Tuesday, May 10, 2016

Have hedge funds advanced the science of finance?

Has the science of finance advanced because of the the presence of hedge funds? Has our knowledge of finance improved because of hedge funds? These are interesting questions to consider not because it may tell us something about hedge funds, but because it may tell us something about the advancement of science and the development of knowledge in finance. Knowledge improves through its general dissemination. Private knowledge generally does not advance science. So the question is whether hedge funds help with the dissemination of financial knowledge.

Of course, there are hedge fund managers who have engaged and published research, but the broader question is whether they effect the advancement of finance knowledge. This is less clear; however, we think hedge funds do play four different roles to help advance knowledge.

Hedge funds as popularizers
Given the large amount of money managed by hedge funds, they become popularizers to the general investment public of specific strategies. Event driven and merger arbitrage has truly developed through hedge funds. If hedge funds try an idea and it is successful, investors and finance professors will usually hear about it.

Hedge funds as experimenters
Hedge funds can be thought of as experimenters in finance because they take academic ideas and test them in the marketplace to see if they work. Recent research has found that after finance research work is published there is a significant drop-off in returns from the strategy. This suggests that a lot of anomalies found in research will be arbitraged away once hedge funds get at them. They take research and use it.

Hegde funds as patrons
We do not have good numbers, but many hedge funds employ finance professors as research consultants through private contracts. In a sense, the hedge funds are patrons of the finance research conducted. The money is not usually in the form of  a grant to a university, albeit hedge fund managers give to schools, but direct payment for research. A professor could have a patron or benefactor for their work.

Hedge funds as laboratories
Hedge funds also run their own laboratories which is some cases could be as good as many academic finance departments. Ph.D's are hired to do original research for the the advancement of the fund. Some work may get published but most of this work is private and may not advance knowledge in the public domain. Their labs may have the tools and databases to compete with universities.

Given these roles, it might be interesting to ask what research work has been sponsored or done by hedge funds which have truly advanced the science of finance.  I would be interested in what examples readers could give. 

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