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Recent Research: Highlights from December 2012

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"Framework for Hedge Fund Return and Risk Attribution"
The Journal of Investing (Winter 2012)
Rob Brown

This article provides a framework for hedge fund return and risk attribution through the construction of a relevant benchmark. It is shown that volatility is a source of systematic risk, volatility measures based on equity market returns are more robust, fees have averaged between one-half and one-third of total gross returns, and high explanatory power can be achieved without the use of exotic systematic risk factors. Finally, the article suggests that alpha and systematic risk loadings are best estimated when regressed on gross returns and that systematic risk exposures are multi-dimensional and effectively modeled using a four-factor model. Hedge fund performance is determined by exposure, skill, and cost. The framework presented here provides robust attribution to exposure, skill, and cost.

"Are Hedge Funds Systemically Important?"
The Journal of Derivatives (Winter 2012)
Gregory W. Brown, Jeremiah Green, and John R.M. Hand

Like derivatives, hedge funds are often blamed for causing or at least contributing to economic and financial disruptions, regardless of whether any factual evidence supports that conclusion. The entire financial system was affected in Fall 2008, which then raised the general question of whether hedge funds are a source of systemic risk, and more specifically, whether they engaged in predatory trading that caused or exacerbated the market crash. For example, fear of “bear raids,” presumably by large and aggressive players including hedge funds, led to a ban on short selling for over 1,000 financial stocks during that period. Hedge funds might cause systemic risk intentionally, to make profits while inflicting losses on the system, such as in a bear raid. Or, their impact could be unintentional, if hedge funds experienced forced liquidations of leveraged positions to meet customer redemptions.

"Raising the First Round of Venture Capital: What Founding Teams Should Understand"
The Journal of Private Equity (Winter 2012)
Fred Dotzler

This article intends to shed light on the process and increase the probability of a successful fundraising effort. Founders of a startup should prepare for the initial fundraising before contacting carefully targeted prospective investors. When meeting with these funds, the team can ask the funds to explain the steps the fund will make in deciding whether or not to invest. The startup team should: pay close attention to what is being said and done by prospective investors; not waste time on those prospects who do not appear engaged; and solicit more than one term sheet so the company is not forced to accept undesirable terms.

"Categorization of Indices: Do All Roads Lead to Rome?"
The Journal of Index Investing (Winter 2012)
Patrick Gander, Daniel Leveau, and Thomas Pfiffner

Based on the theoretical concepts of the various index methods, we first conduct a qualitative categorization. We next try to validate it with a formal statistical analysis. We conclude that many indexing methods, such as fundamental, risk parity, and equal-weighted indexing, can be classified into five distinct groups, the choice of which can have a material impact on an investor’s allocation process.

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