been shrinking to the point where many organizations will be faced with a need to contribute additional funds to their pension plans just as their earnings are falling due to the economic slow-down. Therefore, its not surprising that investors are increasingly drawn to a new strategy thats relatively unaffected by the markets and the economic environment: market neutral investing. With strong positive returns and low levels of volatility, market neutral strategies are making their way into the asset allocation plans of a growing number of institutional and other qualified investors. Incorporating investment techniques that, in isolation, have historically been considered risky, investors are discovering that certain market neutral strategies are, in fact, less risky than traditional equity investments. Click here for full article I extend the classical market timing model of Merton (1981) to the case of multiple risk factors and show that the equilibrium value of a market timers forecasting ability can be written more generally as a weighted-sum of Arrow-Debreu-type contingent claim prices. Following these results I develop a class of return-based parametric tests to evaluate the ability of a portfolio manager to time multiple markets. I apply these tests to evaluate the performance of fund of funds hedge fund managers. I show that, both individually and on aggregate, fund of funds managers do not exhibit timing ability with respect to a variety of hedge fund styles. However, I argue that this result is due to frictions created by the hedge funds into which these vehicles invest. Click here for full article This paper attempts to evaluate the out-of-sample performance of an improved estimator of the covariance structure of hedge fund index returns, focusing on its use for optimal portfolio selection. Using data from CSFB-Tremont hedge fund indices, we find that ex-post volatility of minimum variance portfolios generated using implicit factor based estimation techniques is between 1.5 and 6 times lower than that of a value-weighted benchmark, such differences being both economically and statistically significant. This strongly indicates that optimal inclusion of hedge funds in an investor portfolio can potentially generate a dramatic decrease in the portfolio volatility on an out-of-sample basis. Differences in mean returns, on the other hand, are not statistically significant, suggesting that the improvement in terms of risk control does not necessarily come at the cost of lower expected returns. Click here for full article That hedge funds have started to gain widespread acceptance while remaining a somewhat mysterious asset class enhances the need for better measurement and benchmarking of their performance. One serious problem is that existing hedge fund indices provide a somewhat confusing picture of the investment universe. In this paper, we present detailed evidence of strong heterogeneity in the information conveyed by competing indices. We also attempt to provide remedies to the problem and suggest various methodologies designed to help build a pure style index, or index of the indices, for a given style. Finally, we present evidence of the ability of pure style indices to improve benchmarking of hedge fund returns. Our results can be extended to traditional investment styles such as growthvalue, small caplarge cap. Click here for full article A key measure of track record quality and strategy riskiness in the managed futures industry is drawdown, which measures the decline in net asset value from the historic high point. In this discussion we want to look at its strengths and weaknesses as a summary statistic, and examine some of its frequently overlooked features. Click here for full article The growth in demand for hedge funds since 1995 has been significant. During this period, the assets invested in hedge funds grew from an estimated 100 billion to over 500 billion. Ultimately, the sustainability of this growth depends upon the relative and absolute investment performance ofthe hedge fund industry. Hedge funds provide sophisticated investors with access to virtually every investable asset class combined with the expertise needed to manage these complex investments. These investors receive positive returns, enhanced diversification when combined with stocks and bonds, low volatility, and protection against significant drawdowns..This paper discusses systematic trend following, a hedge fund style that has a 20 year track record of producing positive annual returns with low to negative correlation to most other asset classes and hedge fund strategies. Exhibit I compares the ZCMMAR Trend Following Index versus the SP 500 and the Lehman Treasury Bond Index since 1983. Click here for full article Hilary Till continues in the spirit of her August 2002 Quantitative Finance feature on measuring risk-adjusted returns in alternative investments. Click here for full article In this paper we study the possible role of managed futures in portfolios of stocks, bonds and hedge funds. We find that allocating to managed futures allow investors to achieve a very substantial degree of overall risk reduction at limited costs. Apart from their lower expected return, managed futures appear to be more effective diversifiers than hedge funds. Adding managed futures to a portfolio of stocks and bonds will reduce that portfolios standard deviation more and quicker than hedge funds will, and without the undesirable side-effects on skewness and kurtosis. Overall portfolio standard deviation can be reduced further by combining both hedge funds and managed futures with stocks and bonds. As long as at least 45-50 of the alternatives allocation is allocated to managed futures, this again will not have any negative sideeffects on skewness and kurtosis. Click here for full article There are many benefits to investing in hedge funds, particularly when using a diversified multi-strategy approach. Over the recent years, multi-strategy funds of hedge funds have flourished and are now the favorite investment vehicles of institutional investors to discover the world of alternative investments. More recently, funds of hedge funds that specialize within an investment style have also emerged. Both types of funds put forward their ability to diversify risks by spreading them over several managers. However, diversifying a hedge fund portfolio also raises a number of issues, such as the optimal number of hedge funds to really benefit from diversification, and the influence of diversification on the various statistics of the return distribution (e. g. expected return, skewness, kurtosis, correlation with traditional asset classes, value at risk and other tail statistics). In this paper, using a large database of hedge funds over the 1990-2001 period, we study the impact of diversification on naively constructed (randomly chosen and equally weighted) hedge fund portfolios. We also provide some insight into style diversification benefits, as well as the inter-temporal evolution of diversification effects on hedge funds. Click here for full article Franccedilois-Serge Lhabitant and Michelle Learned Thunderbird, the American Graduate School of International Management Managed Futures: A Real Alternative Managed Futures investments performed well during the global liquidity crisis of August 1998. In contrast to other alternative investment strategies, the performance of Managed Futures was good in that year and had once more demonstrated their diversification potential. More assets did subsequently flow into Managed Futures, but 1999 did turn out to be one of the worst performing years for the industry. Since then, the performance as well as the acceptance of Managed Futures has improved. As the global stock markets are declining, an increasing number of investors is getting attracted to the strategy. The following article will take a closer look at this asset class. Click here for full article The popular perception is that hedge funds follow a reasonably well defined market-neutral investment style. While this long - short investment strategy may have characterized the first hedge funds, today hedge funds are a reasonably heterogeneous group. They are better defined in terms of their freedom from the constraints imposed by the Investment Company Act of 1940, than they are by the particular style of investment. We study the monthly return history of hedge funds over the period 1989 through to January 2000 and find that there are in fact a number of distinct styles of management. We find that differences in investment style contribute about 20 percent of the cross sectional variability in hedge fund performance. This result is consistent across the years of our sample and is robust to the way in which we determine investment style. We conclude that appropriate style analysis and style management are crucial to success for investors looking to invest in this market. Click here for full article We study the diversification effects from introducing hedge funds into a traditional portfolio of stocks and bonds. Our results make it clear that in terms of skewness and kurtosis equity and hedge funds do not combine very well. Although the inclusion of hedge funds may significantly improve a portfolios mean-variance characteristics, it can also be expected to lead to significantly lower skewness as well as higher kurtosis. This means that the case for hedge funds includes a definite trade-off between profit and loss potential. Our results also emphasize that to have at least some impact on the overall portfolio, investors will have to make an allocation to hedge funds which by far exceeds the typical 1-5 that many institutions are currently considering. Click here for full article This column will discuss the state of the art in applying returns-based analyses to hedge funds. It will pay particular attention to those hedge fund strategies where the use of derivatives and dynamic trading strategies can lead to highly assymetric outcomes. Click here for full article Hedge funds and other actively managed strategies contain two fundamental sources of risk: 1) Systematic risk - the risk associated with exposure to market-wide influences such as the broad equity or fixed-income market, and 2) Active risk - the risk associated with the performance of active managers relative to their market benchmarks. The conventional asset allocation approach employed by most plan sponsors and consultants fails to integrate these two sources of risk. This can lead to the formation of inefficient portfolios. In this article we propose a risk allocation framework that focuses on risk exposures instead of asset class exposures. Click here for full article Brett H. Wander and Dennis M. Bein Analytic Investors Private Placement Life Insurance The New Alternative in Insurance Within this report, we attempt to illustrate a simple bridge between hedge fund and insurance language and products, attempting to uncover the edge that exists in combining these fundamental vehicles of traditional and alternative investment worlds. Click here for full article Brad Cole and Christine Kailus Cole Partners Alternative Asset Strategies: Early Performance in Hedge Fund Managers This paper investigates the effects of age on hedge fund performance. In particular, we seek to ascertain whether hedge funds perform better during the early stages of their development. Existing studies seem to lack practicality and conclusiveness, with some studies failing to address adequately the issues of survivor and market biases. Survivor bias results from the tendency of hedge funds with poor performance to drop from available databases, causing industry performance returns to appear better than they are in reality. Market bias suggests that the recent success of many hedge funds results from strong general market performance and not necessarily from hedge fund managers skills. Unfortunately, the lack of complete and consistent data makes addressing these biases difficult. As hedge funds disappear from databases, survivor bias becomes embedded in available data. In addition, since most hedge fund databases only have significant information for the past five to ten years (coincident with one of the strongest U. S. equity market periods) market bias would also seem to be inherent in the data. In order to attempt to address these issues, this study has compiled information from various sources, including deceased funds, to create a more comprehensive database of available hedge fund information. Additionally, hedge fund returns were calculated according to age rather than vintage so that not all early returns come from the same market period. Where appropriate, subsets of this database were used. In all cases, individual hedge fund return data and not hedge fund style or hedge fund index data was used.1 Based upon this data, our conclusion is that despite the biases found in the data, investors may gain enhanced returns by investing in young hedge funds if proper due diligence is completed. Hedge funds under three years of age tend to perform better than do older hedge funds without necessarily adding to the volatility of returns. Click here for full article Given the tremendous rise in hedge fund assets, one of the most common queries we receive from clients today is: Have hedge funds grown to the point where they are no longer the market tail but the entire dog And if hedge funds have become the market dog, does the dog now have fleas That is has the proliferation of hedge funds created yet one more bubble that needs to be popped before the market can resume even a vague semblance of normal behavior Click here for full article Innovative financial engineers in alternative investments are knitting a web of complex interdependencies, yet no one has a masterplan. Click here for full article In a previous article Hillary Till touched upon the difficulty of using standard measures to evaluate certain hedge fund strategies. Here, after reviewing these difficulties, she discusses state-of-the-art solutions. Click here for full article Randy Warsager examines the treasures and the pitfalls awaiting those who make the transition from traditional to hedge fund manager. Click here for full article Selling managed futures to institutional investors is like trying to get the National Bowling Championships on primetime network TV. While the networks are making unprecedented allocations of primetime to sports coverage, bowling gets a continually smaller slice. In fact, Ive heard of one venture capitalist who is buying up all the bowling alleys in the country in order to launch a new craze, Ballroom Hurdle Dancing. Really, it is easy to pick on managed futures. In fact, the only reasons more people are not kicking managed futures is because they are too busy gagging on their distressed debt, high tech and value equity investments. The Barclay Systematic Traders index which some consider to be the core CTA index was -3.63 for 1999 and is -1.70 through September 2000. But is managed futures a strategy that is just out of favor or are the wheels falling off the cart Through a series of interviews with database providers, investors, distributors and managers, we estimate a net outflow of assets due to poor performance and redemptions somewhere between of between 35 to 50 over the last eighteen months. We also feel the number of players has been trimmed by about 30. Our source for these numbers was not purely scientific, but as a 20-year participant in the futures industry, we have had to do some digging - enough to make us believe that this group is truly at a crossroads. Herein, we cut through the carnival of marketing jargon to find the real drivers running CTA-land. Click here for full article Brad Cole, President, Cole Partners Managing Investor Drawdowns Through a Risk Control Plan: A New Model for Evaluating Manager Performance Tushar Chande, President LongView Capital Management, L. L.C. The Benefits of a Long Volatility Investment Approach in a Multi-Fund Portfolio Alan R. Kaufman Chief Investment Officer, Trilogy Capital Management Group, L. L.C. Risk Management: A Practical Approach to Managing a Portfolio of Hedge Funds for a Large Insurance Company Norman Chait, CFA, AIG Global Investment CorporationCase 3: Social Security Crisis Section III: Cost-Benefit Analysis Discounting I: Probability, Expected Values, and Risk10. Discounting II: Time 11. Cost-Benefit Analysis Human societies seem complex. People who study them spend a lot of time comparing differences, and trying to figure out why people do what they do. This is the task of the social sciences, including psychology, sociology, political science, economics, and history. Even though the social sciences, in their current form, have only existed for about a century, we have made lots of progress toward understanding many pieces of the puzzle of human behavior. There is another social science profession which draws on some of the best features of the main disciplines listed above. This profession is called policy analysis. In addition to studying what people actually do, and why, policy analysts establish benchmarks for evaluating those actions. More simply, policy analysis tries to answer two practical questions: First, what would be the best thing to do Second, what is the best result that can actually be achieved . This book is an introduction to both questions. We will examine the way policy analysts conceive of the best policy choice, using the concepts of efficiency and equity. We will also look at the limits and constraints that restrict real policy choices. As with any nascent science, some of the news I will be reporting will be bad. At times, it may appear to the student that real policy analysis is impossible. But dont be dismayed, because good policy analysis is not impossible . It is just hard . I hope the difference will become apparent. In any case, let me be clear from the outset: there is no more important task, in any of the social sciences, than identifying what a good policy would look like. With some idea of what is good, we have some hope of knowing bad, or mediocre, when we see it. We can start with some broad alternatives. Though governments, and nations, are complicated, the fact is that there are only three ways for humans to organize activity: Markets . or decentralized actions by many individuals, whose aggregate implications may be hard to predict or reconcile. Leadership by authority . or people who by virtue of insight or experience know more than the rest of us. Of course, the basis of authority may be simple military power, or savage repression, but even in these cases the authority generally touts his or her vision, intelligence, or judgment. Some collective choice mechanism, or democracy . where all enfranchised citizens register beliefs about what society should do. These beliefs are recorded in some, and the aggregate will of the people is revealed. It appears that something like the market form of organization dominates almost every society in the world. Most activity, after all, takes place in a setting where government acts to limit, rather than to direct, human choices. Markets happen almost spontaneously, requiring only a rudimentary set of property rights definitions, some reasonably accepted medium of exchange, and a legal system for adjudicating disputes. In the absence of government provision of this institutional infrastructure for markets, something mysterious can happen, something not well understood from a scientific perspective. Without any central plan or direction, a dizzying array of conventions, informal rules, or other means of reducing the costs of transactions emerge spontaneously. These institutions for facilitating exchange may be imperfect, but they are neither haphazard nor ineffective. The market places of the ancient Egyptians or Aztecs, the law merchants of the middle ages, and the present day diamond markets of Antwerp and New York are all examples of the spontaneous emergence of institutions which reduced transactions costs and permitted an wide variety of welfare-enhancing exchanges which would have been impossible without markets. On the other hand, the fact that effective private institutions might emerge spontaneously, if we wait and have faith, is hardly proof that we should always count on the deus ex machina of the markets invisible hand. Sometimes, as in Italy in the 8 th and 9 th centuries, or Russia in the late 20 th century, the organizations that emerge in the absence of government control are far from optimal. Incentives are pathological, outcomes are disastrous, and people lose faith in markets. To avoid such missteps, every government in the world manages its markets. In deciding how to set and monitor these regulations, decision-makers rely for guidance on either authorities (the experts in all but the most primitive societies) or democracy in choosing the form that management should take. Some societies manage markets very intensively, taking over many of the markets functions in broad sectors of citizens activities. Others rely on something much closer to the laissez faire . or let (the people) do (as they will), ideal of classical liberalism. Few nations stay with precisely the same set of policies regarding the management of markets for very long, adjusting and reforming their regulatory policies almost every year. Policy analysis helps explain why are there so many differences in the way we organize productive activity. It also helps us judge if some policies are good, and others are bad, by creating benchmarks for comparing the results we observe in one country, or at one point in time, with others. These benchmarks are hypothetical, because perfect policies are never observed, but without a standard of comparison evaluation is impossible. My goal is for the reader of this book to take away two, apparently conflicting ideas about policy analysis: optimism and skepticism. The conflict between these two perspectives drives much of the debate we see in Congress, on talk shows, and in the newspapers. Optimism can mean one of two things. Market-oriented optimists tend to believe that that the world we live in is the best of all possible worlds (a variant of the view espoused by Liebniz, but mocked by Voltaire in Candide ). Regulation-oriented optimists tend to believe that all will turn out well, and expect the best, rather than the worst, outcome from any attempt to redirect market activities in a direction that will make everyone better off. Neither of these two extreme forms of optimism is satisfactory, as a guide to policy choice. As Voltaire said through his artless naiumlf, Candide, optimism of the laissez-faire sort is the mania of maintaining everything is well when we are wretched. (1977 p. 73). On the other hand, many government policies harm, rather than help, but optimists keep trying anyway to reform and improve policies. As Hegel(1832) said, What experience and history teach is thisthat people and governments never have learned anything from history, or acted on principles deduced from it. So, the first theme of this book is simple: the best policy analysts are skeptical optimists. They believe, in principle, that better policies are possible, but any particular proposal with a strong presumption of doubt. More simply, a good policy analyst hopes for the best, but assumes the worst unless her skepticism is disproved. The use of analytic techniques described in this book, including models of incentives, discounting with respect to time, and discounting to account for uncertainty, are all crucial tools for someone who wants to evaluate, and usually reject, the claims of optimists. Another theme, obvious from the title as well as the sequence of chapters, is that I believe there are three conflicting sources of power and legitimacy in policy processes. The power bases are (1) markets, (2) politics, and (3) expertiseauthority. Policy conflicts tend to be dyadic, with some pair of these decision bases clashing over the right course of action. The result is that a policy which answers a conflict between politics and markets may appear irrational or harmful when viewed by policy experts. Policies that reconcile expert-market conflicts may be politically infeasible. Consequently, the first step in understanding a particular policy is to understand what sort of conflict gave rise to the policy in the first place. We will consider each of the three power bases at some length in later chapters. Policies and Institutions Suppose we could establish that some kinds of results, the outcomes of choosing policies for managing markets and directing resources, are better than others. Then we have to face the fundamental dilemma: how should we choose how to choose . Are good outcomes more likely if we rely on the institutionalized judgments of experts, or the aggregated voices of citizens, expressed through votes or surveys This book describes advantages and drawbacks in using expertise and democracy in choosing outcomes, as well as giving the reader some important tools for deciding whether a particular attempt at management, or policy, is good or bad. If it sounds like policy analysis has too many meaningswell, it may Policy analysis defies easy definition, because it is hard to pin down as belonging to any one social science discipline. The simple reason is that no one discipline has all the answers. In fact, no one discipline even has all the right questions . and asking the right questions is the heart of good policy analysis. Policy analysts get blamed for asking hard questions, because they are skeptical. They worry about how much a policy will cost, who will pay those costs, and whether the benefits promised by the policy will ever be delivered. They worry about unintended, and unanticipated, consequences of policy choices. On the other hand, being a policy analyst is one of the best jobs there is. Providing advice to key decision-makers is scary, but it is also exhilarating. Rather than just sitting in a room thinking about theories, or analyzing data, policy analysts have to know about every aspect of the policy being considered, from the theory which got it started to the history of similar programs in other states, or other countries, to the process of implementation and evaluation of the nuts and bolts of the policy itself. At the end of the day, elected officials and appointed bureaucratic leaders have to make decisions. If you the policy analyst dont know the answers, or have the information they need, they are going to make decisions anyway. Worse, decision-makers under pressure may end up listening to some crack-pot who has even less information, but lots more confidence. Everything you know, and everything you think, adds up to make you a better policy analyst. Good luck This book is targeted at undergraduates in public policy programs or political science departments, as well as masters programs in public policy or public administration. programs. There are three distinct goals in these courses: Help students to understand the different roles that policy analysts play. I have served as both an administrator and an instructor in professional policy analysis programs, and will admit the following dirty little secret: Students come in believing that they will learn how to make policy, yet they leave with little knowledge of how policy is made I know from my own experience as a policy analyst in Washington, D. C. and as a consultant in a variety of state and local government analysis projects, that analysis is often an afterthought. Policy analysts have at least two roles, and it is important not to confuse them. Analysts serve sometimes as advocates for a particular perspective, and sometimes as objective searchers for truth. But even if you think that you have found the truth, that doesnt mean that anyone is going to believe you. They probably wont even listen. The reason students must learn the language, tools, and roles of policy analysis is not that by learning they can make policy. Rather, if they dont learn policy analysis they will be ignored, and excluded from the debate altogether. Teach students the basics of the welfare economics paradigm. This includes basic microeconomic theory, the theory of consumer surplus as a metric for measuring welfare gains and losses, and the effects of policy intervention (taxes, subsidies, price restrictions, and standards or rules based regulations). This field has evolved rapidly in the last ten years, and right now there is no text that provides an accessible treatment and overview for the student just getting started. Give a well-grounded introduction to cost-benefit analysis. For students to do cost-benefit analysis on their own, as professionals, they must be intimately familiar with two types of discounting: First, they must understand the idea of expected value, and be able to account for risk. Expected value serves to put alternatives with different risks and payoffs on a common footing, so that these alternatives can be compared and judged. Second, they need to be able to account for time, using the concept of present value, so that accurate judgments can be made in comparing streams of costs or benefits in the future with spending or income today. Accounting for both risk and time allows the professional to arrive at the appropriate discount rate for a project, policy, or activity. Further, a sensitivity analysis, allowing for varying assumptions, can be used to judge how sensitive a conclusion is to particular assumptions. Acknowledgements . I tried out many of the arguments, and examples, in this book over more than a decade of teaching policy analysis and public administration classes at the University of Texas at Austin and the University of North Carolina at Chapel Hill. While there were far too many students with helpful suggestions to name, I should acknowledge just how useful their responses and comments have been in teaching me about policy analysis. Several faculty colleagues have been particularly helpful in guiding me toward useful ideas, and away from foolish ones. Perhaps the most influential are Duncan MacRae, at UNC, and Murray Weidenbaum, at Washington University. Their views of what constitutes good policy are very different, but each in his own way has a level of insight that leaves me feeling both admiration and envy. Further, each conducts himself in a way that sets a high standard for intellectual discourse. Michael Ensley and Melissa Harris provided first rate research assistance at several parts of the process of writing and rewriting, as well as finding obscure information that had eluded me completely. Rebecca Lewis read several chapters, and helped me clarify the ideas I was trying to get across. Brooke Barton read the whole manuscript, and made many useful suggestions for clarification. Jay Hamilton and Brian Sala were the most helpful readers of all, carefully criticizing the whole project as well as many of its parts. Thanks to all. Finally, for Kevin and Brian Munger: Yes, we can go outside now, and play baseball. I get to pitch first, though. 1. An Overview of Policy Analysis as a Profession and a Process Policy . (1) Political wisdom or cunning diplomacy prudence artfulness (2) wise, expedient, or crafty conduct or management (3) any governing principle, plan, or course of action. Analysis . (1) A separating or breaking up of any whole into its parts so as to find out their nature, proportion, function, relationship, etc. (2) A statement of the results of this process (3) An examination of the relations among variables (4) The tracing of things to their source the resolving of knowledge into its original principles. ( Websters New Universal Unabridged Dictionary . New York: Dorset and Baber, 1983) Policy analysis is as old as policy. Everyone has an opinion on policies everyone wants to believe their conclusions are the result of careful and objective analysis. But they are often wrong. As William Fulbright said, We are handicapped by policies based on old myths rather than current realities. Fulbright was referring to U. S. foreign policy, but the same could be said about welfare policies, prison reform, or dozens of other problems. You may have noticed the problem: on most policies, most people think the answer is obvious. But they sometimes disagree about what the obvious answer is. One wonders, of course, if Fulbrights myth is really just what someone else believes. Ones own beliefs, by contrast, are the truth. Clearly, that is no basis for having a debate: we have to be able to say more than you have your opinion and I have mine. We have to say what is right, and what is wrong, or at least make a good guess. Are there good policy analysts How would we know one if we saw one Shakespeare praised Henry V as many things, but not least was old Henry a policy analyst of the first rank: Hear him debate of commonwealth affairs, You would say it hath been in all his study: List his discourse of war, and you shall hear A fearful battle rendered in music: Turn him to any cause of policy, The Gordian knot of it he will unloose, Familiar as his garter that, when he speaks The air, a chartered libertine, is still. Unloosing the Gordian knot is a perfect metaphor for the practice of policy analysis. After all, analysis comes from a Greek word meaning to loosen, or to break up a complex whole into parts that can be understood. The problem is that, for most causes of policy, the Gordian knot resists loosening. In Greek legend, Gordius was a King of Phrygia who tied an intricate, incomprehensible knot. But the knot was of great importance, because the Oracle at Delphi revealed that whoever untied the knot would be the future king of all Asia. Alexander the Great tried, for a time, to untie the knot. Before long, though, he gave up and angrily whacked at the thing with his sword. The rope fell in pieces, Alexander went on to become king of the whole region, and now we all rush out to elect politicians who grossly oversimplify our policy problems. Blame Alexander when Ross Perot says, Listen Its simple The point is that we admire those who can cut the Gordian knot. This is just a colorful way of saying such a person can come up with a quick, simple solution for what seems to be a complex problem. As we shall see, however, this is a fundamental problem in a democracy, because the same sword appears to work for all knots: just cut the darned thing, and get on with it. But every knot is a little different, and if you want to untie the knot, to understand it, you have to have a process for simplifying complex problems, for focusing on parts to get an idea of the nature of the whole. Unfortunately, many of our difficulties, as a city, a state, or a nation, will not be solved with by impatient knot-whacking. Shakespeare was giving Alexander a not so subtle jibe, because King Henry unloosens the knot, actually solving the problem, rather than just slicing through it, which gets rid of the knot but ruins the rope. And there you have the essence of policy analysis: we try to understand the knotty problems of policy, rather than propose simple, universal solutions. This means that policy analysts are not very popular with politicians. Political leaders often feel they were elected to make problems go away, fast, and get on to the next task. A politician elected for a two year term is not likely to have to patience to want to appreciate the uniqueness, depth, and difficulty of the policy being analyzed. Consequently, there is a natural conflict between elected officials, who (probably rightly) see themselves as the delegates of the people, and policy experts who think they know what is right because of an abstract, and in some cases highly developed, theory of cause and effect. All politicians, not just Ross Perot, would like to apply a simple, universal principle, because politics rewards the ability to offer consistent reasons and explanations. It is tempting to think that one should ignore all the complex analyses of experts, and get back to underlying fairly simple reality. On the other hand, expert policy analysts often think of problems in odd ways, because they are reconceiving the problem as they analyze it. Someone familiar with the problem, or with the politics of coalition-building, may find the recommendations of policy analysts ludicrously naive. For example, in the mid-1980s, some analysts who worked for the Social Security Administration, and some Congressional staff analysts, realized that many elderly people would not be able to afford hospital stays in the event of a long-term illness. Because of the federal budget deficit, it was decided that the government could not help for free some charge for the service would have to be levied. For most people, with annual incomes under 30,000, the charge would have amounted to about 4 per month. For those who had high incomes, a maximum fee of 67 per month would be charged. The advantage of the program (or so the analysts thought) was that mandatory membership among the elderly would make the catastrophic coverage, as it was called, a very effective, inexpensive insurance program with benefits that far exceeded the fees paid by most seniors. Well, as soon as the Medicare Catastrophic Coverage Act of 1988 was passed, there was a firestorm of protest. Surprisingly, the protest did not come from young people, whose Social Security taxes would have been subsidizing the below-cost benefits received by the elderly. Instead, it was the supposed beneficiaries, the people the policy analysts thought they were going to help . who raised a ruckus. Seniors were not much concerned with hospital stays they wanted the government to help pay for long-term care, in nursing homes. Further, the fact that the program was (a) mandatory, and (b) not free, was very upsetting to senior citizens on very tight, fixed budgets. The Act was repealed, in its entirety, in 1989. The very people who appeared to be helped by Catastrophic Coverage were the ones who killed it. Not surprisingly, the politicians caught in this politically misguided policy imbroglio were furious at the analysts. It seemed as if the analysts had no idea what real people actually wanted or thought. They just used abstract theory as a guide to what should be done, based on what a rational person should want. The Process of Policy Analysis Policy analysis is a process. More specifically, policy analysis is the process of assessing, and deciding among, alternatives based on their usefulness in satisfying one or more goals or values. Generally, the policy recommendation is made by one person, a decision is made by another entity, and enforcement of the policy actually chosen is left to yet a third person or group. For the sake of clarity, lets consider an example. Suppose you are a policy analyst for a governor of a state in the U. S. Your state has a problem: There are nearly twice as many prisoners as there are normal beds in the state penitentiaries. Up until now, the situation has been handled by putting in temporary cots, so that prison rooms designed for two inmates hold three, or even four, people. But that has to change: A federal court has ordered that prison overcrowding in your state has to be reduced within 30 days. The governor asked you to do an analysis, and make recommendations. It is useful to think of the process of analysis as having five parts: (I) Problem Formulation (II) Selection of Criteria (III) Comparison of Alternatives (IV) Consider Political and Organizational Constraints Lets consider each briefly. I. Problem formulation . The analyst must create a statement of the policy problem to be addressed. The problem often includes, at least implicitly, a theoretical model of causation. This stage includes the listing of available alternatives. One important task for the analyst is the redefinition or creative restatement of the problem in such a way that new alternatives become available. Often, the context that gives rise to the analysis is different from the analytical problem formulation, if the analyst is doing her job right. In our prison-overcrowding example, the context is simply too many prisoners per room. But the problem formulation may be elusive, and controversial. Are there too few prisons If so, more should be built. Are there too many prisoners If so, what is needed are programs to improve economic opportunities, educate under-privileged children, and rehabilitate prisoners to reduce recidivism. There are other possibilities, of course, including a mismatch of sentencing practices and type of crime, or prisons that are too comfortable and attractive to provide deterrence. The point is that the analyst has to be careful. By saying, The problem is that , some alternatives are advantaged, others impaired, and still others ruled out completely. Psychologists call this framing, and it has been shown that the way one frames the question may determine the type of answer you get. Later, we will consider the difference between objective analysis and advocacy for now, just remember that the problem formulation, or the way the policy is conceived or framed by the analyst, has a lot to do with the direction the analysis takes. II. Selection of criteria . Criteria are the bases for judging or choosing. The word comes from the Greek krites . a judge. Once you have selected a way of framing the problem, this immediately suggests some alternative solutions. Criteria are the premises for analysis, for saying that one alternative is better than another. The difficulty, of course, is that one alternative may be superior in satisfying one criterion, but another alternative is better in other ways. Consequently, in the criteria stage the analyst must first specify the list of criteria that are relevant, and then define the trade-offs, or relative importance . of those criteria. This is in many ways an ethical problem, rather than a purely analytic one. Criteria, and their relative importance, are statements about the ethical world-view of the analyst, or of the society the analyst serves. There have been many attempts to guide analysts in choosing criteria. The clearest, yet most useful, guidelines come from MacRae (1993), and MacRae and Whittington (1997). They argue that criteria should themselves satisfy five meta-criteria, which can be paraphrased as follows: Criteria should focus on ends . not means Each criterion should be stated clearly and precisely enough to imply a measure for how well it is satisfied by an alternative All else equal, a set of criteria is better if trade-offs can be quantified The set of criteria should be complete . accounting for all the concerns of all citizens Criteria should address separate aspects of the policy problem, so that satisfaction of each criterion is mutually exclusive To continue our example of prison overcrowding, imagine that we select four criteria:(a) cost (where less is better, all else equal) (b) justice (the sense that the incarcerated person is neither mistreated nor coddled, but is being appropriately punished) (c) space (immediate prison beds freed up by the policy choice) (c) recidivism (fewer repeat offenders is better) III. Comparison of alternatives . The notion of alternatives implies, by definition, at least two courses of action. In terms of our example, we could: Build more prisons Rent prison space from a nearby state Slate nonviolent offenders for early release after they have finished a rehabilitation and job placement program. This conception of alternatives implies that the choice must be mutually exclusive: the selection of one course of action rules out the alternatives. One immediate difficulty with this idea of discrete choice is that the actual choice could be some combination of these policies. For example, we could build one small new prison, rent a little prison space, and focus most of our attention on the rehabilitation program. The problem, of course, is that the choice among alternatives (whether the choice is mutually exclusive, or some combination) requires some assumptions about the trade-offs between criteria. No question about it: this is the hard part. The framing of the problem, identification of alternatives, and the choice of criteria, are all functions that trained analysts can handle. But the choice of one alternative, one policy, requires a knowledge of the values of the polity. Tradeoffs now have to be explicit, because it often happens that one alternative does well on one criterion, but some other alternative is preferable on other grounds. How can we know how much better is enough There is no magic answer, but a good place to start is the criteriaalternatives matrix, or CAM. As you can see in Table 1.1, this matrix is a way of organizing the process of analysis. The CAM sets up a comparison of the performance of alternatives in satisfying different criteria. Alternatives are columns . and criteria are rows . Table 1.1 about here What goes into the cells in the CAM It depends on the kind of information you can get. More specifically, the CAM cell entries depend on the types of measures you can find about the way that the alternatives satisfy the criteria. In general, there are three levels of measurement: Categorical Measures . Values fall in categories, such as male and female, or rural and urban. A CAM analysis is generally not possible with categorical level measures, because there is (by definition ) no basis for saying one category is better than another. You need to be careful, because sometimes categorical measures look like numbers (e. g. rural1, suburban2, small city3, large city4). Not so these numbers are really just names, or shorthand for the categories. You cant say a large city 4 is really four times as much of anything as a rural 1, yet that is what the numbers seem to say. Ordinal Measures: Values can be ranked, from worst to best. However, statements about the size of the difference between alternatives cannot be made. For example, if a group of experts rank one technology for waste disposal as best, you might assign it a 10. The second best gets a 9, and so on. CAM analysis is possible with ordered, or ordinal, measures, but it can be deceptive. Is a 10 twice as good as a 5, or five times as good as a 2 No all we know is that a 10 is better. IntervalRatio Measures: Values have specific, numeric meanings. In particular, the difference (for example) between 20 and 21 is the same (has the same analytic meaning) as the difference between 167 and 168. Further, for ratio measures, the zero point is meaningful, so that if the variable changes from 10 to 11 we can say the level of the concept being measured increased by 10. To compare, you have to be able to aggregate the good and bad aspects of each alternative, and determine which is best overall. If there are n different criteria, what you are looking for is the alternative with the highest rating on the criteria, given the relative importance you have assigned those criteria. In equation form, that goes something like this:(1) a terms: These are weights. They give the relative importance of the criteria in the decision process. That is, if a i 0, then criterion i is not important. If a i lt0, then the criterion is a bad in the decision. An example of such a criterion would be cost: usually, more cost means the alternative is less preferred. If a i 0, the criterion is a good. In our example, justice would be such a criterion. V terms: These are the values of the alternatives measured by satisfaction of the criteria. It is worth saying again: these values must have some mathematical meaning for the CAM approach to work. Categorical values are not measures they may be important, but they cannot be shoehorned into this approach. Dont do it, and dont let other people do it in your presence To clarify the abstract content of equation (1), lets go back to our prison overcrowding example. Suppose you had filled in Table 1.1 as shown in Table 1.2, using estimates from published studies from other states, interviews with experts, and some of your own educated guesstimates. Table 1.2 about here Now, before you can continue, you have to assign weights to the criteria. You could assign equal weights (e. g. a i 0.25 for all four criteria, though with a negative sign for cost). You could assign all weight to one criterion (space is the only concern, so that a space 1, and all the other weights are zero). But what is the right thing to do This is not a technical question, but an ethical one. For decisions to be accepted as legitimate (at least in democracies), the idea of trade-offs needs to capture the relative weights placed on the criteria by the public. The dilemma of choosing a set of weights is a problem of democracy, or social choice, which will be considered at length in Chapter 6. For now, I will simply point out that the choice of weights in the CAM is almost exactly the same problem as the use of a voting procedure to select policies. In both cases, information is required about voter preferences and values. This information might be acquired through surveys, public meetings, voting, etc. but it has to come from somewhere. Suppose you decide on equal weights. Then the results of your analysis might look like the first panel in Table 1.3. Note that all the ratings are negative, because cost is large, and has a negative weight (i. e. more costs are bad). But we can still judge the highest rating: it is for the Early Release program. Early release is not very costly (at least in terms of the governors budget), and frees up lots of beds immediately. There are recidivism problems, of course (in this example, nearly three times as high as the other alternatives), but it looks like early release is the way to go. You can go to the governor now, and make your recommendation. Table 1.3 about here Or can you Recidivism is a real problem maybe you should give it more weight in the decision analysis. How about if we try a weight of 40 on recidivism, and 20 each on the other criteria That set of weights, .2. 2. 2. 4, is not so different from the equal weights .25. 25. 25. 25 used earlier. Disturbingly, we get a different answer. Rent prison space is now the best alternative, by quite a bit. Lets make some observations about the choice of weights. The decision about the best alternative may depend on the choice of weights on the criteria . To the extent that this is true (and it always is, in any decision process where the answer is not so obvious that analysis is a waste of time), policy analysis using the CAM is weak. More precisely, you are only as sure about your conclusion as you are about the weight assignments. You had better have good reasons for choosing one set of weights over another. The units of the measures are extremely important. Without warning you, I have used millions as the units for costs, thousands as the units for beds, an ordinal scale for justice, and percentages as the units for recidivism. This amounts to a weighting scheme, all by itself For example, notice that the justice scale only can change 2 units, as it goes from 3 (best) to 1 (poor). That means that, in terms of units . justice counts (at most) as much as a 2 million difference in costs. The implied substantive justice difference between best and poor may be large, but a 2 million cost difference is relatively small. Why Why should they count the same They shouldnt We should have been more careful to standardize units, so that the criteria are counted on a more equal basis. The problem is that it is not clear how to standardize, unless we know the weights The CAM approach is much better conceived as a means of organizing a decision, rather than being a decision itself. The discipline imposed by laying out alternatives, coming up with criteria, and then deciding on weights to describe the trade-offs among criteria, is very useful. But if we had stopped after the first round of measurement in Table 3.1, we would have been making a mistake. I dont mean to be too negative in my description of the CAM approach, because it really is useful. Often, analysts go something like the procedure I have discussed without calling it a criteria-alternatives matrix, or even realizing they are doing a formalized analysis at all. The main value of writing down the matrix, and thinking hard about the cell contents, is that one can identify the sensitivity of the answer the analyst comes up to small changes in assumptions, or to difficulties in quantification. Further, if you can get good, accurate measures of the levels of satisfaction of the criteria for each alternative, the CAM approach is a genuinely scientific approach to decision analysis. I have seen groups of people, ranging from faculty deciding on curriculum reforms to a collection of scientists debating technical aspects of hazardous waste reform, change their minds about the best course of action after doing a CAM analysis. It really works, because of the structure it imposes on the decision process, and the discipline it imposes on the analyst to reveal and justify assumptions about trade-offs in values. IV. Consideration of political and organizational constraints. Once the analyst has decided on a policy recommendation, there are two kinds of constraints that come into play. These constraints have to do with the acceptability of the policy to other participants in the process: (a ) Political feasibility --Will elected officials vote for the proposal and make it law (b) Organizational feasibility --Will appointed officials support the law and implement it in a way that makes its success possible It is tempting to merge step IV into step III, adding political and organizational feasibility as new criteria in the CAM. That would be a mistake, however, for two reasons. First, these are not criteria for judgment, in the sense that more or less of the quality is a good for the policy. Remember: policy analysis starts with a benchmark for the best policy, and then considers how real policy may be different. Political and organizational feasibility are constraints . not criteria. If the legislature, city council, or other relevant elected body wont convert the policy proposal into law, then it is time to stick a fork in the thing: its done Likewise, bureaucrats charged with implementing the policy are fully capable of foiling an otherwise well-designed initiative, either by a lack of enthusiasm or actual sabotage. Second, the analyst generally cannot get accurate information on the likely reaction to a proposal until it is proposed. Predicting the reaction of elected officials, or bureaucrats, to a proposed policy is at best an inexact science. As we will see in Chapter 6, there is some basis for predicting how legislators may vote, but lots of things can happen to change the mind of policy-makers. In general, there is only one way to ensure that politicians and bureaucrats are more likely to favor, or at least not oppose, a policy. It seems obvious, but it is often overlooked: get them involved from the beginning . There are at least two places where their participation is most important, at the stage of framing the problem, and at the stage of selecting alternatives. Since politicians and bureaucrats have different kinds of veto power over many policies, it is important to get their views on each alternative before you go too far down the road toward selecting that alternative. For example, if one of your alternatives is the elimination of a cabinet level agency, with the associated budget transferred to another agency, you have to recognize that you are activating powerful forces whose interest is in maintaining the status quo. You will need to anticipate their response, and offer the affected employees, managers, interest groups, and their elected supporters in Congress some compensation. It doesnt matter if your policy is the right thing to do from an analytic perspective, because the costs of transition to your ideal policy will be all the affected parties can see. On the other hand, even if you do everything right, you may run afoul of the feasibility constraints. Even if you asked questions, invited comment, and thought everyone had said they would support you, when the policy proposal is actually introduced, it is as if you are starting over. Carefully crafted compromises, and detailed, interdependent portions of the proposal may be selectively changed, modified completely, or reworded in such a way that your goals for reform are no longer met. Once the proposal leaves the analysts desk, it is a whole new world. Consider the misadventures of the Clinton administration with health care reform. Health care and the economy had been the two central issues of the 1992 U. S. presidential election. After the election, the administration began a series of meetings focused on developing a proposal for reform. The goals of the reform effort were complex, and the kind of information available for real decisions was just not available. The first lady, Hillary Rodham Clinton, was appointed by the president to head the so-called Health Care Reform Task Force, a large group of analysts and departmental representatives with a stake in the outcome of the reform process. Another central figure in the process of developing a policy proposal was Ira Magaziner, a Rhodes Scholar turned business consultant. What happened over the next 18 months was a case study in how to not to do policy analysis. Listen to Woodwards (1995) description, which is worth quoting at length. Magaziners strategy on health care reform had been to run two tracks of briefings. First, he held a series of briefings attended by the entire Task Force. For the second track, Magaziner met with just the president and Hillary aloneOne day at one of the larger group meetings on the fourth floor of the Old Executive Office Building, Bob Boorstin another staff member was summoned awayMagaziner said not to worry. The meeting was not that significant. He was having regular private, confidential meetings with the ClintonsA regular series of secret meetings was explosive, Boorstin felt. If they find out, youre a dead man. Youre digging your own grave. Not only will the policy be dead, but it will be dead for less than a good reason. It will be because these people from eight different federal agencies, all affected by health care reform feel cut out. Magaziner ignored Boorstins warning. The private briefings for the Clintons continued. (pp. 188-189). In a meeting a year later, in August, 1994, Treasury Secretary Lloyd Bentson was disturbed that health had not been subjected to the collegial deliberative process of the economic plan now passed into law, in modified form, but was handled back channel with Magaziner trying to keep all the information to himself. He argued that the resulting plan was not politically attainable in CongressMagaziner felt that by proposing a plan that was left of center, Clinton would eventually win something in the center. But Magaziner did not fully grasp that the health plan, no matter how wonderfully configured or academically sound . would get dropped in the same caldron as the economic plan. The Congress, the media, and the interest groups would all have their spoons in the brew stirring at his creation(pp. 372-373, emphasis mine). President Clinton said I am like the captain of a ship, grasping for the metaphor of a very old ship with oars. That is, I can steer it, but a storm can still come up and sink it. And the people that are supposed to be rowing can refuse to row . In the fall of 1994Congress killed any and all proposed health care reformno compromise, no half measures, none of the meagerest changes . Nearly two years of work went down the legislative drain . Clinton, his wife and Magaziner had designed an unwieldy monster of a plan (p. 389, p. 398, emphasis mine). In devising a health care proposal, analyst Magaziner seemed to believe that there were only three steps in the policy process, ending with the proposal itself. By denying a role in the process to others with a stake in the outcome . he had doomed the whole enterprise. The Clintons, by allowing an analyst to dominate the process of drafting the proposal, seemed to forget that all policies eventually have to satisfy the legislature who must vote on the program, and the bureaucrats who must implement the program. The key to success (and I am not saying its easy) is to get information about political and organizational feasibility built into the proposal itself. V. Evaluation of the program as it is passed by the legislature and implemented by the bureaucratic agency, given steps1-4. MacRae and Wilde (1985, pp. 266-268) point out that there are three types of accountability in social processes: 1. Market accountability Citizens decide whether they like the goods and services provided by firms. Firms that fail the market test (i. e. do not provide quality service, deliver inferior quality goods, or charge exorbitant prices) will not survive, as citizens express their dissatisfaction by taking their dollars elsewhere. Market accountability is a decentralized process, with significant subjective elements, because it relies on the aggregation of the tastes of consumers choosing products. 2. Political accountability Citizens decide whether they like a particular policy or activity. If citizens oppose the policy, they can use the direct democracy (such as a referendum) or indirect democracy (vote in elections where representatives are chosen) to express this opposition. If enough (often, but not always, a majority of the citizens) oppose a policy, it will be changed. Political accountability may be either decentralized (if primarily a grass-roots, citizen-led phenomenon) or centralized (if organized by the president, or leaders of the legislature). Furthermore, it can be just as subjective as market accountability, as voters decide whether they like, or dont like, a policy. That is, the reasons why a voter doesnt like a policy dont matter: if enough oppose the policy, for whatever reason, the policy is dead. 3. Expert analysis Experts use some objective, scientifically grounded, set of criteria to decide if the policy or activity is a success. Many of the tools we will consider later in this book, such as cost-benefit analysis, discounting to account for time, and indirect valuation, are intellectual devices for analysis by experts. However, unlike both market accountability and political accountability, expert analysis purports to be objective. It may be centralized, in a blue ribbon panel or commission. Or it can be decentralized, as experts debate policy consequences in refereed professional journals and at conferences. Consider how these three types of social accountability would work in an everyday example. Are Beanie Babies a good product Do Beanies pass the market test You bet they do It has been estimated that Ty Inc. has grossed over 600 million since it started manufacturing and selling Beanie Babies. Lots of people just love Beanie Babies, so much so that a substantial secondary market has developed, where buying and selling Beanies has become a highly speculative business. Do Beanie Babies pass the test of political accountability Apparently. We could outlaw them, just like we outlaw heroin or other addictive drugs. But we havent (though some parents I know have been heard to mutter support for prohibition after waiting in line for hours for some new little beansack with arms). Interestingly, there are import restrictions on Beanies, created by Ty, Inc. and enforced by the U. S. Customs Service. Would Beanie Babies pass an expert analysis That is, do Beanies serve a social purpose Are Beanie Babies, in the final analysis, the best use of the resources employed in this way Should Ty be allowed to manufacture, and people be allowed to purchase, this product What are the alternatives What criteria should be established to judge the alternatives How would we evaluate the performance of the status quo (i. e. Beanies are legal), compared to other alternatives Now, it should be pointed out immediately that there has been no Ban Beanies movement among policy experts. Further, if there were, such a recommendation would clearly fail the political accountability criterion above (i. e. the experts would be overruled by politicians, for fear of being trampled to death by waves of Beanie-loving moppets).But we evaluate things all the time, by some combination of market test, political test, and expert analysis . Most of the time, we dont think much about it, but sometimes it matters. The choice not to evaluate using expert analysis is tantamount to selecting the status quo (usually the market outcome), or risking subjective and perhaps poorly informed change (resulting from the vagaries of democratic politics.) Still, I will use evaluation in the narrower sense of expert analysis, because that is the usual sense of the word in the policy analysis literature. In short, evaluation is a different process from the policy analysis performed in problem formulation, selection of criteria, and comparison of alternatives. Evaluation is an analysis of whether the program or policy that was implemented has achieved its stated goals. The analyst may use some of the same information, and ask some of the same questions, as in the original analysis, but in evaluation the set of alternatives, and the scope for creative problem redefinition, are sharply circumscribed. There have been many descriptions of types of evaluation within the policy analysis literature. The one presented here is adapted from the discussions of Trisco and League (1978) and Bingham and Felbinger (1989). Before giving the general format for an evaluation, it is useful to offer a qualification: There are many types of programs, and many dimensions of programs that can be evaluated. You have to know what kind of evaluation you are performing if you are going to complete the job successfully. To clarify these differences, consider Trisco and Leagues typology of levels of evaluation, which have to do with the types of objectives being evaluated Types of Evaluations: Purely Formal Evaluation . monitoring daily or routine tasks. Are contracts met Are budgets balanced Are procedures followed An answer of yes doesnt mean that the program is a good one, but no almost certainly means trouble. Client Satisfaction Evaluation . performance of primary functions. Do employees understand who is the client, or customer, for the program Are clients satisfied Again, passing this type of evaluation is not necessarily a sign that the program is successful, but failing this test is a bad sign. Outcomes Checklist . satisfaction of list of measurable desired outcomes. How many of the programs objectives have been met Expense and Effectiveness . cost-benefit analysis, measuring both the costs and impact of the program. Was the program cost effective What would have happened to the target population in the absence of the program Long-term Consequences . impact on the core problem, rather than symptoms. Has the program, in the long run, achieved its goals of curing the social problem it was designed to address If the cure was not achieved, is the program worth continuing Notice that a program might pass most of the other types of evaluation, yet still be found wanting in the long run. All of these types of evaluation are important, but the first three are relatively straightforward to carry out. These evaluations (formal rules, client satisfaction, and outcomes checklist) can be accomplished by the careful collection of data using surveys and interviews, and a study of the rules and procedures that are supposed to govern the programs functioning. It is with the fourth and fifth types of evaluations (cost-benefit analysis, and the long-term evaluation of program effectiveness) that we will be concerned later in this book. These are the types of evaluation where analysis, of both the theoretical and statistical types, are most important. And it is for these types of analysis that the following process of evaluation is most appropriate. Process of Evaluation: 1. Identify the goals and objectives of the program or policy in a way that makes measurement, and evaluation, possible. 2. Construct an analytic model of what the policy or program is expected to accomplish. This model will embody a set of theoretical propositions about means-end relationships, based on the accumulation of knowledge from research on the subject. 3. Develop a research design capable of distinguishing (a) what is expected from the program ( goal ), (b) what is actually observed ( data ), and (c) the range of outcomes that might be observed if the variation of outcomes is simply random, or unaffected by the policy ( null hypothesis ). 4. Collect the data, or actual measurements that describe the phenomena of interest. 5. Analyze and interpret the results. In particular, do the data imply that actual performance is at or above the goal For example, suppose the goal was the improvement in some measurable indicator (such as prison recidivism). Is there a difference observable in the data Is this difference statistically significant, in the sense that it is unlikely to have been generated by chance variation Review of the Process of Analysis: At the beginning of this section, I claimed that the process of analysis can usefully be divided into five parts: (I) Problem Formulation (II) Selection of Criteria (III) Comparison of Alternatives (IV) Consider Political and Organizational Constraints We considered a specific example for each of the first three steps that example was a decision about making a recommendation to your boss, the governor of a state facing a court order to make its prisons less crowded. The political and organizational constraints may simply overwhelm any policy recommendation you make, of course. For example, if the court order says that the prisons have to be less crowded by tomorrow . then early release might be your only option. You would have to stay up all night coming up with criteria for the classes of criminals, or types of crimes, that would indicate releasing that inmate is likely to do the least damage (on average) to the states citizens. And you wont be able to perform step V, evaluation, until enough time has passed to decide what the effects of your decision have been. Most of the rest of this book will be devoted to elaborating parts of this process of analysis and evaluation. Dont worry if portions seem unclear now this chapter has served only to give an overview of what will be developed at length in later chapters. This chapter will close with a little perspective on the profession of policy analysis in the broader context of expert advice to decision-makers generally. Policy Analysis as Part of a Broader Profession: Expert Advice on Policy Because policy can be analyzed in many ways, from a variety of theoretical and ethical perspectives, it is useful to consider policy analysis as part of a broader profession: experts providing advice to decision-makers on policy. In some cases the experts may themselves be decision-makers, but the two functions can usefully be analytically separated. Expert advice to policy-makers is concerned with the development of a community of experts in a variety of fields to aid public policy choice. This field of policy analysis involves research regarding the design of policy alternatives and the decision to choose one among several possible alternatives. Broadly construed, advice includes both policy relevant research such as basic scientific or social science research (theory about causal connections, empirical research about the magnitudes of the cell entries in a particular CAM) and research designed to improve the way policy is designed, either in terms of its ethical or procedural basis (metapolicy analysis) and specific institutional design questions. Consequently, expert advice on policy could encompass both an political scientists research on committee decision making and an environmental scientists research on the implications of lead levels in sumac leaves on a gradient away from an interstate highway. Clearly, the nature of expertise is difficult to define, because the term is used in many ways. The discussion given by MacRae and Whittington (1997) may be the most useful for present purposes. The quality of expertness here refers to a claim by a specially trained group to contribute knowledge or advice. an expert groups claim of authority can be based both on their collective training and on group members quality control over one anothers work. Disciplinary definitions of expertise are not, however, transferred to EAP because most policy problems extend beyond the domain of any one discipline. Moreover, the extension of analytic capacity to citizens and the media can blur the boundaries of expertise. (MacRae and Whittington, 1997, p. 12). In this view, then, an expert is someone whose advice is likely (at least on average) to improve the outcomes of a policy choice, from the perspective of the society. This is clearly a much broader definition than would be implied in a discussion of policy analysis as conceived in this book. In the broader sense MacRae and Whittington intend, an expert is anyone who has something useful to say, because of their high level of training or experience. I will go with a narrower definition: An expert in policy analysis is someone who has mastered the techniques presented in this book. Now, mastery is quite different from the level of understanding one can achieve from reading an introductory text, but the goal of the remaining chapters will be to expose the reader to the basics of policy analysis. Policy analysis is that portion of expert advice devoted to the choice among specific policy alternatives. The process of policy analysis is primarily the gathering of data and the measurement of various values achieved by different alternatives. Policy analysis is ideally performed when a problem is first recognized, but is more commonly done only when the problem becomes acute. Expert advice, in the broadest sense, may be sought at any time, and may be performed quite independently from any specific problem or policy concern. Ideally, EAP assists decision-makers by providing courses of action that prevent the more crisis-oriented kind of policy analysis from ever happening Plan of the Book The rest of the book develops and extends the themes we have glimpsed in this first chapter. Chapter 2 describes some sources of conflict between the three institutional sources of accountability already described: markets, politics, and expert analysis. The next section examines the performance of each of these institutions separately. Chapters 3 and 4 consider the performance, and potential failures, of markets. Chapter 5 outlines the difficulties, and advantages, of focusing on expertise as a basis for policy decisions. Chapter 6 is a brief introduction to the performance of governments and the limits of collective choice. We then move to the nuts and bolts of how policy analysis is practiced. The welfare economics paradigm, in the many ways the methodological center of policy analysis, is the subject of chapter 7. Chapter 8 identifies three conflicting metacriteria in the choice of regulatory form: efficiency, equity, and politics. Chapters 9, 10, and 11 introduce the concept of cost-benefit analysis, first giving a description of discounting for risk (in Chapter 9), discounting for the rate of time preference (in Chapter 10), and then presenting examples and techniques of cost-benefit analysis in Chapter 11. Chapter 12 then offers some caveats, and other perspectives, on cost-benefit analysis in particular and policy analysis in general. As I noted earlier, this introduction will hardly make you an expert in policy analysis. But for students interested in finding out what policy analysis really is, or for experts in other fields who need to learn how policy analysis is performed, this book will prove very useful. And I promise that we will try to have some fun along the way. Key Concepts Process of Policy Analysis: 1. Problem formulation 2. Selection of criteria 3. Comparison of alternatives4. Political and organizational constraints 5. Evaluation Criteriaalternatives Matrix Levels of Measurement 1. Categorical 2. Ordinal 3. Interval4. Ratio Types of Evaluations 1. Formal 2. Client Satisfaction 3. Outcomes Checklist5. Long-term Consequences Expert Advice to Policy Makers Homework Questions Choose a problem that concerns policy makers. State the problem situation (for example, Our prisons are overcrowded) clearly, and then give at least three different problem formulations (for example, Criminals dont fear imprisonment enough, or Underprivileged people have no economic opportunities, and so turn to crime. Notice that the problem situation simply claims that we have a problem, while the problem formulation makes an implicit argument about why we have a problem. How would you go about deciding which of your problem formulations is better 2. Consider the following criteriaalternatives matrix, which describe the problem of which health plan to choose at your new job: Suppose you expect to get sick enough to require an office visit to the doctor 2 or 3 times per year, and have never had to go to the hospital. What additional information would you need to choose a health plan In particular, what weights would you assign to the three criteria in the CAM Choose a set of weights that would imply that A. Aaron is better, and a nother that makes Fee-for-Service preferable. Which set of weights seems more plausible to you Why Give an example of a policy variable that can best be measured categorically. What sort of analysis can be performed on such variables If we assigned each category a numerical value, what would this mean For example, suppose you find the following information in a report: Trees in a public park were counted and recorded, with an oak tree assigned a 1, a pine tree assigned a 2, and a birch tree assigned a 3. The average value of all trees in the park is a 2.05 if you took a walk in that park, would you expect to see lots of pines, or no pines and lots of oaks and birches 2. Deciding How to Decide: experts, the people, and the market Government is a contrivance of human wisdom to provide for human wants. Men have a right that these wants should be provided for by this wisdom. (Edmund Burke, Reflections on the Revolution in France, 1790). What should government do What do you want it to do What does everyone else want Do the desires of the people have anything to do with the wisdom that Edmund Burke cites How should we discover what is wise Policy analysis is mostly about the last question: Which policy is wise . That is, given a proposed policy, or a policy actually in operation, what tools of analysis can guide us in identifying and evaluating the effects of the policy How can experts improve what government does What policies can experts propose that will improve the functioning of markets Of course, policy analysis does not take place in isolation. Instead, there are many groups in the political process who think that they know what wisdom is. These groups may have little use for experts or evidence. Furthermore, as was argued in the previous chapter, the market has a logic, and a kind of wisdom, of its own. These three kinds of wisdom markets . democracy . and experts are constantly in conflict. This chapter considers the sources of this conflict, and how it affects the practice of policy analysis by experts. To understand the nature of this conflict, it is useful to consider the overview depicted in Figure 2.1. To the casual observer, it often seems that policies are in conflict with one another, or that policy-makers are just confused. This may be true, but the panoply of polices we see can only be understood as ways of reconciling the various conflicts depicted in the figure. Figure 2.1 about here We can consider each pairwise conflict separately: Experts v. Markets As we will see in later chapters, markets have an internal logic of operation. However, markets can fail, sometimes spectacularly, without management and support of experts. While there is debate about the extent of intervention required, there is substantial agreement about the categories of intervention that can improve market performance. Although in principle an expert could have any sort of goal one can imagine, I am going to use the term expert in this chapter to mean someone who has the goal of improving the functioning of politics or markets. What is meant by improve should become clear as we proceed, but I am intentionally leaving the goals of experts unspecified for now. These categories of market failure are (1) market structure regulation, including management of natural monopolies (such as utilities), or anti-trust policies to control concentrations of economic power, (2) policies to control externalities . such as pollution, through regulation or internalizing costs, (3) the systematic undersupply of public goods . due to the related problems of free riding (if privately provided) or demand revelation (if publicly provided, but financed by tax shares revealed by the individual), and (4) information problems, such as drug approvals or physician licensing, to reduce the costs of fraud or simple confusion. The conflict between markets and experts will be analyzed in Chapters 3 and 4. We can call these policies efficiency policies, because the guiding value is efficiency . While we will consider efficiency much more deeply later on, it is worth pointing out that efficiency, for the policy analyst, is defined a little differently than you might expect. The dictionary definition of efficient includes: producing the desired effect or result with a minimum of effort, expense, or waste working well competent able capable. We will use the following definition, applying the concept of efficiency to the allocation of resources: A particular matching of resources to uses is efficient if and only if there exists no alternative allocation of those same resources which results in a more desirable result. One obvious problem with this definition is that more desirable is hard to specify precisely, when there are two or more people involved. Suppose person 1 likes allocation A better, and person 2 likes allocation B better which allocation is more desirable To solve this problem, we will simply ignore it: if there is disagreement, we will not be able to apply our concept of efficiency More precisely, we will apply the so-called Pareto criterion, which requires unanimous agreement. To see how the concept of efficiency based on the Pareto criterion would work, imagine that both allocation A and allocation B are technically feasible, in the sense that society can marshall the resources and apply them to the uses required in those two allocations. Now, suppose person 1 likes A better, and then imagine that person 2 likes A better also. That is, all people agree that A is better than B. Then forcing allocation B on our two person society would be inefficient. What is meant by efficient in this context is a lot like wasteful. It would be wasteful to choose allocation B, because A is feasible and because both person 1 and person 2 prefer A. In this case, we say that A is Pareto superior, or unanimously preferred, to B. It is worth remembering, however, that efficiency is not the only consideration in expert management of markets. It is as if the analyst, in focusing efficiency, is saying, For a given distribution of income That is, the distribution of gains is an important, but separate, question. As the dotted line in Figure 2.1 indicates, there may be substantial influence from political actors. In some sense, this influence is secondary, because it does not directly involve the management of markets. But political considerations may distort, or even rearrange, attempts by experts to manage markets. Politics v. Markets The nature of politics in a democracy inevitably creates a tension between markets and collective decision-making. Markets are decentralized, operate with little central direction, and (most importantly) recognize power based on wealth. If you have more dollars than someone else, you have more votes in the market. Democratic politics operates on a much more egalitarian basis: each person gets only one vote, so that in the ballot box, at least, the poor person and the rich person have the same power. Consequently, conflicts between politics and markets often take the form of disagreements over the outcomes of market processes, such as the redistribution of income or the use of publicly held resources such as national forests or fisheries. In a larger sense, since markets are the engines of growth in capitalist economies, but politics is the process by which property rights, tax rates, and social programs are decided, this conflict may be the most fundamental of all. There are those who portray the conflict between collective decision-making and market processes as a battle of good versus evil, but this view is simplistic. The fact is that both markets and politics provide us with a useful way of deciding the conflict has to be managed, because it isnt going to go away. This type of conflict can be called equity policy. Another word for equity is fairness. One meaning of fair, of course, is average, as in the following scale you might find on a survey about food service on your campus: The food at the cafeteria was . Pick one: (a) poor (b) fair (c) very good The other meaning is more complimentary: fair means honest, just, or unprejudiced. It is the second meaning that makes fair a synonym for equitable, but the first meaning sometimes creeps in when we are thinking of politics. As we shall see, some people argue that the distribution of income implied by the use of markets is not fair, and requires political intervention. But the standard for fairness seems to be that we all get the average, with no deviations allowed. This conflict between the two notions of fair as definitions for equity is a microcosm of the policy conflicts between politics and markets. People who favor markets tend to think that equitable and equal are unrelated concepts, at least for descriptions of the distribution of wealth among the members of society. People who favor political redress for the inequities they perceive in markets appear to think equitable and equal are very nearly the same word. Once again, the source of wisdom not directly involved in the conflict may have an influence. Experts may try to affect the debate in equity policy by proposing solutions, or new problem definitions. We will consider expert analysis of equity policies in Chapters 5, 6 and 7. Experts v. Politics The way that we decide influences what is decided. As we will see later in this book, the particular institutions of choice, given public opinion, make a big difference. Consequently, experts often have advice for politicians on how the political process itself should be reformed. However, these reforms may not be popular with elected officials. The reason may seem obvious, but it is worth remembering: whatever else politicians may differ on, they share incumbency . Incumbents were all elected under the current system, every one of them Consequently, efforts at improvement by experts may be met with skepticism, or open hostility. This final type of conflict, between experts and popular politics, can be called institutional reform policy. This brings us to the third dotted line in Figure 2.1, the one where markets may influence institutional reforms. Depending on your point of view, this influence can be fairly benign, or completely evil. The choice of institutional form for public choices is fundamental to the functioning of any democracy. Most importantly, whatever the institutions of collective choice, it is crucial that the public perceives the government selected by this process to be legitimate and fair. Markets, by injecting considerations of wealth and economic power into political choice, may distort choices and threaten the legitimacy on which the whole system depends. In some ways, this problem is outside the scope of policy analysis, but we will consider it briefly in Chapters 6, 8, and 9. Lets summarize what has been said so far in this chapter: there are three bases of wisdom, or sources of accountability, in policy processes. These are markets, politics, and experts. In choosing the wise policy, there is inevitably conflict about which of these to follow. If the primary conflict is between markets and experts, the result is an efficiency policy. If the primary conflict is between markets and politics, the result is an equity policy. Finally, if the primary conflict is between experts and politics, the result is an institutional reform policy. The State of Nature: No Markets, No Politics, No Experts In the previous section, I argued that the context of a policy debate is the key feature in determining what kind of policy results. Different policies seem to be contradictory, but that is because they resulted from different conflicts. Efficiency policies often seem in conflict with equity policies institutional reforms may seem to serve neither efficiency nor equity very well. Each policy arena has its own logic, where policies may seem rational given the problem the participants think they are trying to solve. From a larger perspective, of course, the whole thing may seem messy and incoherent. Before we start thinking about trees, we should take a step back and think about the forest, and where it came from. This step back must take the form of a thought experiment: What would policy look like without any political, market, or expert context. Precisely because the context of policy analysis is so important, it is useful to imagine what things would be like if we remove context, at least as far as is possible. In the U. S. we live in a democracy, in an advanced industrial society, with well-developed norms of choice and an elaborate system of expertise in almost every field. Suppose that none of this were true. Imagine we had only rudimentary role definitions and rules of behavior to guide us, but that we face problems of deciding what to do. How would we conduct make decisions Philosophers and social scientists call this idea the state of nature, a thought experiment considering what life would be like without institutionalized markets, politics, or experts. Different people have had very different ideas about what natural life would be like. One of the most famous is Thomas Hobbes, who was not (to say the least) optimistic: the nature of War, consisteth not in actual fighting but in the known disposition thereto, during all the time there is no assurance to the contrary Whatsoever therefore is consequent to a time of War, where every man is Enemy to every man the same is consequent to the time, wherein men live without other security, than what their own strength, and their own invention shall furnish them withall. In such condition, there is no place for Industry because the fruit thereof is uncertain and consequently no Culture of the Earth no Navigation, nor use of the commodities that may be imported by Sea no commodious Buildings no Instruments of moving, and removing such things as require much force no Knowledge of the face of the Earth no account of Time no Arts no Letters no Society and which is worst of all, continual feare, and danger of violent death And the life of man, solitary, poore, nasty, brutish, and short. (Chapter 13, p. 186). Hobbes recognizes that his dark portrayal of the condition of humankind in the state of nature may not be realistic (It may peradventure be thought, there was never such a time p. 187). But that is not his point. What Hobbes is analyzing are the conditions or conventions that enable a society to avoid the cataclysmic war of every man against every man. (p. 188). In Hobbes view, societies are able to avoid the state of nature by vesting power, and the legitimate ability to focus force, in the person of the sovereign . As democratic theory has progressed, we have adapted Hobbes notion of sovereignty into something more abstract, and at the same time more concrete. That something is the will of the people . This is really quite an astonishing intellectual achievement: we start with (1) a state of nature . move to (2) the person of the sovereign . who embodies the power and legitimacy of the state, and then (3) mentally divorce the literal person (king, sultan, or chieftain) from the function of that office, which is to carry out the will of the people . In this construction, the sovereign is the will of the people, which (in theory, at least) is the anthropomorphised ruler of the society. Not everyone would accept this formulation, not by a long shot. For some, it is not the state of nature that is to be avoided, but rather the rule by the general will we should fear. Edmund Burke, speaking perhaps ironically, makes this argument most clearly: In vain you tell me that Artificial Government is good, but that I fall out only with the Abuse. The Thing The Thing itself is the abuse Observe, my Lord, I pray you, that grand Error upon which all artificial legislative power is founded. It was observed, that Men had ungovernable Passions, which made it necessary to guard against the Violence they might offer to each other. They appointed governors over them for this Reason but a worse and more perplexing Difficulty arises, how to be defended against the Governors (Burke (1982 1756), pp. 64-65). In this passage, Burke would appear to argue that nature, or natural society, may be preferable to government, since there is no way to ensure that the will of the people is obeyed. The thing is government saying the thing itself is the abuse means that Hobbes had it all wrong, and humans in the natural state would be just fine. It is the power of unjust government we should fear, and guard against. I am not going to pretend to offer an answer in this debate, but it is useful to think about where governments, and societies, come from. Consider Aristotles account, from Book I, chapter 2 of the Politics . When several villages are united in a single complete community, large enough to be nearly or quite self-sufficing, the state comes into existence, originating in the bare needs of life, and continuing in existence for the sake of a good life. And therefore, if the earlier forms of society are natural, so is the state Hence it is evident that the state is a creation of nature, and that man by nature is a political animal . And he who by nature and not by mere accident is without a state, is either a beast or a god. (emphasis added). This passage leads to a hard question: Is it true that man by nature is a political animal If the answer is yes, then institutions of collective decision are required. More simply, humans will have to make decisions as a group that somehow embody, or at least account for, the desires of the individuals who make up the group. Many people have worked on the problem of how to make collective choices out of individual desires. One of the most important early efforts was by Jean-Jacques Rousseau. Rousseaus thought was complex, so any attempt at brief summary will not do it justice. However, it is clearly true that Rousseau believed in the superiority of some idealized natural condition of humanity, where people are free to delight in liberty and nature. On the other hand, he recognized that some mechanism is required for generating binding collective choices, and for governing the otherwise unavoidable tendency for inequalities among citizens to arise. These two ideas (complete freedom of the individual, the need for submission of the individual to the general will) are not fully reconciled in Rousseau, but he certainly recognizes the problem. In a celebrated and controversial passage, Rousseau makes his argument: As long as several men in assembly regard themselves as a single body, they have only a single will which is concerned with their common preservation and general well being. A State so governed needs very few laws and, as it becomes necessary to issue new ones, the necessity is universally seen. The first man to propose them merely says what all have already felt. There is but one law which, from its nature, needs unanimous consent. This is the social compact, for civil association is the most voluntary act in the world. Since every man is born free and master of himself, no one can, under any pretext whatsoever, subjugate him without his consent. Apart from this primitive contract, the vote of the majority is always binding on all the others this is a consequence of the contract itself. But it may be asked how a man can be free while he is forced to conform to wills that are not his own. How are the opponents free while they are bound by laws to which they have not consented I reply that the question is not properly. The citizen consents to all the laws, even to those that pass against his will, and even to those which punish him when he dares violate any of them. The unchanging will of all the members of the state is the general will through it they are citizens and free. When a law is proposed in the assembly of the people, what they are being asked is not precisely whether they approve or reject the proposal, but whether or not it is consistent with the general will that is their own each man expresses his opinion on this point by casting his vote, and the declaration of the general will is derived from the counting of the votes. When, therefore, the opinion that is contrary to my own prevails, this proves neither more nor less than that I was mistaken, and that what I thought to be the general will was not so. If my private opinion had prevailed, I would have done something other than what I had willed it is then that I would not have been free. (Rousseau, 1973, pp. 150-151). This reasoning may seem a little tortuous, but the argument is important. As a citizen, you want government to do the right thing. However, citizens may disagree about what the right thing is. We could vote, as a way of deciding what we think, as opposed to insisting that we must all think the same thing. Provided each of us renders a judgment about what is best for society, rather than just what is in our self-interest, this process of voting is a means of discovering the collective wisdom, or general will. Each member of a society must agree, in the abstract, to accept specific decisions we may not agree with. Rousseau is arguing, then, that this submission to the general will is the price of freedom. In mentally creating the general will out of some combination of individual desires, we have also created something else, the society. In fact, the very essence of the general will is the notion that there is some group larger than the individual whose welfare we can measure, or at least compare across different policy choices. The comparison of the welfare of the individual and the welfare of some larger entity, whether it is a rural community, a city, or the entire nation, is at the heart of many policy questions. You have probably seen media accounts of attempts by cities to expand a road system, where one old house (owned in our example by Grandma Filinda Blank) stands in the way. The city offers to pay the market value of the house, but the property and the family farm is worth much more than that to Ms. Blank. What should the city do It can use its right of eminent domain, and force Grandma Blank out of the house. Or it can spend millions of extra dollars to reroute the road, delaying completion of the highway by six months. How should we decide What is the wise policy, in a situation where the welfare of one individual is clearly in conflict with the welfare of most, or even all, other citizens We will consider, in Chapters 10, 11, and 12, some potential ways to address the question, accounting for risk, time, and the use of cost-benefit analysis. While these techniques arent perfect, they offer at least a starting point for measuring values and organizing our thinking. The set of techniques called cost-benefit analysis are some of the most widely used, and valuable, tools a policy analyst can possess. But like any potent tool, cost-benefit analysis can be misleading or even dangerous if it is used improperly. One word of caution, however. My mother, who grew up on a farm, always said You cant make chicken salad out of chicken feathers. (Yes, I am paraphrasing she didnt say feathers). Cost-benefit analysis is a way of coming up with measures of the values of certain actions, but it cant tell you what the fundamental values of a society are, or should be. If you believe that the society has interests, and rights, that are superior to those of any one individual, or even groups of individuals, then some very aggressive actions by government on behalf of that collective interest may be justified. On the other hand, if you think that the rights of individuals are paramount, the ability of government to function in the face of disagreement may be severely curtailed. One cant rely on cost-benefit analysis to answer the really fundamental questions, or to create consensus where there is profound disagreement. Policy analysis generally works best for societies that have already agreed, among themselves, on most of the hard questions of collective choice and values. Let us now turn back to the notion of a state of nature, and see how policies may have originated in the simplest sorts of human cultures. The Hun-gats: Choosing and the Wisdom of the Group Consider the simplest case of collective choice, and see if it has some lessons for larger societies. Suppose we lived in a small extended family group, or clan, of hunter-gatherers. Imagine we had only rudimentary role definitions and rules of behavior to guide us, but that we face problems of deciding what to do. How would we conduct the business of society How would we make decisions Each persons membership in the clan is initially conferred by birth, or marriage. But as life continues, each person has the option to leave, to strike out on their own and abandon the we to live as I. The fact that tribes stay together, and try to decide as a group, tells us the first thing we need to know about policy analysis. Policies are public . once a policy is chosen, all of us have to live with it, whether we agree with it or not. Consequently, policy analysis is different from any other problem you are likely to encounter when making decisions. You arent just deciding what you want, or what is best for you. Somehow, you have to figure out what is best for other people. Lets make the example more specific. Suppose you are a member of a hunter-gatherer tribe (I will call them the Hun-gats, as in my earlier book, Hinich and Munger, 1997) You, and the clan, have hunted (and gathered) all of the food in the area that you know is safe to eat. Now, everyone is hungry, and everyone is starting to look at other plants, strange animals, and maybe even Cousin Gombog, in a whole new way. These are all things that the tribe does not normally consider to be food, but hunger has made them define potential food sources more broadly. What policy should the tribe adopt about eating The first thing the Hun-gats would have to decide is how to decide. It is by no means obvious that the what do we eat question is a collective one. So, step one is to decide whether we need a policy at all, or whether it is okay to let a more private or market oriented solution (i. e. each of us tries whatever we want) work itself out. Figure 2.2 about here Lets suppose the Hun-gats decide they need a policy, for two reasons. The first is the chance that lots of members of the tribe will eat something poisonous, and then die. This is a waste of effort, because more people are exposed to risk than is necessary to find out if the food is safe. This is a problem of too much risk. The Hun-gats ancestral enemies, the fierce Raouli tribe, would likely find out about widespread food poisoning, and use the Hun-gats weakness as an opportunity to attack. Second, there is a free rider problem: someone found an oyster, opened it up, and then looked at his companion: Hey, this looks like food. Ooohwhy dont you try it Free riding creates a problem of too little risk: some foods would not be sampled, because everyone is waiting for someone else to try it first. The two problems (too much risk from uncontrolled experimentation, and too little risk from free-riding) are not likely to cancel out. Instead, the two problems are both going to hurt the effort to find new foods that will relieve the impending famine. The tribe has two choices: (1) it can try to use theory, or (2) it can use empirical experimentation to determine what is safe. The sort of theory they might use is not based on knowledge of germs and poisons, of course. Rather, for primitive peoples theory is more likely to be religious law, applied by the use of analogy. Suppose someone finds a beaver, and brings it back to camp. The shaman, the Hun-Gats chief religious official, makes a policy pronouncement based on theory: Our laws say that pigs are unclean, and you may not eat them. Beavers look like pigs, albeit with large teeth and funny, flat tails. Therefore, beavers (like pigs) are unclean. Obviously, theory may have problems as a tool for policy analysis, especially if the theory was really designed to explain something else. The alternative might be an experiment, based on empirical investigation: Lets roast up this bad boy, and see how he tastes. Here, you take the first bite. If the person who takes the first bite says it tastes good, and shows no ill effects in the next day or so, then the policy is decided: Beavers can be added to the acceptable foods list for the tribe. In fact, the shaman may even update his theory, using the newly acquired empirical knowledge: Animals that look a lot like pigs are okay to eat, provided that (unlike pigs) those animals have big teeth and funny flat tails. My example has been rather silly, of course, but theory and analogy can play an important role, even when cause and effect relationships are poorly understood. In fact, it may be precisely in those instances that little is known about the mechanics of cause and effect that people are likely to use theory. This is a very conservative (in the sense of avoiding risk) approach to policy analysis, but it can work pretty well. Consider Table 2.1, which gives a comparison between the rules for handling meat in a kosher butcher shop, and the 1998 version of USDA procedures for doing the same tasks. Table 2.1 about here The similarities are striking, yet the approach to creating the policy in each case was dramatically different. Kosher rules were designed, but not by scientists. Kosher rules are a set of religious practices keeping kosher is a moral imperative, not a health concern. Yet it seems obvious that the kosher rules have a strong basis in science, or at least in health. In many ways, the religious kosher food handling rules approximate the scientific USDA guidelines. The USDA requirements (presumably) are based on science their sole goal is to promote health. The USDA has the benefit of significant experience, and a well-developed germ-based theory of contamination of food products. In a primitive society, adopting a policy like orthodox Jewish rules for keeping kosher has important health benefits. You could imagine how the policy might be adopted: people notice that if one eats chicken prepared according to the rules, one is less likely to get sick. Without a germ theory of disease, or an understanding of food parasites, the people may misattribute this sickness to the anger of spirits or deities that control our health. Consequently, policies about food might start out as religious rules. If the rules adapt over time to record safe, and outlaw unsafe, foods and practices, the power of the shamans will increase, because they really do appear to speak for the gods. For example, suppose the shamans say, Dont eat pork, as it is unclean. If you eat pork, you will die demons will possess your stomach. You flout the policy, and eat pork in a hot environment where cleanliness and cooking procedures are (at best) inconsistent. Before long, parasitic trichinae from an undercooked piece of pork enter your intestines. Untreated, the trichinosis becomes acute, affecting your viscera and then even some of your voluntary muscle groups. You die, screaming. The shamans, shaken by the power of God to punish the wicked, redouble their efforts to ensure that Gods will is both universally known and obeyed. This leads us to a problem: how are we to evaluate the opinions of experts, or (alternatively) the democratic decision processes that use majority rule Our Hun-gats dont know what foods are safe to eat they are very uncertain, and afraid. Their votes would be meaningless on this question, because they have no basis for making good choices. The shamans only have laws based on accumulated experience, codified as religious dietary restrictions. These rules do not apply to new foods, because it is not clear where new comestibles fit into the existing system of safe and unsafe foods. Without a scientific understanding of what causes disease, or of what foods are safe, we have no means of making a decision. Neither expertise, nor democracy, is equipped to handle this problem. But being a policy analyst means you never get to say I dont know. The Hun-gats have to do something, because their children are crying from hunger. And Gombog, who is a bulky man, is starting to get nervous at the way people stop talking, but keep staring, when he walks up. Suppose you are a consultant, whose job it is to help the Hun-gats decide what policy they should adopt for new foods. What would you recommend What are the alternatives There is a general process of policy decision, which you need to understand to get through the rest of this book. We will spend quite a bit of time fleshing out this process later, but for now lets just give the outline, as depicted in Figure 2.3. Step 1: Is there a problem What is it Step 2: Should we decide collectively, or privately, how to solve the problem Step 3: If a collective decision is required, should we decide using democracy, or delegate policy-making authority to experts Figure 2.3 about here The outcomes of this process have three broad categories, the figure shows. In the broadest sense, the alternatives are those listed in Figure 2.3: (a) Allow the problem to remain outside the scope of collective control. This might occur because no one cares, or because the issue is not deemed as important. Alternatively, this nondecision may be an aspect of civic or religious culture: it never occurs to citizens to have government intervene. In practical terms, citizens may choose whatever action they like, subject to other restrictions the society has placed on individual action. In the case of our Hun-gats, if no explicit policy is chosen, each person may eat, or not eat, new foods. (b) Decide the problem collectively, but choose to allow citizens to make their own choices. This seems a lot like option (a), but there is an important difference. In the first case, there is no decision, or else it just appears that the problem is beyond the appropriate scope of government action. For option (b), there is an affirmative act, an actual decision that citizens must be allowed to make their own choices, even if the collective may not like those choices. This means there has been a collective choice that the problem will be treated as if it were private. So, though in practical policy terms these two seem the same (in each case, people choose), in fact there is a world of difference (in the second case, the choice was collective, so it is much more likely to change in the future). (c) Collective choice. Once a decision has been made to decide collectively, the collective choice is often made by democratic means, such as voting in a referendum or choosing representatives. Within the prescribed limits of the collective choice, the will of the majority (or whatever other decision rule is in use) is binding on the other citizens. (d) Delegate authority to make a collective choice to experts. This type of outcome has different properties than the option (c), democratic choice. In some ways, it may be better, because the choice is made by well-informed, highly trained people. On the other hand, the decision may appear less legitimate, because it seems imposed. The people did not consent to the choice, as in majority rule they delegated the choice. What this all means is that the basis of the grant of expertise is crucial. If expertise comes from knowledge of reading goat entrails or star portents, there are likely to be problems. The biggest problem, of course, is that non-experts have a hard time judging expertise. Experts have to judge themselves, with peer review and licensing requirements. For most of the rest of this book, we will consider some of the implications of delegation to experts, and look at problems with markets and democracy. The technical tools we consider in the later chapters are all designed to ensure that the reader, once he or she has become an expert policy analyst, will get things right, or will recognize when others have things wrong. Before we can do that, however, it is useful to consider the biggest question that societies have to face, one that we already mentioned but did not really address in any fundamental way. That question is the choice of the public or private arenas for decision. Public Decisions and Collective Decisions So far, I have talked about public and private decisions as if there were clear and obvious differences. But this is hardly the case. In fact, the rhetoric of many policy conflicts is about just the problem of whether the public has any business telling individuals what to do. While I cant offer a general solution to that problem, I can point out a subtlety that is often missed in policy debate: there is a difference between public decisions and collective decisions. The easiest way to appreciate this distinction is to consider Figure 2.4. Public decisions can be defined as those where my choices affect your welfare. Private decisions are then choices that affect only my welfare. This affect welfare standard is subjective, of course. It may affect my welfare that you wear an ugly (in my opinion) tie, or use racial epithets, or enjoy pornographic films and books. In the extreme, you have offended me could be an almost universal excuse for forcing my will on others. Alternatively, the idea of private actions is hard to define, or sustain. I have said that marriage is a private act. Yet the potential that gay men or lesbian women may want to marry is an important political issue, because at present that right is not established. In some ways, public decisions are just those that other people care a lot about, which is simply subjective. Still, some objective criteria for externalities can be devised, as we will see. Figure 2.4 about here The difference between individual and collective decisions, by contrast, can be defined in practical, measurable terms, as a question of the power to choose. Individual decisions are those where I can choose on my own. Collective decisions are made by a group, using some choice rule, and are binding on all. As can be seen, there is a difference between the public-private and individual-collective conceptions of choice. Certainly, many of the decisions a society faces fall along the main diagonal (top left and bottom right boxes) in Figure 2.4: private decisions are made by individuals, and public decisions are made collectively. But that is not always true. There is nothing about the machinery of democracy that prevents private decisions from being made collectively. This result is usually identified as tyranny of the majority over an individual, or smaller group. Conversely, public decisions may be made by individuals: I may choose to pollute common pool resources such as air or water, or I may undertake activities that affect others positively (such as seeking an education) without being able to capture the full gains from the activity. These negative externalities (if the activity is harmful to others) can effectively result in theft of value from the rest of society. Positive externalities (when the activity results in uncompensated benefits to others), may explain why there is underinvestment, or too little of such activities undertaken privately. The final point worth noting about Figure 2.4 is the fact that it identifies rhetorical strategies in policy debates. In most cases, the default policy is the top left box: Individual decisions made on private matters. Earlier, in Figure 2.3, we saw that the first two steps in a public policy process are identification of a problem, and then a decision about whether the problem is public. The rhetoric of the debate will focus on the question of whether the problem is really more appropriately in the bottom right box, or public decisions, collectively reached. So the point of the debate is whether the decision should be made collectively . but the words of the debate will be a contest over whether the decision has public implications. It turns out that the concept of externality is a powerful rhetorical tool, as well as a legitimate analytical concept. I began this chapter with a quote from Edmund Burke: Government is a contrivance of human wisdom to provide for human wants. Men have a right that these wants should be provided for by this wisdom. Using human wisdom to provide for human wants is not easy, but it is what policy analysis is all about. In this chapter, there were three separate themes of introduction to policy analysis. It is useful to summarize each so the reader can see how they fit together. First, as the title of the book suggests, policy outcomes are the results of policy conflicts. I argued that there are three main dyadic conflicts in the policy world, with three different types of associated policies. The reason that policy may seem contradictory or incoherent is that the results a particular policy conflict produces is an answer to a very specific question. If the goals or interests of the observer are different, then the result may be hard to explain. The three main policy conflicts are as follows: Markets vs. Experts: efficiency policies Markets vs. Politics: equity policies Politics vs. Experts: institutional reform policies Second, the origins of many policies may be obscure. We tend to use thing that work, even if we dont understand quite why. Just as dietary laws had to be based on accumulated trial-and-error knowledge from the past rather than a scientific theory of epidemiology and disease, our understanding of policy from a theoretical perspective is primitive. This makes policy analysis frustrating, since so little is known about cause and effect. It also makes policy analysis exciting, because it is possible to make lots of progress very quickly on fundamental problems. Third, it is important to recognize that there may be policies even when we havent decided anything, or even when we havent decided whether to decide. I proposed a three-stage process for conceiving the policy process: Step 1: Is there a problem What is it Step 2: Should we decide collectively, or privately, how to solve the problem Step 3: If a collective decision is required, should we decide using democracy, or delegate policy-making authority to experts In many cases, the fact that there is no formal policy is not the result of any failures in steps 2 or 3. Rather, we never got past step 1, realizing that there is a problem or agreeing on its nature. The notion that a problem exists is logically antecedent to the conclusion that something should be done. Generally, we hope that something should be done about what I have called public problems, where the actions of one person affect the welfare of others. The difficulty is that what is decided is not whether the problem is public rather, what is decided is whether the authority to delegate power is held collectively . This contest, over what is legitimately within the purview of the society to decide for its citizens, may be the biggest policy conflict of all. Key Concepts Markets Democracy Experts Market-Expert Conflicts: Efficiency Policies Market-Democracy Conflicts: Equity Policies Expert-Democracy Conflicts: Institutional Reform Policies The State of Nature: No Policies Public Decisions vs. Collective Decisions Homework Questions 1. In Figure 2.4, two kinds of potential tyranny were identified. One of these occurred when a group decides a private matter for an individual, as when I am told how I must act, dress, eat, or think. This is tyranny of the majority. The other type occurred when an individual imposes his or her will on the group, as when one person pollutes the atmosphere or steals public property. This is tyranny of the individual. Obviously, societies face an important problem in deciding how to balance these two types of tyranny: giving the collective more power helps control tyranny of the individual, but encourages tyranny of the majority. Write an essay to answer each of the following questions. uma. In this chapter, we saw some philosophers (e. g. Rousseau) who thought that the power of the collective is most important, and others (e. g. Burke, at least in the quoted passage) who that that freedom of the individual is paramount. Who is right b. More importantly, how should society divide the public and private spheres of our lives, identifying what should be decided collectively and what should be chosen by individuals without government interference c. Finally, should the answer to this question be taken from economic theory, and the notion of public goods, or from theories of justice, and the good society If neither tells us everything we need to know, then how should we approach the problem 2. Define, and give an example of, each of the following categories of policy. Describe also the policy conflict that gives rise to such policies. uma. Efficiency policies b. Equity policies Institutional reform policies 3. A Benchmark for Performance: What is a Market Overview of Markets The first two chapters have described the profession of policy analysis, given a little background on the problem of making collective and private decisions, and identified the key tensions or conflicts that shape real policy debates. Now it is time to turn to the form of organization most commonly used to direct human activity: the market. This chapter, and the next, are devoted to an outline of basic economic concepts. Let there be no mistake, however: this introduction is no substitute for a real course of study in economics. Economics is central to the study of markets, and to the analysis of policy in general, so if you are serious about becoming an analyst you will have lots more work to do. On the other hand, it is possible to give a quick, and hopefully intuitive, overview that will actually take you quite a long way toward appreciating the value of economic reasoning. Markets arent like politics, which takes place in a particular institutional context created by rules and procedures, or expert analysis, which follows professional norms and guidelines. A market is a set of institutions, rules, or informal norms, that promote exchange. Interestingly, it is not unusual for complex institutions for the facilitation of exchange among owners of resources to emerge spontaneously, without any central plan or conscious act of collective creation. More simply, markets happen. That doesnt mean that what happens is always good. Precisely because a market is likely to break out in almost any context, sometimes markets perform well and sometimes they perform poorly. Any one of the following conditions is likely to give rise to the set of exchange institutions we think of as a market. Preconditions for the existence of a market 1. Differences in goals, tastes, or desires ( diverse preferences ) 2. Differences in endowments of productive resources and personal talents ( diverse endowments ) 3. Declining average costs as more output is produced ( economies of scale ) 4. Declining average costs as the scope of action of one producer is decreased ( specialization ) If people were clones in preferences and endowments, and production processes were linear in scale and scope, then markets would be irrelevant. It would be just as easy (efficient) to produce everything we wanted on our own. This go it alone kind of economic organization is called autarky . or a Robinson Crusoe economy, after the famous Daniel Defoe character. The fact that markets are widely observed is a hint about their function: markets make human beings better off. Not all human beings are better off, perhaps, and some of us are helped more than others, but by and large markets improve the human condition. There are three aspects to the benefits of markets. Any action by experts, or by politics, to suppress or distort the functioning of markets can cause harm by denying citizens these three advantages. That doesnt mean that such action may not be necessary, or even beneficial. Rather, identifying the beneficial aspects of markets helps us keep in mind the nature of the costs of using regulation, or alternative means of organization. Gains from trade . Differences in endowments, or differences in preferences, result in improved welfare for all participants, as long as trades are informed and voluntary. This is a benefit in consumption, since by rearranging the consumption bundles among citizens, we can make everyone better off, even though there is no increase in the total amount of goods available for consumption. Magic No, just markets. Gains in productive efficiency: By allowing entrepreneurs to take advantage of economies of scale, or economies accruing to increased specialization, markets foster economic growth. An increase in the level of economic activity means growth in the total amount of consumption goods available to citizens. Increased efficiency in production means that more can be produced with the same resources, again creating the potential for everyone to be better off. Reductions in transactions costs using information transmitted by prices: Quite separate from efficiency in the allocation of consumption goods (i. e. ensuring all gains from trade are exhausted) and efficiency in the allocation of productive resources, markets also provide the important service of providing information. Prices convey information about relative scarcity in a concise, yet effective way. To see how these aspects of markets work, it is useful to consider some thinkers who have studied market processes. Nearly 2,500 years ago, the Greek philosopher Aristotle made some accurate and important observations about the origins of money, and of markets, that are no less true today. Of everything which we possess there are two uses: both belong to the thing as such, but not in the same manner, for one is the proper, and the other the improper or secondary use of it. For example, a shoe is used for wear, and is used for exchange both are uses of the shoe. He who gives a shoe in exchange for money or food to him who wants one, does indeed use the shoe as a shoe, but this is not its proper or primary purpose, for a shoe is not made to be an object of barter. The same may be said of all possessions, for the art of exchange extends to all of them, and it arises at first from what is natural, from the circumstance that some have too little, others too much. Hence we may infer that retail trade is not a natural part of the art of getting wealth had it been so, men would have ceased to exchange when they had enough. In the first community, indeed, which is the family, this art is obviously of no use, but it begins to be useful when the society increases. For the members of the family originally had all things in common later, when the family divided into parts, the parts shared in many things, and different parts in different things, which they had to give in exchange for what they wanted, a kind of barter which is still practiced among barbarous nations who exchange with one another the necessaries of life and nothing more giving and receiving wine, for example, in exchange for coin, and the like. This sort of barter is not part of the wealth-getting art and is not contrary to nature, but is needed for the satisfaction of mens natural wants. The other or more complex form of exchange grew, as might have been inferred, out of the simpler. When the inhabitants of one country became more dependent on those of another, and they imported what they needed, and exported what they had too much of, money necessarily came into use. For the various necessaries of life are not easily carried about, and hence men agreed to employ in their dealings with each other something which was intrinsically useful and easily applicable to the purposes of life, for example, iron, silver, and the like. Of this the value was at first measured simply by size and weight, but in process of time they put a stamp upon it, to save the trouble of weighing and to mark the value When the use of coin had once been discovered, out of the barter of necessary articles arose the other art of wealth getting, namely, retail trade which was at first probably a simple matter, but became more complicated as soon as men learned by experience whence and by what exchanges the greatest profit might be made. Originating in the use of coin, the art of getting wealth is generally thought to be chiefly concerned with it, and to be the art which produces riches and wealth having to consider how they may be accumulated. Indeed, riches is assumed by many to be only a quantity of coin, because the arts of getting wealth and retail trade are concerned with coin. Others maintain that coined money is a mere sham, a thing not natural, but conventional only, because, if the users substitute another commodity for it, it is worthless, and because it is not useful as a means to any of the necessities of life, and, indeed, he who is rich in coin may often be in want of necessary food. But how can that be wealth of which a man may have a great abundance and yet perish with hunger, like Midas in the fable, whose insatiable prayer turned everything that was set before him into gold (Aristotles Politics . Book I, Section 9). The paradox that Aristotle points out is interesting. Money is clearly not wealth, because a person with nothing but money would starve. The answer, of course, is that money represents all other commodities. The medium of exchange is a measure of value, or the unit of account, of the barters people would negotiate if money were not available. Instead of me trading you two bottles of wine for a sheep, we can exchange money. I give you 10 for a sheep. You give me 5 each for bottles of wine, and end up buying two bottles. The 10 went back and forth, to no net effect for this reason, some economists say that money is a veil, disguising but not really affecting the contours of trade. In our example, money was an artifice: the real exchange was the trade of wine for mutton. Having a currency, however, reduces the frictions or transactions costs of the exchange, making it easier for both of us. Furthermore, if we have money the exchange need not be directly a barter between two people. If my only option is trading wine for sheep, but you dont like wine, I cant get any sheep, even if each sheep is worth two bottles of wine Money breaks the dyadic relations of barter into separate exchanges, allowing me to obtain abstract command over goods and services (i. e. units of money) instead of having to take physical possession of a commodity I dont value or cant use. Money allows us to focus on an important aspect of scarcity, the opportunity cost of a commodity. It is worth pausing to consider opportunity cost more carefully. Opportunity Costs and Scarcity Using a resourcetime, gold, wood, a drill press, or laborfor one purpose means you can not use it for something else. We all want more things (more leisure, more consumption, more savings), so there couldnt possibly be enough to go around. Consequently, societies have to find ways to allocate limited resources in the face of unlimited wants. This is what economists mean when they talk about the problem of scarcity: How do we allocate limited resources to satisfy unlimited human wants To understand scarcity better, I have to define a related concept, opportunity cost. Opportunity cost : the cost of foregone alternatives, or uses given up if a resource is used in a particular way. If a resources can be used for activity A or activity B, the opportunity cost of using it for B is the value of its use for A. In an idealized, perfectly functioning market system, the opportunity cost of a resource is greater than or equal to its price. In practice, however, the relation between opportunity cost and price has no necessary sign or magnitude. Opportunity cost can be illustrated fairly simply, but it is a subtle concept. Consider this: If you found a valuable diamond, and I wanted it, would you give it to me Suppose you dont know me, and that I am not a member of your family, and so have no claim on your affections. Then I suspect you would not give me the diamond for one penny less than its market value, despite the fact that the diamond was free. The price you paid to obtain a commodity is completely irrelevant to its value to you, or to the opportunity cost of using it or giving it away. As an illustration, ponder a test question I asked in an intermediate microeconomics class while teaching at Dartmouth College. I was surprised then how many people missed it see if you get the right answer. Mental exercise on opportunity cost: What would you do Suppose you are a really big fan of the rock star, Mickey Martin, especially his number one hit about root canal surgery without anesthesia, Living, But Need a Local You hear he is coming to town to give a concert in two weeks. Seating at the concert is festival style, so that there are no reserved seats: one ticket is just like another, since you have to stand in line at the gate to get seats. Tickets cost 25.00, and you want two, so you can take your friend along. Arriving to buy tickets when they go on sale a week before the show, you see that you have underestimated how popular Rartin is in your city. The line stretches around the block. You wait in line, and move slowly toward the ticket window. When you are only about 30 people from the front of the line, with hundreds now standing behind you, you hear the ticket window slam shut, and hear a loud murmur rippling back along the line: Sold out SOLD OUT Oh, no. Days later, back at home, you read that scalpers (assume re-selling tickets, or scalping, is legal in your state) are asking, and getting, 200 or more for a ticket to the show. As you walk out to your car, you hear snatches of Martins songs from a nearby fraternity house. You think to yourself how much you want to see that show. You have more than 1,000 in your checking account, and still have no plans for the night of the concert. But there is just no way that it is worth 400 for two tickets Heck, for that much money, you can buy a CD player, and every Mickey Martin CD ever made As you start to get in the car, you notice a scuffed envelope on the sidewalk. Looking around, you dont see anyone. You pick up the envelope and inside, mirabile dictu . you find two tickets to the Bingsteen show. You make a legitimate effort to see if anyone lost the tickets, but of course you cant just go ask random people, because they would say, Yeah, sure, hand em over. I lost those. You bet I did Deciding the tickets really are yours now, here is the question: Do you go to the concert The answer, as any economist will tell you, is no. After all, you can scalp the tickets, which means you should value the tickets at their opportunity cost: 200 each. But we have already established that the concert was not worth 200 per ticket, at least not to you, because you had a chance to pay that price to a scalper and decided against it. This turned out to be a bad test question: all my students missed it. It is not that I am a bad teacher: the student seemed to understand opportunity cost as an abstract concept, and could recite the formal definition without a hitch. But when it came time to apply the concept, they had no intuition. They all had some version of the same answer: Of course I would go. Free tickets: cool No, no, NO . The tickets are not free, because using them costs you the 400 you could have obtained by selling them. It doesnt matter what you pay for something the price is what you give up by using the resource. The real price of something is its opportunity cost. Obtaining something for free is very different from valuing that thing at zero. If you found a diamond, you would not give it away. Having defined opportunity cost, it is immediately possible to define scarcity: Scarce resource : A resource is scarce if its effective opportunity cost exceeds zero. Generally, this means that any resource with a price greater than zero is scarce, because opportunity cost is at least as great as price. If a resource has a zero effective price it may still be scarce, however, because property rights to the resource may be imperfectly specified. Notice that scarce, by this definition, and another adjective, valuable, are certainly not synonyms. Air to breathe is not scarce . for most of us, because it can be obtained for free. But it is of paramount value . If property rights to air are poorly specified (if the air is what is sometimes called a common pool resource), the market price of air might be zero. Yet the opportunity cost of using the air as a dumping ground for industrial waste may be far higher than zero. One of the main goals of experts working in policy analysis is to find ways to make the price to an individual of using a resource equal to its true social opportunity cost. It is useful to state the reason explicitly, in a form I will call Pigous Conjecture, after A. C. Pigous famous argument in The Economics of Welfare . Pigous Conjecture : Markets are inefficient, as a means of allocating resources, to the extent that the (social) opportunity cost of a resource diverges from its price, or private cost to the user. The inefficiency derives from the overuse (if social cost is greater than price) or underuse (if social cost is less than price) of the resource. To return to the air pollution example, if the cost to me of using the air to dump wastes is small, but the costs to society are large, then I will overuse (in terms of efficiency, to say nothing of justice) the atmosphere as a trash can. The policy prescription that arises from this conjecture is the need to use a system of taxes or subsidies to make the opportunity cost of the resource equal the effective price as nearly as possible. That is, if the amount I pay is equal to the full social cost, I will take all of those social costs into account when making decisions on resource use. Consequently, I will use the resource only if the advantages to me exceed the full social costs. There is a counterclaim that questions Pigous Conjecture I will call it Coases Counter-Conjecture, from R. H. Coases (1960) The Problem of Social Cost. Coasess Counter-Conjecture : If property rights are clearly and exclusively defined, and the cost of writing and enforcing contracts is not too high, market forces will make the opportunity cost and the price of a resource converge. Why are these two claims conjectures Because neither is proven In fact, each claim is true, in some deductive sense. The debate turns on the question of which approach makes better public policy: an expert-managed approach (Pigou) or a decentralized market-oriented approach (Coase). In terms of the model of policy conflict developed in the previous chapter, we are in the arena of markets vs. experts, with attempts by political actors to manipulate the outcome to their benefit. In later chapters, the bases of this debate will be considered in more detail. At this point, I will turn to an introduction to the logic and function of a market system, so that we can begin to evaluate the two conjectures. Allocating Scarce Resources Markets exist for a reason. Our interest in market processes derives from their importance as a mechanism for addressing scarcity. But it is worth remembering that markets are not the only means available. As a matter of institutional technology, there are, there are four major ways to allocate resources in the face of scarcity: 1. Price System (market): Resources are directed to their highest-valued use, so that whoever is willing to pay the most (either in terms of other valuable goods, or in currency) gets to control the resource. Big winners . People with lots of money, or with talents or resources the society values highly. Disadvantages . There are two. (1) Poor people may get too little, creating ethical problems of equity. (2) Independently of their basis in justice, market allocations may be politically untenable, if democratically based authority is in a position to impose redistributive or confiscatory taxes. 2. Queuing: A queue is a line. Queuing means a system of allocation based on waiting your turn. So, first in line is first in priority. If all the resource is used up before your turn, you lose out. Big winners . People with lots of time (actually, a low opportunity cost of time spent waiting in line). Disadvantages . There are two. (1) People standing in line incur lots of deadweight losses, or time wasted, for no gain in consumption or productivity. (2) There is no reason to believe that resources are directed to their highest valued uses. As evidence, consider that queue-based allocations often evoke secondary, or black, markets, where allocations initially dictated by queueing are reallocation by prices. 3. Chance: Lotteries, drawings, or other random selection processes mean everyone has an equal chance of winning. Big winners . No individual is a winner from the process, because in terms of expected value everyone is treated the same. From an ethical perspective, however, this may be an advantage. Disadvantage . By definition, allocation is random. The person who actually gets the resource may value it at only a fraction of its worth to someone else. Opportunity cost is explicitly ignored in random processes. Consequently, chance allocations evoke secondary markets for reallocating by price. 4. AuthorityDiscretion: Allocations can be made by experts, party officials, elected leaders, or central planners. This sort of allocation process is also called a command system. Big winners . Guess who: the party officials, their friends, and family Alternatively, the beneficiaries of the policy may be those targeted by the policy, if discretion is used to avoid corruption and follow the rules. Disadvantage . There are two. First, it is very difficult to obtain the information required to make accurate judgments about scarcity and opportunity cost, without some mechanism for measuring intensity. In effect, command systems often fall back on queuing, as people are forced to stand in long lines for products sold far below their opportunity cost values. Second, command systems present almost irresistable opportunities for corruption and favoritism, because the central authority cant monitor all the officials with the ability to hold up products in exchange for bribes or in-kind payoffs. The distinguishing feature of a market system of allocation is the reliance on prices. You are used to prices you have dealt with them all your life. Some prices are stated in terms of goods, as when you decide whether to trade baseball cards: Is a Ken Griffey rookie card worth a Mark Lemke plus a Dave Stieb, or would it take a third card to make the values equal (Hint, non-sports fans: it would take a third card) Some prices are quoted in terms of dollars, like when you go into a store and see a candy bar in a display rack. The price is on a sticker on the candy, or on a sign above the rack: 75 cents. Have you every thought about what this price means, what it really means The price is what you give up to get something else. If you spend the 75 cents on the candy, you wont have it anymore. But there are other prices operating here, in ways that are less obvious but just as important. The storeowner decided to display that candy bar, and not some other another display choice might have resulted in increased sales. The candy maker uses her machines, buildings, and distribution network to put that candy bar, and not some other one, in the stores. Just as price affects your decision to buy the candy bar, price influences the store owner and the manufacturer in their choices about what to display, and what to produce. More broadly, in a market system, the prices of resources serve two very different, and very important functions. First, prices are signals about the relative scarcities of resources. Second, prices determine wealth by giving a concrete value to the resources owned by individuals. Lets consider each of these functions in turn. Prices are scarcity signals Suppose you arent just worried about candy bars anymore. Suppose you were put in charge of planning a very large number of activities. In fact, you must make all production decisions and consumption choices in an entire nation. What is the right set of choices You must first allocate all of your productive resources among myriad alternative uses. Then you have to decide who gets to consume all these different outputs, and how much they get. Start with farmland: should you grow corn, wheat, or soybeans Should you grow cotton Should you use the land for cows, or pigs for food, or sheep for wool to make warm clothing After all these production decisions are made, your storehouses are full of clothes, food, and machines how do you dole them out What allocation rule would give you the best result You could give everyone an equal share, or you could use some other rule to assess each persons needs. Obviously, in a market system this is not the way things work, because there is no central planner who directs resources to their highest valued use. A farmer in central Illinois doesnt wait for a letter from the government to decide how to use his land. Instead, he makes forecasts of the results of different courses of action, and then chooses the one that results in the largest excess of revenue over costs. What information is available to make these forecasts How does the farmer know what to do, if he is not given instructions from a central planner The farmer uses prices as a signal. Notice how cheaply, and yet elegantly, price signals the value of different resources for the society. The farmer looks at a newspaper, and sees that soybean prices (lets keep this simple, and ignore futures markets) have risen by more than 2.00 per bushel, from 6.20 per bushel to 8.25 per bushel. If he is a reflective man, he may wonder why. If he is a compassionate man, he may feel sorrow for the hardships that the scarcity of soybeans is imposing on consumers. But suppose he is neither reflective nor compassionate. All this farmer is is a terrible, selfish man, not at all given to altruistic impulses. What does he do He immediately drives to the seed store, and plants every inch of land he owns in soybeans So the selfish, narrow-minded, only out for himself farmer hurries to do what an omniscient, benevolent central planner would have wanted the farmer to do from the perspective of benefiting the entire society. This should give you goosebumps: the selfish farmer (1) didnt need to know the source of the scarcity, and (2) doesnt need to care about the welfare of those harmed by the scarcity. All he needs to do is care about himself, and the scarcity is very effectively addressed. This feature of markets has been extensively analyzed, by F. A. Hayek (in his 1945 article The Use of Knowledge in Society) and others, but the best-known statement of the function of prices is the earliest. In his 1776 The Wealth of Nations . Adam Smith resolved the problem of how resources are directed to their highest valued use without resort to any central direction whatsoever: Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting itBy preferring that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it. (Smith, 1994, pp. 484-5). In these passages, Smith is making two rather astonishing claims: (1) In a properly functioning market system, actions based on self-interests are identical with those actions implied by altruism (ignoring problems of the distribution of wealth). (2) The net value (i. e. the benefits minus the costs of operation and transmission of information) of a price system for signaling scarcity, and directing resources, is so great that no expert-driven central planning regime could possibly duplicate it. With hindsight, and two hundred years of economic analysis of markets, we now know that there are a number of important qualifications and corrections that weaken these claims. In some cases, as we will see in later chapters, one or both claims are simply not true. Still, the basic structure of the reasoning of Smith has stood the test of time: markets are uniquely suited to foster the organization of large numbers of decentralized production and consumption decisions. Not only is no central plan required to create this happy result, but even the most draconian repression of market processes is unlikely to snuff out a black market system of exchanges based on the self-interest of the participants. This is the efficiency argument for market processes, and it is a powerful argument indeed. Prices Determine Wealth in a Market System As I noted above, prices have two functions in a market system. The first, directing economic activity in production and consumption by producing signals of relative scarcity, is the one proponents of the market point to when they advocate the use of markets. What about the second function, the determination of wealth Wealth has two very different definitions, and it is important to keep them distinct. In a material sense, wealth might simply mean possession of a surplus of consumption goods. Robinson Crusoe, alone on his island, might have been wealthy in this sense, if he were able to provide for his own needs very comfortably by farming and by using the flotsam washed up from the wreck of his ship. But we usually mean something different by wealth, because we live in a society where there are markets, with production and exchange going on all around us. In this setting, wealth means the possession of command over lots of resources, and the ability to sell these resources to others, to direct their use, or to store them for use in the future. So one can no longer measure wealth by how much stuff one has. Instead, wealth is determined by the monetary value of all that stuff. And value means that we need prices. Suppose that there are n different products or resources one might own, and let us use i as an index for some unspecified resource. Let x represent resources, and let p represent prices. Then, for example, x 7 might be acres of land (suppose the person has four acres), and p 7 is the price of one acre (each acre is worth 15,000). The value of land the person owns would then be x 7 acute p 7 (in this case, 4 acute 15,000 60,000) so that part of the persons wealth could be measured this way. Formally, total wealth can be defined as follows: This may seem disturbing, when you think about it. If prices change, your wealth changes, even though the amount of stuff you own hasnt changed at all . To put it another way, you arent wealthy unless the society you live in places a high value on the resources you control. Most disturbing of all, a significant part of the wealth of most people is their own labor, which they offer in the market in exchange for wages. If the value of your labor is very low, you are poor. This may happen because your skills, though significant, are obsolete, as in the case of a buggy whip maker, or are in excess supply, as with a migrant farm field worker. The reason this creates difficulty is that, in a market system, the demand each of us has for consumer products is based not on how much we want the product, subjectively, but rather on how much our want is made effective by wealth. For example, consider this problem: how much does a starving person want a sandwich The answer is hard to swallow: if the starving person doesnt have any money, he doesnt want the sandwich at all, not one bit From a practical perspective, this is nonsense, of course: the starving man is desperate for food. But market systems operate on the premise that human desires have to be made effective by an offer of wealth, of one form or another. If the working of market processes leaves some people with too little wealth to survive, society may decide that the distribution of wealth needs to be changed. There are many ways of effecting this redistribution, but the premise is always the same: markets may operate efficiently, in the sense of directing resources to their highest-valued use. But that conception of value relies on the prices of resources possessed by individuals, and on the demands made effective by the value of those resources. To the extent that this definition of monetary value (based on scarcity) does not correspond to the ethical values (in terms of a theory of justice) of the society, then the distribution of wealth needs to be adjusted. The particular value which is generally invoked to justify income redistribution, from the wealthy to the poor is equity, or the sense that all citizens are entitled to a certain standard of living. The performance of markets in terms of scarcity-signaling ( efficiency ) is well-established the performance of markets in terms of ethical values ( equity ) is much more hotly debated. Furthermore, just to make everything a little more interesting, it turns out that expert-driven regulatory policies to improve performance on one dimension of performance may hurt performance on the other dimension. For example, an income tax designed to redistribute wealth from the rich to the poor can hurt efficiency, because it distorts the signal sent by effective (after tax) income. The conflict between efficiency arguments and equity arguments is one of the central themes in policy analysis, as we will see. For the remainder of this chapter, I will focus on four specific questions regarding the functioning of markets. First, how do markets originate Second, how does a pure barter system (i. e. exchange of goods, with neither currency nor production) serve to improve aggregate welfare Third, what are the functions of money, and how does money affect market processes Fourth, how can we evaluate, using ethical or normative criteria, the aggregate performance of a market system Market Origins Earlier in this chapter, I claimed that markets are likely to arise, spontaneously and without conscious decision on the part of any central authority, under any one of four conditions. It is useful to repeat those four conditions, because it is easy to forget just how general and flexible markets can be. The four conditions were: GAINS FROM TRADE Diverse preferences: My likes are different from your likes. Suppose we all got an identical initial endowment of fruit to eat: 4 oranges and 4 apples. Imagine I like oranges better than apples, but your likes, or preferences, are the reverse. Then, if I give you an apple and you give me an orange, we are both better off. This may seem like magic, because we are both better off even though the total amount of resources (8 apples and 8 oranges) in our little society is unchanged. It isnt magic, of course. Instead, fostering exchange at low cost is the primary reason markets, or something like markets, are universal in human societies, even those which had no contact with other groups. Resort to the market, or exchanges among people, improves the allocation of resources by directing each resource to it highest valued use. In this case, each person gets to eat more of the fruit he or she prefers. Diverse endowments: My likes are the same as yours, but we have different resources. Using the fruit example again, suppose that both of us like the same thing, fruit salad Imagine our resource endowments are distressingly monochrome, however: I have eight oranges, and you have eight pints of blueberries. If we really like fruit salad (sliced oranges with blueberries), we are mutually benefited by exchanging apples for oranges EFFICIENCY GAINS Economies of scale: An economy of scale is a technical condition, meaning that the cost per unit of producing an output falls as more output is produced. Suppose you had to hammer a nail, and bought a hammer for 10 to do it. Hammering that nail cost you 10.00, plus a nickel for the nail and a quarter for your time. So your cost per nail is 10.30. Now suppose you were hired to hammer ten nails your average cost is (10 .50 2.50)10, or 1.30 per nail. This situation is common in the use of expensive capital, or equipment for jobs. Because markets allow us to exchange services, one person who is pursuing nothing but his own self-interest will purchase tools which he could not justify for his personal use alone. But this results in a lower price for the service for everyone. As Adam Smith notes: It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours, and to purchase with a part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for. (p. 485). As a market system becomes more highly developed, enterprises spring up that can realize enormous economies of scale. Consider the cost per automobile if each automobile, or personal computer, had to be made separately, from a unique plan. If each of us had to rely on our own resources, we would enjoy very few of the technological marvels that now fill our homes. The reason we see these amenities, and are able to buy them at low prices, is that markets have developed to exploit the profit potential of economies of scale. Specialization: Efficiency gains from specialization are different from decreasing average costs. Adam Smith was the first to recognize this important feature of production processes in his famous example of the pin factory: To take an example, therefore, from a very trifling manufacture but one in which the division of labour has been very often taken notice of, the trade of the pin-maker a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head the making of the head requires two or three distinct operations to put it on, is a peculiar business, to whiten the pin is another it is even a trade in itself to put them into the paper and the important business of making a pin is, in this manner, divided into about eighteen distinct operation, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty eight thousand pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day. (Smith, 1994, pp. 4-5). It is important to understand the distinction between the two types of productive efficiencies fostered by markets. Economies of scale mean products in capital intensive industries are cheaper, as more output is produced. The gains to specialization derive from the division of labor into a larger number of smaller, discrete tasks. But both economies of scale and the division of labor are limited by the extent of the demand for the product. By rewarding increases in scale, and specialization, markets tie us all closer together, and create links, first across families, then across communities, and eventually across nations, as entrepreneurs seek out larger markets. Barter and Pure Exchange A barter system is created, or may just emerge spontaneously, as a means to capture gains from trade. As was pointed out in the apples, oranges, and blueberries examples earlier in this chapter, diversity in either preferences or endowments create the surprising opportunity for doing magic: Exchange improves everyones welfare, just by rearranging consumption bundles. That is, allowing trade, without increasing the total quantity available for consumption, can increase the value each person places on his or her consumption. We could start at a simpler level, of course. A true Robinson Crusoe economy, with just one person, is still an interesting problem. Our Robinson has complex analysis to perform, as he decides how to allocate his effort in growing, hunting, and gathering food, finding water, and building shelter. Each minute spent in one activity costs Robinson whatever he could have done with that minute in some other activity. Suppose he spends a month working on a garden, instead of fishing and preserving the fish he catches by salting and drying them. If the garden fails, Mr. Crusoe may starve. But the fact that there are costs doesnt mean that there is a market. The distinctive feature of markets is their use of a price system to allocate resources and send signals of relative scarcity. As F. A. Hayek (1945) argued, The economic problem of society ishow to secure the best use of resources known to any members of society, for ends whose relative importance only these individuals knowthe knowledge of the particular circumstances of time and placeTo know of and put to use a machine not fully employed, or somebodys skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alternative techniques. (pp. 520-522). It follows from this that central planning based on statistical information by its nature cannot take direct account of these circumstances of time and place(p. 524). Assume that somewhere in the world a new opportunity for the use of some raw material, say tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matterand it is very significant that it does not matterwhich of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere, and that in consequence they must economize tinThe most significant fact about market processes is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on, and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pricesin order to adjust their activities to changes of which they may never know more than is reflected in the price movementThe marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly i. e. they move in the right direction. (pp. 526-527). To put the point simply, then, markets are useful to societies because they can organize the activities of members of society, even in the absence of any central plan or direction. That is why even the most primitive market requires at least two people. Hayek is claiming that, especially in huge markets with thousands or millions of people, the organizing and directing function of prices is more important than one might think. People have tastes that drive their consumption choices exchange is perhaps the most important way for people to satisfy these tastes. To see how this works, lets consider a simple example. Everybody talks about the trade-offs between guns and butter lets not be so boring. We will analyze the trade-off between guns (more broadly, defense) and roses (representing the arts and other cultural amenities). Consider a representative citizen in the society where roses and guns are the only products available for consumption, and assume the following four statements are true: More guns are better More roses are better The fewer guns I have, the more I value an additional gun The fewer roses I have, the more I value an additional rose If these statements are accepted, we can depict a map of the value the citizen places on different combinations of roses and guns. More technically, we can represent the citizens preferences . using what are called indifference curves . Pick any point in the nonnegative quadrant of consumption space, depicted in Figure 3.1. Restricting ourselves to the nonnegative quadrant simply means that the citizen must consume quantities of roses, and guns, of at least zero: there can be no negative consumption. Figure 3.1 about here Suppose, when I said pick any point, that you picked B. There are then three types of alternative consumption bundles in the picture. Some, like D, with fewer roses and fewer guns, the citizen likes less than B. On the other hand, if there are more guns and more roses, the citizen likes it better, as with point E. If there are some points the citizen likes better, and some the citizen likes less, than B, there must be some boundary between these two sets. This boundary is the indifference curve, or the set of consumption bundles the citizens likes just as well as B. All we know for sure is that there are some points with more guns and fewer roses, and others with more roses and fewer guns, such that the citizen is indifferent between these points and B. For the sake of example, I have arbitrarily chosen points A and C, and drawn the indifference curve implied by this preference profile. The notion of an indifference curve is very useful for analyzing bargaining and the gains from trade. The fact that every point above the indifference curve (i. e. all consumption bundles with no less of both, and more of at least one, of the commodities compared to the points on the curve) is strictly preferred to any point on the curve, and that points below the curve are strictly inferior, allows us to depict problems of commodity exchange very precisely. To see this, consider Figure 3.2. Panel A of the figure depicts an exchange problem for two people, Mr. 1 and Ms. 2. Suppose there is a total of 40 guns, and 30 roses, available for allocation for consumption for the two people, and that Mr. 1 starts out with thirty guns, five roses (lets write this (30, 5)), and that Ms. 2 starts with (10, 25). Figure 3.2 about here The box in Figure 3.2 is called an Edgeworth Box, after its creator, Francis Ysidro Edgeworth. The clever thing about an Edgeworth Box is that its dimensions depend on the total amount of the resources available (the box is 30 roses high, and 40 guns wide). But each position in the Edgeworth Box depicts the way this total quantity of resources is divided up. That is, any point in the interior of the box actually has four coordinates: an allocation for Mr. 1 (in this case, (30, 5)), and an allocation for Ms. 2 (here, (10, 25)). Notice that the allocations are assumed to have no waste, or leakage, so that 301040, and 52530. The top right corner of the box is the origin, or (0,0) point, for Ms. 2 it is also the point where Mr. 1 gets everything: (40, 30). The question the Edgeworth Box provokes is obvious, but it is important: Are there any allocations that are stable . in the sense that if such an allocation is ever achieved, at least one party will refuse to exchange any of the commodities they possess for a quantity of some other commodity their trading partner is willing to give. A stable allocation of this sort is called an equilibrium, because it does not change. Is the initial allocation, where Mr. 1 has (30, 5) and Ms. 2 has (10, 25), an equilibrium The answer depends, of course, on whether there are any feasible trades that make both parties strictly better off. As you recall, any allocation above the relevant indifference curve is strictly preferred by the citizen to any point on the curve. This is true for both people, so the question of whether there are any mutually beneficial trades amounts to a simple graphical question: is there a nonempty intersection of the sets of consumption bundles preferred to the initial allocation You bet there is The hatched area, called the lens for its resemblance to an optical glass in side view, is the set of points both parties prefer to the initial allocation. The edges of the setthe two indifference curvesrepresent the boundaries of the set of mutually beneficial trading outcomes. So, the initial allocation is not an equilibrium, and we might conclude (rightly) that any division of the commodities is not an equilibrium if the intersection of preferred bundles is nonempty. But then it seems like you could draw a figure analogous to Panel A over and over, without ever establishing what we really want to know: what allocations could be equilibria The answer is actually fairly easy, when you think about it. Panel B shows an example of an equilibrium consistent with trading starting at the initial allocation of (30, 5), (10, 25). That equilibrium occurs at (22, 16) for Mr. 1, and (18, 14) for Ms. 2. How do we know that this is an equilibrium Consider the set of points Mr. 1 prefers to this final allocation: the points above, and to the right of the indifference curve through (22,16). Likewise, for Ms. 2: she likes points below, and to the left, of (18, 14) (where the coordinates are measured out from her origin, at the top right corner). What is the overlap of the two sets of preferred bundles Nothing, nothing at all, except the allocation itself: the indifference curves are tangent to each other. Tangency means, by definition, that the curves intersect at only point: the equilibrium itself. There are many such points of tangency for different pairs of indifference curves, of course. Depending on the preferences of the traders, the points of tangency can lie near the straight 45 deg line connecting the two origins, or these points can wander around, as shown in the heavy dotted line in Panel B. Regardless of the shape of the line connecting the points of tangency, this set of potential equilibria is called the contract curve. The reason is that we expect that fully informed trading partners will always ultimately write a contract that puts them somewhere on this curve. Later in this chapter, I will introduce some measures for evaluating performance, but it is worth pointing out that we have already discovered one, the Pareto optimum. Pareto optimum : An allocation of resources such that any trade or exchange makes at least one party to the trade worse off. It follows immediately that all points on the contract curve are Pareto optima. It also follows immediately that the concept of Pareto optimum is not a very strong criterion for evaluation. Notice that the following allocation (one endpoint of the contract curve) is a Pareto optimum: Mr. 1 gets everything, Ms. 2 gets nothing. So is the opposite endpoint on the contract curve, where Mr.1 gets nothing and Ms. takes it all. In a broader sense, we might want to say that neither of these is terribly optimal, from the perspective of society. Still, it is clearly true that points off the contract curve (i. e. allocations that are not Pareto optima) are poor candidates for selection as policy solutions. By definition, points off the contract curve allow reallocations such that both parties can be made better off. So, the intuition of the Pareto optimum really has more to do with efficiency (the absence of waste), than with any normative criterion of equity in distribution. One final point: what about price I have argued that the essence of the market system is the use of price to allocate resources. Yet it doesnt seem like prices appear anywhere in the analysis of exchange I have presented. Well, thats wrong: prices are lurk at each point on the contract curve in the Edgeworth Box. We are all accustomed to thinking of prices in terms of money, but the example in Figure 3.2 involves only pure exchange. That is how prices started out: to get something you wanted, you had to give up something in exchange. Consequently, the price of a gun (in our example) is the number of roses you have to pay. In our example, it appears that (at the equilibrium) two guns exchange for three roses that means that the price of a gun is 1.5 roses. Graphically, the price is the slope of the line through the point of tangency which intersects the indifference curves only at that point. The Functions of Money Why do we need money at all What is wrong with barter After all, as we saw from the Edgeworth Box in the previous section, it is possible to arrive at a Pareto optimum through barter alone, and the price implied by that equilibrium reflects the relative scarcity of the commodities available for consumption, given the preferences of the market participants. If I have to give up one apple to get half an orange, the opportunity cost of consuming that half orange is clear: I dont get to eat the apple. But prices are usually stated in terms of an abstraction: money. You may never have given money much thought (unless you were trying to get more), but money is an astonishing creation. Without money, societies as we know them could not possibly exist. Lets start with a definition. money: anything generally accepted as a medium of exchange, meaning that money represents abstract command over any goods and services available in the market. But that doesnt help very much, and is very nearly circular: if I will accept something in exchange for my goods, that means I must believe it has value as a medium of exchange. Why would I believe that it has such value Because I think other people will accept it in exchange for their goods. This is all rather upsetting, because we would like to have a better definition. But there really isnt one all that can be done is list the characteristics that make for good money. Characteristics of a Good Currency 1. Widely accepted as a medium of exchange . for any kind of transaction 2. Clear, consistent unit of account (one unit is identical with another). 3. Store of value (does not deteriorate if unspent) 4. Durable (does not wear out) 5. Difficult to counterfeit or create (not easily debased) 6. Divisible into small units (so you can make change) Now we can answer the why not barter question. Suppose that we had not just two, but three people, and three commodities. This is still a pretty simple society, but the added complexity in negotiating exchanges is considerable. The problem with three people and three commodities is that you may not be able to exchange your goods directly for what you want. Instead, you may have to conduct intermediate exchanges, and visit both other traders, to reach a Pareto optimal distribution of resources. Suppose Mr. 1 has apples, doesnt like oranges, and wants to get some bananas. Mr. 1 goes to Mr. 3, who has lots of bananas. However, Mr. 3 doesnt like apples he will only trade his bananas for oranges. So Mr. 1has to go over to Ms. 2, the orange farmer, and trade apples for oranges. Then, but only then, can Mr. 1 go back to Mr. 3 and effect the trade 1 wanted to make all along, securing bananas for his supper. Notice that this is true even if there is universal agreement (or a law) that the price of any one fruit is any other fruit. That is, an apple exchanges for an orange exchanges for a banana exchanges for an apple. If I have an apple, and you have a banana, I would like to trade. But you hate apples, and insist on an orange. I could walk over to the neighbors house, a mile away, and trade my apple for an orange, but that is too much trouble. More simply, the difference in my satisfaction between the banana I love and the apple I like is not enough to make me walk two miles. The essence of barter is then not haggling, or the separate negotiation of price, but rather the act of physically exchanging one commodity for an agreed-on amount of another commodity. The inconvenience and wasted time in making trades through barter dissipates much, or all, of the value of the trade. Economists call this friction in making exchanges transactions costs. Transactions costs are pure, deadweight losses, because no one gets any value or advantage out of the waste of time and energy. Reducing transactions costs is Pareto superior, because you are (in effect) getting something for nothing. And so, we have our answer: people use money, instead of barter, because money reduces the transactions cost of exchange. Our three fruit lovers might agree to create a fruit note, with the understanding that one unit of fruit note exchanges for an apple, a banana, or an orange. Then the holder of a note has abstract command over fruit of any type Mr. 1 can immediately obtain his bananas, without the intermediate exchanges. There are other advantages, of course. Mr. 1, who has apple trees, could plausibly borrow against his nearly ripe, but not yet edible, apple crop, obtaining fruit notes on loan from Mr. 2, with the understanding that the fruit notes will be paid back when it becomes possible to sell the apples. In effect, Mr. 1 is just exchanging apples in the future for bananas now, but the institution of a currency facilitates this exchange. In nearly all human societies, most economic activity is concerned with the making and spending of money incomes. Historically, many different objects have served as money, including stones, shells, ivory, wampum beads, tobacco, furs, and dried fish, but it appears that even from the earliest times precious metals (especially gold and silver) have been preferred because they satisfy the characteristics of good money listed above. To a larger and larger extent, however, money does not depend on its value as a commodity. Paper currency was first issued about 300 years ago, but until recently was almost universally backed by some standard commodity of intrinsic value into which the currency could be freely converted on demand. By contrast, fiat money is inconvertible money made legal tender by the decree of the government. The Australian government has introduced a plastic money, lighter and cheaper than metal, and more durable than paper. But most money in the world does not exist at all, at least not in any physical sense. More than 90 of the worlds money exists only as a binary code on some electromagnetic medium, with an electronic tag identifying who owns it. The increasing use of credit cards, ATM-debit cards, and other paperless forms of transacting appear destined to eliminate the last 10 of money held as currency or commodities. Why Because eliminating the physical aspect of money reduces transactions cost even further. Arent markets wonderful Well, yes, markets are wonderful. Immediately following this chapter is a case study, excerpted from a fascinating account of the spontaneous emergence of a set of institutions of exchange, and how a market based on a cigarette currency allowed a group of prisoners of war to improve their lives. But the market system of organization is not perfect, and sometimes it is downright bad. In Chapter 4, following the case study, we will consider failures of markets, and difficulties in evaluating market processes. Key Concepts Markets Barter Preconditions for Markets A. Gains from Trade1. Diverse Preferences 2. Diverse Endowments B. Technical Cost Conditions 1. Economies of Scale 2. Division of Labor Autarky Money A. Uses of Money 1. Medium of Exchange2. Unit of Account 3. Store of Value B. Characteristics of Good Money 1. Widely Accepted 2. Consistency, Interchangeability 3. Nonperishable 4. Durable 5. Hard to Counterfeit