Factor models yield an R2 insignificantly different from 0 for one-third of hedge funds in a broad sample. These funds illustrate the concept of market neutrality and feature lower volatilities, higher Sharpe ratios, and higher alphas than other funds, indicating that they provide a successful alternative investment. However, large portfolios of zero-R2 funds contain fully half the volatility of portfolios of other funds, suggesting that they feature substantial systematic risk. Furthermore, these funds display an increased probability of failure even after controlling for idiosyncratic volatility. These results indicate the presence of an omitted factor that exposes investors to significant downside risk.

We show that if true returns are independently distributed and a manager fully reports gains but delays reporting losses, then reported returns will feature conditional serial correlation. We use conditional serial correlation as a measure of conditional return smoothing. We estimate conditional serial correlation in a large sample of hedge funds. We find that the probability of observing conditional serial correlation is related to the volatility and magnitude of investor cash flows, consistent with conditional return smoothing in response to the risk of capital flight. We also present evidence that conditional serial correlation is a leading indicator of fraud.

I study the dynamics of investor cash flows in socially responsible mutual funds. Consistent with anecdotal evidence of loyalty, the monthly volatility of investor cash flows is lower in socially responsible funds than in conventional funds. I find strong evidence that cash flows into socially responsible funds are more sensitive to lagged positive returns than cash flows into conventional funds, and weaker evidence that cash outflows from socially responsible funds are less sensitive to lagged negative returns. These results indicate that investors derive utility from the socially responsible attribute, especially when returns are positive.

This paper measures changes in mutual fund trading costs following two reductions in the tick size of U.S. equity markets: the switch from eighths to sixteenths and the subsequent switch to decimals. We estimate trading costs by comparing a mutual fund's daily returns to the daily returns of a synthetic benchmark portfolio that matches the fund's holdings but has zero trading costs by construction. We find that the average change in trading costs of actively managed funds was positive following both reductions in tick size with a larger and statistically significant increase following decimalization. In contrast, index fund trading costs were unaffected.