5. “HEDGE FUNDS”
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Executive Summary
The project on “HEDGE FUNDS” has been undertaken by
me with a view to study the overall hedge fund industries in
India and their products offering, services, operations ,client
management systems and other part of the industry.
In the above study, I have highlighted the key regulatory
parameters regarding Hedge funds like Introduction of hedge
funds, Industry & Growth of Hedge funds, , Case studies,
Comparison between other funds with hedge funds.
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CHAPTER 1: HEDGE FUNDS
1.1: Introduction
A hedge fund is an investment fund that pools capital from accredited individuals or institutional
investors and invests in a variety of assets, often with complex portfolio-construction and risk-
management techniques. It is administered by a professional investment management firm, and
often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds
are generally distinct from mutual funds, as their use of leverage is not capped by regulators, and
distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets.
The term "hedge fund" originated from the paired long and short positions that the first of these
funds used to hedge market risk. Over time, the types and nature of the hedging concepts
expanded, as did the different types of investment vehicles. Today, hedge funds engage in a diverse
range of markets and strategies and employ a wide variety of financial instruments and risk
management techniques.
Hedge funds are made available only to certain sophisticated or accredited investors and cannot
be offered or sold to the general public. As such, they generally avoid direct regulatory oversight,
bypass licensing requirements applicable to investment companies, and operate with greater
flexibility than mutual funds and other investment funds. However, following the financial crisis
of 2007–2008, regulations were passed in the United States and Europe with intentions to increase
government oversight of hedge funds and eliminate certain regulatory gaps.
Hedge funds have existed for many decades and have become increasingly popular. They have
now grown to be a substantial fraction of asset management, with assets now totaling around $3
trillion.
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Hedge funds are almost always open-ended and allow additions or withdrawals by their investors
(generally on a monthly or quarterly basis). The value of an investor's holding is directly related
to the fund net asset value.
Many hedge fund investment strategies aim to achieve a positive return on investment regardless
of whether markets are rising or falling ("absolute return"). Hedge fund managers often invest
money of their own in the fund they manage. A hedge fund typically pays its investment manager
an annual management fee (for example 2% of the assets of the fund), and a performance fee (for
example 20% of the increase in the fund's net asset value during the year). Both co-investment and
performance fees serve to align the interests of managers with those of the investors in the fund.
Some hedge funds have several billion dollars of assets under management (AUM).
1.2: History
Former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the
first hedge fund in 1949. It was while writing an article about current investment trends
for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000
(including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-
term stock positions by short selling other stocks. This investing innovation is now referred to as
the classic long/short equities model. Jones also employed leverage to enhance returns.
In 1952, Jones altered the structure of his investment vehicle, converting it from a general
partnership to a limited partnership and adding a 20% incentive fee as compensation for the
managing partner. As the first money manager to combine short selling, the use of leverage, shared
risk through a partnership with other investors and a compensation system based on investment
performance, Jones earned his place in investing history as the father of the hedge fund.
Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained
further popularity when a 1966 article in Fortune highlighted an obscure investment that
outperformed every mutual fund on the market by double-digit figures over the past year and by
high double-digits over the last five years.
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However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away
from Jones' strategy, which focused on stock picking coupled with hedging and chose instead to
engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-
70, followed by a number of hedge fund closures during the bear market of 1973-74.
The industry was relatively quiet for more than two decades until a 1986 article in Institutional
Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying
hedge fund once again capturing the public's attention with its stellar performance, investors
flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic
strategies, including currency trading and derivatives such as futures and options.
High-profile money managers deserted the traditional mutual fund industry in droves in the
early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated
itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including
Robertson's, failed in spectacular fashion. Since that era, the hedge fund industry has grown
substantially. Today the hedge fund industry is massive—total assets under management in the
industry is valued at more than $3.2 trillion according to the 2016 Preqin Global Hedge Fund
Report.
The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in
2002. That number increased to over 10,000 by 2015. However, in 2016, the number of hedge
funds is currently on a decline again according to data from Hedge Fund Research. Below is a
description of the characteristics common to most contemporary hedge funds.
1.3: REGULATIONS
Dodd–Frank Wall Street Reform and Consumer Protection Act, a bill passed in 2010, requires
hedge fund advisers with $150 million or more in assets to register with the Securities and
Exchange Commission.
Hedge funds are subject to the anti-fraud provisions of the Securities Act of 1933.
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Only accredited investors can invest in hedge funds. Accredited investors include individuals who
have a minimum net worth of $1,000,000 or, alternatively, a minimum income of $200,000 in each
of the last two years and a reasonable expectation of reaching the same income level in the current
year. For institutional investors, the minimum net worth is $5,000,000 in invested assets.
Hedge funds that have more than 499 investors must register with the SEC and must comply with
quarterly reporting requirements. Many funds are also under the jurisdiction of the Commodity
Futures Trading Commission.
1.3: FEES STRUCTURE
Performance-based Fees
Hedge fund managers are compensated by two types of fees: a management fee, usually a
percentage of the size of the fund (measured by AUM), and a performance-based incentive fee,
similar to the 20% of profit that Alfred Winslow Jones collected on the very first hedge fund. Fung
and Hsieh (1999) determine that the median management fee is between 1-2% of AUM and the
median incentive fee is 15-20% of profits. Ackermann et al. (1999) cite similar median figures: a
management fee of 1% of assets and an incentive fee of 20% (a so-called “1 and 20 funds”). The
incentive fee is a crucial feature for the success of hedge funds. A pay-forprofits compensation
causes the manager’s aim to be absolute returns, not merely beating a benchmark. To achieve
absolute returns regularly, the hedge fund manager must pursue investment strategies that generate
returns regardless of market conditions; that is, strategies with low correlation to the market.
However, a hedge fund incentive fee is asymmetric; it rewards positive absolute returns without a
corresponding penalty for negative returns. Empirical studies provide evidence for the
effectiveness of incentive fees. Liang (1999) reports that a 1% increase in incentive fee is coupled
with an average 1.3% increase in monthly return. Ackermann et al. (1999) determine that the
presence of a 20% incentive fee results in an average 66% increase in the Sharpe ratio, as opposed
to having no incentive fee. The performance fees enables a hedge fund manager to earn the same
money as running a mutual fund 10 times larger [Tremont, 2002]. There is the possibility that
managers will be tempted to take excessive risk, in pursuit of (asymmetric) incentive fees. This is
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one reason why, in many jurisdictions, asymmetric incentive fees are not permitted for consumer-
regulated investment products
• Determining Incentive Fees: High Water Marks and Hurdle Rates
To ensure profits are determined fairly, high water marks and hurdle rates are sometimes included
in the calculation of incentive fees. A high-water mark is an absolute minimum level of
performance over the life of an investment that must be reached before incentive fees are paid. A
high-water mark ensures that a fund manager does not receive incentive fees for gains that merely
recover losses in previous time periods. A hurdle rate is another minimum level of performance
(typically the return of a risk-free investment, such as a short-term government bond) that must be
achieved before profits are determined. Unlike a high-water mark, a hurdle rate is only for a single
time period. Liang (1999) determined that funds with high water marks have significantly better
performance (0.2% monthly) and are widespread (79% of funds). Hurdle rates are only used by
16% of funds and have a statistically insignificant effect on performance.
• Equalisation
The presence of incentive fees and high water marks may complicate the calculations of the value
of investors’ shares. If investors purchase shares at different times with different net asset values
(NAV), naïve calculations of incentive fees may treat the investors differently. For example,
presume shares in a hypothetical hedge fund are originally worth £100 when investor A purchases
them. Subsequently the shares fall to £90, which is when investor B invests, and then shares return
to £100. If there is a high-water mark at £100, then investor B theoretically can liquidate her shares
without incurring a performance fee, because the high-water mark has not been passed. Since B
has made a gross profit of £10 per share, this is obviously unfair, so an adjustment is required. To
treat both earlier and new investors fairly, the adjustment of profit calculations is an accounting
process called equalisation. Since new investments are usually limited to certain periods
(sometimes monthly or quarterly), a very simple form of equalisation is to issue a different series
of shares for each subscription period, each with a different high-water mark and different accruals
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of incentive fees. However, this form of equalisation leads to an unwieldy number of series of
shares, so it is rarely used. A more common equalisation method involves splitting new purchases
into an investment amount and an equalisation amount that matches the incentive fee of earlier
investors. The equalisation amount is used to put earlier investors and the new investor in the same
position. If the hedge fund shares go up in value, the equalisation amount is refunded. If the hedge
fund shares lose value, the equalisation amount is reduced or eliminated [habitant, 2002]. Many
US hedge funds do not require equalisation, because they are either closed, so they do not allow
new investments, or they are structured as partnerships that use capital accounting methods.
• Minimum Investment Levels
Minimum investment levels for hedge funds are usually high, implicitly dictated by legal limits on
the number of investors who are not high net worth individuals (“qualified purchasers” or
“accredited investors”), and restrictions on promotion and advertising. The SEC & FSA
requirement of private placement for hedge funds means that hedge funds tend to be exclusive
clubs with a comparatively small number of well-heeled investors. $250,000 is a common
minimum initial investment, and $100,000 is common for subsequent investments [Ackermann et
al., 1999; Liang, 1999]. From the perspective of the fund manager, having a small number of
clients with relatively large investments keep client servicing costs low. This allows the hedge
fund manager to concentrate more on trading and less on client servicing and fund promotion. 3.5
Fees for Funds of Funds Funds of funds (portfolios of hedge funds) are an increasingly popular
way to invest in hedge funds with a much lower minimum investment. Funds of hedge funds
usually impose a 1-2% management fee and 10-20% performance fee, in addition to existing hedge
fund fees. However, funds of funds often negotiate with hedge funds for lower fees than individual
clients and this lowers their pass-through costs.
1.4: Classification of hedge funds
1. Non-Directional Strategies Fixed Income Arbitrage:
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A strategy having long and short bond positions via cash or derivatives markets in government,
corporate and/or asset-backed securities. The risk of these strategies varies depending on duration,
credit exposure and the degree of leverage employed.
2. Event Driven:
A strategy which hopes to benefit from mispricing arising in different events such as merger
arbitrage, restructurings etc. Manager takes a position in an undervalued security that is anticipated
to rise in value because of events such as mergers, reorganizations, or takeovers. The main risk in
such strategies is non-realization of the event.
3. Equity Hedge:
A strategy of investing in equity or equity-like instruments where the net exposure (gross long
minus gross short) is generally low. The manager may invest globally, or have a more defined
geographic, industry or capitalization focus. The risk primarily pertains to the specific risk of the
long and short positions.
4. Distressed Securities:
A strategy of buying and occasionally shorting securities of companies under Chapter 11 and/or
ones which are undergoing some form of reorganization. The securities range from senior secured
debt to common stock. The liquidation of financially distressed company is the main source of risk
in these strategies.
5. Merger Arbitrage:
A strategy of purchasing securities of a company being acquired, and shorting that of the acquiring
company. The risk associated with such strategies is more of a “deal” risk rather than market risk.
6. Convertible Arbitrage:
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A strategy of buying and selling different securities of the same issuer (e.g. convertibles/common
stock) seeking to obtain low volatility returns by arbitraging the relative mispricing of these
securities.
7. Directional Strategies Macro:
A strategy that seeks to capitalize on country, regional and/or economic change affecting
securities, commodities, interest rates and currency rates. Asset allocation can be aggressive, and
leverage and derivatives may be utilized. The method and degree of hedging can vary significantly.
8. Emerging Markets:
A strategy that employs a “growth” or “value” approach to investing in equities with no shorting
or hedging to minimize inherent market risk. These funds mainly invest in the emerging markets
where there may be restrictions on short sales.
1.5: RISK
For an investor who already holds large quantities of equities and bonds, investment in hedge funds
may provide diversification and reduce the overall portfolio risk. Managers of hedge funds use
particular trading strategies and instruments with the specific aim of reducing market risks to
produce risk-adjusted returns that are consistent with investors' desired level of risk. Hedge funds
ideally produce returns relatively uncorrelated with market indices. While "hedging" can be a way
of reducing the risk of an investment, hedge funds, like all other investment types, are not immune
to risk. According to a report by the Hennessee Group, hedge funds were approximately one-third
less volatile than the S&P 500between 1993 and 2010.
1. Risk management:
Investors in hedge funds are, in most countries, required to be qualified investors who are assumed
to be aware of the investment risks, and accept these risks because of the potential returns relative
to those risks. Fund managers may employ extensive risk management strategies in order to protect
the fund and investors. According to the Financial Times, "big hedge funds have some of the most
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sophisticated and exacting risk management practices anywhere in asset management." Hedge
fund managers that hold a large number of investment positions for short durations are likely to
have a particularly comprehensive risk management system in place, and it has become usual for
funds to have independent risk officers who assess and manage risks but are not otherwise involved
in trading. A variety of different measurement techniques and models are used to estimate risk
according to the fund's leverage, liquidity and investment strategy. Non-normality of returns,
volatility clustering and trends are not always accounted for by conventional risk measurement
methodologies and so in addition to value at risk and similar measurements, funds may use
integrated measures such as drawdowns.
In addition to assessing the market-related risks that may arise from an investment, investors
commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund
might result in loss to the investor. Considerations will include the organization and management
of operations at the hedge fund manager, whether the investment strategy is likely to be
sustainable, and the fund's ability to develop as a company.
2. Transparency and regulatory considerations:
Since hedge funds are private entities and have few public disclosure requirements, this is
sometimes perceived as a lack of transparency. Another common perception of hedge funds is
that their managers are not subject to as much regulatory oversight and/or registration
requirements as other financial investment managers, and more prone to manager-specific
idiosyncratic risks such as style drifts, faulty operations, or fraud. New regulations introduced in
the US and the EU as of 2010 require hedge fund managers to report more information, leading
to greater transparency. In addition, investors, particularly institutional investors, are
encouraging further developments in hedge fund risk management, both through internal
practices and external regulatory requirements. The increasing influence of institutional investors
has led to greater transparency: hedge funds increasingly provide information to investors
including valuation methodology, positions and leverage exposure.
3. Risks shared with other investment types:
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Hedge funds share many of the same types of risk as other investment classes, including liquidity
risk and manager risk. Liquidity refers to the degree to which an asset can be bought and sold or
converted to cash; similar to private equity funds, hedge funds employ a lock-up period during
which an investor cannot remove money. Manager risk refers to those risks which arise from the
management of funds. As well as specific risks such as style drift, which refers to a fund
manager "drifting" away from an area of specific expertise, manager risk factors include
valuation risk, capacity risk, concentration risk and leverage risk. Valuation risk refers to the
concern that the net asset value of investments may be inaccurate; capacity risk can arise from
placing too much money into one particular strategy, which may lead to fund performance
deterioration; and concentration risk may arise if a fund has too much exposure to a particular
investment, sector, trading strategy, or group of correlated funds. These risks may be managed
through defined controls over conflict of interest, restrictions on allocation of funds, and set
exposure limits for strategies.
Many investment funds use leverage, the practice of borrowing money, trading on margin, or
using derivatives to obtain market exposure in excess of that provided by investors' capital.
Although leverage can increase potential returns, the opportunity for larger gains is weighed
against the possibility of greater losses. Hedge funds employing leverage are likely to engage in
extensive risk management practices. In comparison with investment banks, hedge fund leverage
is relatively low; according to a National Bureau of Economic Research working paper, the
average leverage for investment banks is 14.2, compared to between 1.5 and 2.5 for hedge funds.
Some types of funds, including hedge funds, are perceived as having a greater appetite for risk,
with the intention of maximizing returns, subject to the risk tolerance of investors and the fund
manager. Managers will have an additional incentive to increase risk oversight when their own
capital is invested in the fund.
1.6: Characteristics of Hedge Funds
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• Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns
and minimize the correlation with equity and bond markets. Many hedge funds are
flexible in their investment options (can use short selling, leverage, derivatives such
as puts, calls, options, futures, etc.).
• Hedge funds vary enormously in terms of investment returns, volatility and risk.
Many, but not all, hedge fund strategies tend to hedge against downturns in the
markets being traded.
• Many hedge funds have the ability to deliver non-market correlated returns.
• Many hedge funds have as an objective consistency of returns and capital
preservation rather than magnitude of returns.
• Most hedge funds are managed by experienced investment professionals who are
generally disciplined and diligent.
• Pension funds, endowments, insurance companies, private banks and high net worth
individuals and families invest in hedge funds to minimize overall portfolio
volatility and enhance returns.
• Most hedge fund managers are highly specialized and trade only within their area of
expertise and competitive advantage.
• Hedge funds benefit by heavily weighting hedge fund managers’ remuneration
towards performance incentives, thus attracting the best brains in the investment
business. In addition, hedge fund managers usually have their own money invested
in their fund.
1.7 ADVANTAGES:
1. Diversification:
Diversification potential is widely accepted as the greatest benefit of hedge funds (and alternative
investments in general). By adding hedge funds to a typical portfolio of stock and bond investments
you can achieve higher risk-adjusted return. The reason is that most hedge fund strategies have
consistently shown low correlations to the performance of global stock and bond markets. In other
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words, hedge funds often make profits even when stock prices are falling and traditional
investments are losing money.
Strategies which tend to perform particularly well during periods of high volatility and
decreasing stock prices include short selling, global macro and managed futures. On the contrary,
the performance of strategies with net long market exposure, such as long/short equity or distressed
securities, tends to be more highly correlated to market returns.
2. New opportunities:
Besides higher returns and diversification potential, hedge funds also represent a possibility to
invest in assets and trading strategies which would be inaccessible with traditional funds.
Examples include highly illiquid securities or derivatives. This is due to the fact that, compared to
mutual funds, hedge funds are more loosely regulated and their managers enjoy greater freedom
in terms of what and how they can trade.
When investing in hedge funds, you should also be aware of their limitations, disadvantages and
risks, which often arise from the same factors as the above listed advantages – greater freedom in
trading strategies, access to illiquid or exotic assets and greater importance of the fund manager’s
skill.
3. Huge Gains:
One other advantage to hedge funds is the large amount of money that can be made by utilizing
them within your portfolio. The aim of hedge funds is to acquire a high-return despite what market
fluctuations are occurring at any given period. For example, one type of hedge fund strategy is
called a “global macro” approach. This strategy attempts to take a large position in commodities,
stocks, bonds, etc., by forecasting what investment opportunities one can take in relation to what
may happen in future global economic events. This is done in order to create the largest return
with the least amount of risk.
4. Expert Advice:
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There is a very good reason why those working in hedge fund investing, such as a hedge fund
manager, are paid handsomely. Aside from just the big gains that can be made on such investments,
these individuals are extremely experienced and knowledgeable in matters of financial investment;
thus when you invest in hedge funds you are getting expert advice as to not only which hedge
funds to use, but when and where, which can easily ensure you a greater chance of receiving a
large return on your investment.
DISADVANTAGES
1. Large Investment Fees:
One major disadvantage of hedge funds, and a highly criticized one as well, is the often high fees
one must pay in order to invest in hedge funds. For example, hedge fund investors typically charge
both a performance fee on top of a management fee. A management fee is usually 2% of the net
value of the fund, and is paid typically every month. Regarding performance fees, they are typically
20% of whatever the fund earns in any given year. Performance fees are mainly used to motivate
managers to create as big of a profit as they can.
2. Standard Deviation:
Another disadvantage to hedge funds is the use of the statistical tool known as the standard
deviation. This is a very common tool used to anticipate the risk in investing in a particular hedge
fund. So, the standard deviation measures the volatility of possible gains, expressed as a certain
percentage per year. The statistic can provide a good measure of potential variation in gains during
the year, however the downside is that the standard deviation cannot indicate the overall big picture
of the risk of return; mainly because hedge funds do not operate under a bell-curve, or normally-
distributed rate of return.
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3. Downside Capture:
The downside capture is a risk management measure used to assess what level of correlation a
hedge fund has to a specific market when that particular market is on the decline. The smaller the
downside capture measure of a fund, the better equipped the hedge fund is to handle a market
decline. However, the disadvantage is that all funds are compared to a unified benchmark for the
market. So, if a hedge fund manager uses a wildly different style of investing than the benchmark,
the downside capture ratio may, for example, show that the fund is under-performing the
benchmark, even if the market index generates high returns.
4. Drawdown:
The drawdown is basically a statistic that provides an estimation in the overall rate of return on an
investment compared to that investment’s most recent highest return, a peak-to-valley ratio. The
disadvantage to this measure is related to the disadvantage that the standard deviation has with a
hedge fund, mainly that hedge funds do not operate very consistently and predictably in order for
the standard deviation, and thus the drawdown, to be very useful.
4. Leverage:
Leverage is an investment measure that’s often overlooked as being the main factor in hedge funds
acquiring large losses. Basically, when leverage rises, any downsides in investment returns are
magnified, often causing the hedge fund to sell off its assets at a cheap price. Leverage is typically
a main reason why so many hedge funds go bankrupt.
1.7: STRATEGIES
Hedge fund strategies are generally classified among four major categories: global macro,
directional, event-driven, and relative value (arbitrage). Strategies within these categories each
entail characteristic risk and return profiles. A fund may employ a single strategy or multiple
strategies for flexibility, risk management or diversification. The hedge fund's prospectus, also
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known as an offering memorandum, offers potential investors information about key aspects of
the fund, including the fund's investment strategy, investment type, and leverage limit.
The elements contributing to a hedge fund strategy include: the hedge fund's approach to the
market; the particular instrument used; the market sector the fund specializes in (e.g. healthcare);
the method used to select investments; and the amount of diversification within the fund. There
are a variety of market approaches to different asset classes, including equity, fixed
income, commodity, and currency. Instruments used include: equities, fixed
income, futures, options and swaps. Strategies can be divided into those in which investments can
be selected by managers, known as "discretionary/qualitative", or those in which investments are
selected using a computerized system, known as "systematic/quantitative”. The amount of
diversification within the fund can vary; funds may be multi-strategy, multi-fund, multi-market,
multi-manager or a combination.
Sometimes hedge fund strategies are described as "absolute return" and are classified as either
"market neutral" or "directional". Market neutral funds have less correlation to overall market
performance by "neutralizing" the effect of market swings, whereas directional funds utilize trends
and inconsistencies in the market and have greater exposure to the market's fluctuations.
1. Global macro:
Hedge funds using a global macro investing strategy take sizable positions in share, bond or
currency markets in anticipation of global macroeconomic events in order to generate a risk-
adjusted return. Global macro fund managers use macroeconomic ("big picture") analysis based
on global market events and trends to identify opportunities for investment that would profit from
anticipated price movements. While global macro strategies have a large amount of flexibility (due
to their ability to use leverage to take large positions in diverse investments in multiple markets),
the timing of the implementation of the strategies is important in order to generate attractive, risk-
adjusted returns. Global macro is often categorized as a directional investment strategy.
Global macro strategies can be divided into discretionary and systematic approaches.
Discretionary trading is carried out by investment managers who identify and select investments
whereas systematic trading is based on mathematical models and executed by software with
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limited human involvement beyond the programming and updating of the software. These
strategies can also be divided into trend or counter-trend approaches depending on whether the
fund attempts to profit from following trends (long or short-term) or attempts to anticipate and
profit from reversals in trends.
Within global macro strategies, there are further sub-strategies including "systematic diversified",
in which the fund trades in diversified markets, or "systematic currency", in which the fund trades
in currency markets. Other sub-strategies include those employed by commodity trading
advisors (CTAs), where the fund trades in futures (or options) in commodity markets or in
swaps. This is also known as a "managed future fund". CTAs trade in commodities (such as gold)
and financial instruments, including stock indices. They also take both long and short positions,
allowing them to make profit in both market upswings and downswings.
2. Directional:
Directional investment strategies use market movements, trends, or inconsistencies when picking
stocks across a variety of markets. Computer models can be used, or fund managers will identify
and select investments. These types of strategies have a greater exposure to the fluctuations of the
overall market than do market neutral strategies. Directional hedge fund strategies include US and
international long/short equity hedge funds, where long equity positions are hedged with short
sales of equities or equity index options.
Within directional strategies, there are a number of sub-strategies. "Emerging markets" funds focus
on emerging markets such as China and India, whereas "sector funds" specialize in specific areas
including technology, healthcare, biotechnology, pharmaceuticals, energy and basic materials.
Funds using a "fundamental growth" strategy invest in companies with more earnings growth than
the overall stock market or relevant sector, while funds using a "fundamental value" strategy invest
in undervalued companies. Funds that use quantitative and processing techniques
for equity trading are described as using a "quantitative directional" strategy. Funds using a "short
bias" strategy take advantage of declining equity prices using short positions.
4. Event-driven:
Event-driven strategies concern situations in which the underlying investment opportunity and risk
are associated with an event. An event-driven investment strategy finds investment opportunities
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in corporate transactional events such as consolidations, acquisitions, recapitalizations,
bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation
inconsistencies in the market before or after such events, and take a position based on the predicted
movement of the security or securities in question. Large institutional investors such as hedge
funds are more likely to pursue event-driven investing strategies than traditional equity investors
because they have the expertise and resources to analyze corporate transactional events for
investment opportunities.
Corporate transactional events generally fit into three categories: distressed securities, risk
arbitrage, and special situations. Distressed securities include such events as restructurings,
recapitalizations, and bankruptcies. A distressed securities investment strategy involves investing
in the bonds or loans of companies facing bankruptcy or severe financial distress, when these
bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the
distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds
purchasing distressed debt may prevent those companies from going bankrupt; as such an
acquisition deters foreclosure by banks. While event-driven investing in general tends to thrive
during a bull market, distressed investing works best during a bear market.
Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and
hostile takeovers. Risk arbitrage typically involves buying and selling the stocks of two or more
merging companies to take advantage of market discrepancies between acquisition price and stock
price. The risk element arises from the possibility that the merger or acquisition will not go ahead
as planned; hedge fund managers will use research and analysis to determine if the event will take
place.
Special situations are events that impact the value of a company's stock, including
the restructuring of a company or corporate transactions including spin-offs, share-buy-backs,
security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage
of special situations the hedge fund manager must identify an upcoming event that will increase
or decrease the value of the company's equity and equity-related instruments.
Other event-driven strategies include: credit arbitrage strategies, which focus on corporate fixed
income securities; an activist strategy, where the fund takes large positions in companies and uses
the ownership to participate in the management; a strategy based on predicting the final approval
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of new pharmaceutical drugs; and legal catalyst strategy, which specializes in companies involved
in major lawsuits.
5. Relative value:
Relative value arbitrage strategies take advantage of relative discrepancies in price between
securities. The price discrepancy can occur due to mispricing of securities compared to related
securities, the underlying security or the market overall. Hedge fund managers can use various
types of analysis to identify price discrepancies in securities, including
mathematical, technical or fundamental techniques. Relative value is often used as a synonym
for market neutral, as strategies in this category typically have very little or no directional market
exposure to the market as a whole. Other relative value sub-strategies include:
• Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
• Equity market neutral: exploits differences in stock prices by being long and short in stocks within
the same sector, industry, market capitalization, country, which also creates a hedge against broader
market factors.
• Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the
corresponding stocks.
• Asset-backed securities (Fixed-Income asset-backed): fixed income arbitrage strategy using asset-
backed securities.
• Credit long / short: the same as long / short equity but in credit markets instead of equity markets.
• Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical
modelling techniques
• Volatility arbitrage: exploit the change in implied volatility instead of the change in price.
• Yield alternatives: non-fixed income arbitrage strategies based on the yield instead of the price.
• Regulatory arbitrage: the practice of taking advantage of regulatory differences between two or
more markets.
• Risk arbitrage: exploiting market discrepancies between acquisition price and stock price
Miscellaneous
In addition to those strategies within the four main categories, there are several strategies that do
not fit into these categorizations or can apply across several of them.
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• Fund of hedge funds (Multi-manager): a hedge fund with a diversified portfolio of numerous
underlying single-manager hedge funds.
• Multi-strategy: a hedge fund using a combination of different strategies to reduce market risk.
• Minimum account fund: the minimum amount to open a hedge fund account is (say) 10 million
dollars (with 25% non-holding) or 2.5 million dollars with holding.
• Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing
in their own strategy.
• Withdraw holding: a hold is placed on all major withdrawals for 90 days prior and after hedge fund is
created and established.
• 130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of
100%.
• Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing gains
through financial leveraging.
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CHAPTER 2
2.1: GROWTH & INDUSTRY
• Estimated to be a $1 trillion industry and growing at about 20% per year with
approximately 8350 active hedge funds.
• Includes a variety of investment strategies, some of which use leverage and derivatives
while others are more conservative and employ little or no leverage. Many hedge fund
strategies seek to reduce market risk specifically by shorting equities or through the use of
derivatives.
• Most hedge funds are highly specialized, relying on the specific expertise of the manager
or management team.
• Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much
capital they can successfully employ before returns diminish. As a result, many successful
hedge fund managers limit the amount of capital they will accept.
• Hedge fund managers are generally highly professional, disciplined and diligent.
• Their returns over a sustained period of time have outperformed standard equity and bond
indexes with less volatility and less risk of loss than equities.
• Beyond the averages, there are some truly outstanding performers.
• Investing in hedge funds tends to be favoured by more sophisticated investors, including
many Swiss and other private banks, that have lived through, and understand the
consequences of, major stock market corrections.
• An increasing number of endowments and pension funds allocate assets to hedge funds.
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2.2: PERFORMANCE MEASUREMENT
Performance statistics for individual hedge funds are difficult to obtain, as the funds have
historically not been required to report their performance to a central repository and restrictions
against public offerings and advertisement have led many managers to refuse to provide
performance information publicly. However, summaries of individual hedge fund performance are
occasionally available in industry journals and databases. and investment consultancy Hennessee
Group.
One estimate is that the average hedge fund returned 11.4% per year, representing a 6.7% return
above overall market performance before fees, based on performance data from 8,400 hedge
funds. Another is that between January 2000 and December 2009 the hedge funds outperformed
other investments were significantly less volatile, with stocks falling 2.62% per year over the
decade and hedge funds rising 6.54%. More recent data show that hedge fund performance has
declined and underperformed the market.
Hedge funds performance is measured by comparing their returns to an estimate of their
risk. Common measures are the Sharpe ratio. Treynor measure and Jensen's alpha. These
measures work best when returns follow normal distributions without autocorrelation, and these
assumptions are often not met in practice.
New performance measures have been introduced that attempt to address some of theoretical
concerns with traditional indicators, including: modified Sharpe ratios; the Omega
ratio introduced by Keating and Shadwick in 2002; Alternative Investments Risk Adjusted
Performance (AIRAP) published by Sharma in 2004; and Kappa developed by Kaplan and
Knowles in 2004.
Sector-size effect
There is a debate over whether alpha (the manager's skill element in performance) has been diluted
by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded
volume may have been reducing the market anomalies that are a source of hedge fund
performance. Second, the remuneration model is attracting more managers, which may dilute the
talent available in the industry.
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Hedge fund indices
Indices that track hedge fund returns are, in order of development, called Non-investable,
Investable and Clone. They play a central and unambiguous role in traditional asset markets, where
they are widely accepted as representative of their underlying portfolios. Equity and debt index
fund products provide investable access to most developed markets in these asset classes. Hedge
funds, however, are actively managed, so that tracking is impossible. Non-investable hedge fund
indices on the other hand may be more or less representative, but returns data on many of the
reference group of funds is non-public. This may result in biased estimates of their returns. In an
attempt to address this problem, clone indices have been created in an attempt to replicate the
statistical properties of hedge funds without being directly based on their returns data. None of
these approaches achieves the accuracy of indices in other asset classes for which there is more
complete published data concerning the underlying returns.
Non-investable indices
Non-investable indices are indicative in nature, and aim to represent the performance of some
database of hedge funds using some measure such as mean, median or weighted mean from a
hedge fund database. The databases have diverse selection criteria and methods of construction,
and no single database captures all funds. This leads to significant differences in reported
performance between different indices.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely
unavoidable list of biases.
Funds' participation in a database is voluntary, leading to self-selection bias because those funds
that choose to report may not be typical of funds as a whole. For example, some do not report
because of poor results or because they have already reached their target size and do not wish to
raise further money.
The short lifetimes of many hedge funds mean that there are many new entrants and many
departures each year, which raises the problem of survivorship bias. If we examine only funds that
have survived to the present, we will overestimate past returns because many of the worst-
performing funds have not survived, and the observed association between fund youth and fund
performance suggests that this bias may be substantial.
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When a fund is added to a database for the first time, all or part of its historical data is recorded
ex-post in the database. It is likely that funds only publish their results when they are favorable, so
that the average performances displayed by the funds during their incubation period are inflated.
This is known as "instant history bias" or "backfill bias".
Investable indices
Investable indices are an attempt to reduce these problems by ensuring that the return of the index
is available to shareholders. To create an investable index, the index provider selects funds and
develops structured products or derivative instruments that deliver the performance of the index.
When investors buy these products the index provider makes the investments in the underlying
funds, making an investable index similar in some ways to a fund of hedge funds portfolio.
To make the index investable, hedge funds must agree to accept investments on the terms given
by the constructor. To make the index liquid, these terms must include provisions for redemptions
that some managers may consider too onerous to be acceptable. This means that investable indices
do not represent the total universe of hedge funds. Most seriously, they under-represent more
successful managers, who typically refuse to accept such investment protocols.
Hedge fund replication
The most recent addition to the field approach the problem in a different manner. Instead of
reflecting the performance of actual hedge funds they take a statistical approach to the analysis of
historic hedge fund returns, and use this to construct a model of how hedge fund returns respond
to the movements of various investable financial assets. This model is then used to construct an
investable portfolio of those assets. This makes the index investable, and in principle they can be
as representative as the hedge fund database from which they were constructed.
However, these clone indices rely on a statistical modeling process. Such indices have too short a
history to state whether this approach will be considered successful.
Closures
In March 2017, HFR – a hedge fund research data and service provider – reported that there were
more hedge-fund closures in 2016 than during the 2009 recession. According to the report, several
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large public pension funds pulled their investments in hedge funds, because the funds’ subpar
performance as a group did not merit the high fees they charged.
Despite the hedge fund industry topping $3 trillion for the first time ever in 2016, the number of
new hedge funds launched fell short of crisis-era figures. There were 729 hedge fund launches in
2016, fewer than the 784 opened in 2009 and dramatically less than the 968 launches in 2015
Who Can Invest In Hedge Funds?
Technically, most people are probably eligible to invest in hedge funds. Practically, only
"accredited investors" and/or "sophisticated investors" will be able to do so as a result of
government regulation that makes it highly unlikely a hedge fund manager is going to admit you
to the partnership or firm unless you qualify. Even if the hedge fund manager were inclined to
make an exception, he or she can really only admit 35 non-accredited investors so they will want
to keep those spots open for close friends and family members.
2.3: WHY INVEST IN HEDGE FUNDS?
1. Risk Reduction:
In any case, a hedge fund that provides consistent returns increases the level of portfolio stability
when traditional investments are underperforming or, at most, are highly unpredictable. There are
many hedge fund strategies that generate attractive returns with fixed-income-like volatility. The
difference between a hedge fund and traditional fixed income, however, is that during times of low
interest rates, fixed income may provide stable returns, but those are typically very low and may
not even keep up with inflation.
Hedge funds, on the other hand, can use their more flexible mandates and creativity to generate
bond-like returns that outpace inflation on a more consistent basis. The drawback, as previously
mentioned, is that hedge funds have certain terms that limit liquidity and are highly opaque. That
said, a carefully analyzed hedge fund can be a good way to reduce the risk of a portfolio, but we
stress again the importance of proper due diligence.
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2. Return Enhancement:
The other primary reason for adding hedge funds to a portfolio is the ability of some hedge funds
to enhance the overall returns of a portfolio. This objective can be considered in two ways. The
first way is to maintain a low-risk portfolio but to try to squeeze out some additional returns
through the use of a low-volatility hedge fund, as described in the previous section. By adding a
hedge fund strategy that substitutes for an otherwise anemic fixed-income return, the returns on a
portfolio can be increased slightly without any increase in volatility.
The second way, which is much more exciting, is to add a hedge fund with a high-return strategy
to boost overall returns. Some strategies, such as global macro, or commodity trading advisors,
can generate some very high returns. These funds generally take directional positions based on
their forecast of future prices on stocks, bonds, currencies, and/or commodities and can also invest
using derivative instruments. But buyer beware that although these strategies are not correlated to
traditional investments, they often exhibit high levels of volatility. The result, when properly
allocated, can be a nice boost in returns without a proportional increase in portfolio volatility.
3. Allocation Considerations:
Adding hedge funds to a portfolio, however, should not be taken lightly. Even a low-volatility
hedge fund can explode, in late 2007, when the subprime mortgage market dried up and even
securities that were paying as planned were written down to pennies on the dollar, as investors bid
down their prices for fear of foreclosures.
The allocation to hedge funds should consider the overall risk/return objectives of the portfolio,
and proper analysis should be conducted to determine how and whether a particular hedge fund
fits into the asset mix. A portfolio manager should not only consider the weighting given to any
particular investment, but should also evaluate the level of concentration of the overall portfolio,
and the correlation of each position relative to each other. For example, in a very concentrated
portfolio, it is even more important that each position is less correlated to others, and one must
also make sure that positions do not have similar performance drivers. A larger allocation to hedge
funds will directly affect the total exposures of an entire portfolio. The implications of this change
can be dramatic depending on the strategy being used by the hedge fund.
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2.4: PARTIES INVOLVED
Most hedge funds are established as limited partnerships. Investors share in the partnership’s income, expenses,
gains and losses; each partner is taxed on its respective share. Key players include:
• Portfolio Manager(s) – Determines strategy and is invested in the fund (compensated based on fund’s
annual performance)
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• Prime Broker – Funds must secure their loans with collateral to gain margin and secure trades. In turn,
each broker (usually a large securities firm) uses its own risk matrix to determine how much to lend to
each of its clients, acting as a stand-in regulator.
• Auditors – Ensure fund compliance; verifies financial statements as required by federal law.
CHAPTER 3: HEDGE FUNDS IN CRISIS
3.1: Problems Associated with Hedge Funds.
While hedge funds add value, they also create problems for the financial sector as a whole and for
their investors in particular. Each is discussed in turn below.
A. Systemic Risk within the Financial Sector.
Funds that follow certain styles (e.g., quantitative funds implementing long-short equity positions)
often follow similar strategies and therefore have interrelated and correlated positions. (Note that
this is certainly not true for all fund styles.) Indeed, it is not surprising that funds with similar
objectives have correlated positions. But funds following different styles have also become more
interconnected over time. But that too, probably isn’t too surprising either. Hedge funds provide
liquidity to the aggregate of liquidity demanders and as such it is quite natural that they are similar
– that is, they all take the other side of the liquidity demand and so end up with returns and positions
that are correlated. That said, even if this commonality is a by-product of hedge funds providing a
valuable function, this commonality may create systemic risk.
Figure 2 describes 13 different hedge fund indices and how they have grown more interconnected
from the period 1994-2000 to 2001-2007.1
In particular, the figure portrays three possible types of
pairwise connections between any two hedge fund indices: correlated returns over 50% (thick line),
correlated returns between 25% and 50% (thin line), and correlations less than 25% (no connecting
line). Two primary observations from Figure 2 are in order. First, the more recent period shows a
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much more correlated structure. That is, many more hedge fund classes are now connected, and,
more important, their return correlations exceed 50%. The figure looks much thicker. Second, and
perhaps more alarming, the multi-strategy class was barely connected to the hedge fund system in
the earlier period, but now is highly correlated to most strategies.
How does this increase in connectedness lead to systemic risk? There are three main ways, all
driven by the fact that capital erosion occurs at the same time for these funds because of price
moves in the same or similar securities. First, the resulting margin calls occur at the same time too
and cause further price moves due to the resulting illiquidity in those securities. The price moves
caused by the hedge funds when they demand immediacy in this way create systemic risk in the
financial system, especially if banks and other financial institutions have similar positions and so
are also moving prices in the same directions with their trades. This is a potential externality that
hedge funds might impose on the financial system.
Second, hedge funds provide liquidity and the simultaneous failure of a number of hedge funds,
whose total net asset value is large, because they are following similar strategies, imposes costs on
the financial system because of the loss of the liquidity services provided by these funds. It could
be a few large funds with correlated positions or a large number of small funds with correlated
positions. The individual funds may be small, but if a large number of funds follow similar
strategies and so have highly correlated positions, these funds may still create systemic risk for the
financial system, even though no one fund is particularly large.
What determines if the created risk is systemic? One important question is whether the total size
of the hedge funds in question is sufficiently large that their collapse creates a vacuum in liquidity
provision that imposes costs on the financial system. Another important question is whether the
hedge funds in question are failing or losing large amounts of capital at the same time that other
liquidity providers to the financial system are also experiencing severe capital erosion. In either
case, new capital will likely flow back into the financial system eventually, but the question is the
extent of the disruption to the financial system in the meantime.
Third, hedge funds impose counterparty credit risk on other participants in the financial system.
The externality that this imposes on the financial system increases as hedge fund positions become
more interrelated and correlated, especially if hedge funds impose high counterparty credit risk
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exactly when banks and other financial institutions also impose high counterparty credit risk. So
many hedge funds having interrelated and correlated positions exacerbates the systemic risk that
hedge funds can generate because of the counterparty credit risk they impose.
Notice that the systemic risk we are discussing here has nothing to do with the argument that hedge
funds manipulate markets to make profits at the expense of other market participants. Rather, this
systemic risk stems from the risk of large coordinated losses or coordinated failures all at the same
time of a large number of hedge funds following similar strategies.
There are two reasons why the systemic risk for the financial system created by the hedge fund
industry can be larger and more significant than the systemic risk created by other asset
management counterparties in the shadow banking system. First, hedge funds are able to use
leverage, which can have a number of unfortunate consequences for the financial system.
Leverage forces hedge funds to unwind their positions when confronted with margin calls, which
can disrupt their ability to provide liquidity to the financial system. It also leaves hedge funds
exposed to the possibility of negative equity positions if prices move against them, which can cause
them to generate counterparty risk. Since leverage causes any given position to suffer larger losses
as a percentage of capital (and to earn larger profits as a percentage of capital), it causes some
hedge funds (the ones that often have interrelated and highly correlated positions) to have all at
the same time even more depleted capital reserves than they otherwise would.
Second, a lack of transparency of hedge fund positions can make it difficult to assess how levered
and exposed hedge funds are. It can also make it difficult to assess the magnitude of the
counterparty risk being generated by hedge funds. Since systemic crises are characterized by
investor “panic” and extreme flights to quality, this lack of transparency will most likely lead to
more extreme reactions on the part of investors and ensuing liquidity runs on the system. As an
example, from the current crisis, consider another class of institutions from the shadow banking
system, namely money market funds. After Lehman Brothers declared bankruptcy over the
weekend of September 13th
-14th
, 2008, one of the largest money market funds, the Reserve Primary
Fund, announced that it had “broke the buck” (i.e., its net asset value had fallen below par value)
due to its owning a significant portion of Lehman Brothers’ short-term debt. The possibility that
money market funds were exposed in such a way to the financial crisis led to a run on money
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market funds, resulting in the government temporarily guaranteeing all losses in these funds. It is
a small leap of faith to recognize that if lack of transparency in safe assets, like money market
funds, can cause a liquidity spiral, then funds that are even less transparent and much riskier pose
an even greater systemic risk.
The above example of the Reserve Primary Fund also shows that redemptions, i.e., runs on asset
management funds, are an additional concern for hedge funds. Investors typically redeem shares
after poor performance and since hedge funds that follow certain styles often have interrelated and
correlated positions, redemptions tend to occur all at the same time for funds following these styles.
This, in turn, causes liquidations of the same positions by these funds at the same time, which can
create systemic risk for the financial system. Finally, it is worth noting that weak operational
controls can lead to excessive risk-taking by fund managers, which in turn can cause some funds
(the ones following certain styles that often have interrelated and highly correlated positions) to
generate even more systemic risk than they otherwise could.
2. Problems faced by Hedge Fund Investors.
When thinking about whether to regulate hedge funds because they might impose externalities on
the financial system, it is important to be aware of any problems being faced by hedge fund
investors because the regulations may affect the severity of those problems. There are a number
of problems that the hedge fund industry inflicts upon its investors. First, a lack of transparency
of hedge fund positions can allow hedge funds not to disclose their leverage levels to their
investors. To deal with this, investors can require leverage limits in contracts and violating these
limits is fraud. Even so, funds with bargaining power, because of high demand, can insist on no
leverage limits.
Second, hedge funds earn liquidity premia most of the time. But interrelated and highly correlated
positions across groups of hedge funds that follow certain styles can lead to periods when these
hedge funds are forced to unwind similar positions at the same time to meet margin calls or satisfy
redemptions. At these times, these funds are forced to pay liquidity premia to obtain the
immediacy they need, which adversely affects their performance.
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Third, lock-up periods force investors to keep their capital in hedge funds for prespecified periods,
and the reduction in flexibility is likely not good for investors. However, it may sometimes be in
the investors’ best interests that they’re all locked up, as it might prevent a “bank run” in which
the hedge fund would otherwise be forced to sell at “fire sale” prices. Fund size affects the
likelihood of the hedge fund getting only “fire sale” prices: small funds are less likely to be subject
to “fire sale” prices than large funds. Moreover, investors can always wait and redeem later when
the “fire sale” is over, though if others redeem early, those that redeem late may end up with the
“fire sale” price as part of their fund holding. Faced with this choice, it may be that investors
would redeem gradually. The fact that investors can redeem later (and their shares of the assets
will still be there) may distinguish this situation from the typical “bank run” situation. Lastly,
operational risks adversely affect the returns earned by investors from investing in hedge funds.
3.2: Principles
There is considerable discussion about the unregulated nature of hedge funds both in the public
policy arena. At first glance, hedge funds being unregulated would seem to be patently unfair as it
allows them to take advantage of regulatory arbitrage, namely the ability to offer intermediation
services in direct competition against regulated institutions like banks. However, this ignores the
substantive advantage banks have through either the explicit guarantee of deposit insurance or
implicit guarantees of “too-big-to-fail”. In fact, one could argue that one of hedge funds’ primary
functions, that of proprietary trading, could be a quite dangerous systemic function as part of a
large complex financial institution (LCFI) because of their cheap access to financing. For example,
in the current crisis, many of the major write-downs were tied to explicit bets on subprime-backed
assets – Morgan Stanley losing $15 billion on …, Merrill Lynch losing $ on its non-prime
mortgage portfolio, and so on.
This stated, however, the analysis in Section III above does suggest that either a large hedge fund
or a collection of smaller ones within this shadow financial system could be systemically
important. Thus, regarding the impact of hedge funds on the financial sector as a whole, all the
following are undesirable because they impose externalities on the financial system: (i)
counterparty credit risk; (ii) correlated trades that move prices away from fundamentals; and, (iii)
systemic capital erosion. Actions that limit the ability of hedge funds to impose these externalities
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on the financial sector often adversely affect the ability of hedge funds to provide liquidity and
generate good performance for their investors. Balancing these considerations is important.
Determining the amount of transparency in the hedge fund industry involves balancing these
considerations as well. Fund investor transparency allows investors to better monitor the hedge
fund managers and to better assess the operational risks of funds. But it is costly since transparency
of positions allows imitation, which adversely affects fund performance. Non-disclosure
agreements between funds and their investors may be able to limit these imitation costs.
Transparency to regulators is desirable, as it can help the regulator measure and manage potential
systemic risk.
Hedge funds need to have in place well-functioning operational controls, because these controls
can limit the adverse impact of hedge funds on the financial system by reducing the possibility that
the failure of one institution brings the system down. Lastly, it must be remembered that many
hedge funds can easily leave the U.S. and will do so if regulation becomes to too burdensome.
This consideration limits the amount of regulation that can be imposed on the mutual fund industry.
3.3: Regulation of Hedge Funds in the Aftermath of the Crisis
It is worth noting that there is very little evidence to suggest that hedge funds caused the current
financial crisis or that they contributed to its severity in any significant way. That been said, it is
possible that hedge funds, or subsets of hedge funds, may still impose externalities on the financial
system. If so, the question is how to manage those externalities.
With respect to any measure designed to limit the externalities created by an entity for the financial
system, hedge funds should not receive any special treatment, either preferential or discriminatory.
Any fees levied on financial institutions for using financial markets in a manner that generates
systemic risk (and the associated externalities) should also be levied on hedge funds when they use
financial markets in this manner. The exception of course is that financial institutions that receive
explicit guarantees from the government (e.g, deposit institutions) necessarily require oversight.
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Most important is the idea that transparency to regulators is desirable, as it can help the regulator
measure and manage potential systemic risk. As described in the other white paper on “Systemic
Risk”, this would require information about the hedge fund’s asset size, both on and off-balance
sheet, its leverage, its proportion of illiquid positions, its risk concentration and its contribution to
aggregate systemic risk. If a hedge fund falls into the class of firms considered to be systemic, then
it would be subject to an externality tax, in other words, to purchase insurance against systemic
states.
There is a secondary issue regarding transparency. While transparency is important to regulators,
it may also be important to financial participants at large. Transparency may help these
participants make better-informed decisions and allocate capital more appropriately. For this
reason, it makes sense to also have recommendations regarding transparency that are designed to
help fund investors better monitor their funds. For example, hedge funds perhaps should be
required to periodically disclose summary leverage measures.
One of the major ways hedge funds currently disclose their positions is through Form 13F.
Specifically, 13F requires hedge funds with more than $100 million under management to disclose
their long positions as of the end of each calendar quarter to the SEC and the public within 45 days
of the end of the quarter. It is difficult to understand why long positions are required to be disclosed
but short positions are not. Either long and short positions should both be required to be disclosed
or neither should be required to be disclosed.2
In general, requiring disclosure of positions imposes
costs on hedge funds since position disclosure by a hedge fund facilitates imitation by others,
which likely leads to deterioration in the hedge fund’s performance. The improvement in
transparency that position disclosure brings reduces the externalities that hedge funds impose on
the financial system. There is a trade-off: it is not clear where to draw the line.
Hedge funds need mechanisms that encourage them to implement well-functioning operational
controls. The reason is the considerable benefits for fund investors of well-functioning operational
controls. Penalties for violating operational controls in place should be sufficiently harsh to act as
a deterrent.
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Any additional regulation of hedge funds is in general not warranted. Since the funds do not receive
guarantees from the government that may induce moral hazard, it is not clear why regulation is
needed. As mentioned above, however, the exception is when the hedge fund imposes externalities
on the financial system. If the hedge fund falls into the class of large complex financial institutions
(LCFIs), like the LTCM example in Section 3, then it is fairly clear it needs to be treated as a
systemic institution and regulated (and taxed) as such.
The regulatory difficulty arises if a subset of funds together imposes externalities because those
funds are capable of generating considerable counterparty credit risk in the financial system,
because they are capable of large trades that move prices far away from fundamentals, or because
of the capacity of those funds for severe capital erosion. Each fund alone though would not qualify
for the LCFI category. The funds involved in the quant fund meltdown described in Section III
might be an example of such a subset of funds. However, it is not clear that systemic risk was
present in very large amounts since the funds generally traded liquid equity securities. At the same
time, prices moved a great deal, seemingly in response only to the hedge fund “unwind” trades,
which suggests that prices may have been far away from fundamentals during the meltdown.
A. Regulation of Small Hedge Funds – Some Considerations
Each hedge fund in such a subset may be too small in terms of its positions or trade volume to be
subject to any fees that might be levied on financial institutions for using financial markets in a
manner that generates systemic risk (and the associated externalities). However, if the subset taken
together as a single entity qualifies to pay such fees, then each fund in the subset should pay a
fraction of the fees depending on its contribution to the subset along whatever trading dimension
(most likely positions or trade volume) is being used to determine the fees to be paid.
Hedge funds that belong to one of the subsets imposing externalities on the financial system may
need mechanisms that discourage investors from withdrawing funds after bad performance, since
correlated performances across the funds in such a subset leads to correlated withdrawals, which
may be contributing to the externalities that the subset is imposing on the financial system. Here
are some possible channels that could be used.
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• Lock-up periods could be lengthened, though this imposes a cost on investors who
otherwise would like to withdraw their money. There is a trade-off and it is not clear
exactly what restrictions would best balance the competing considerations.
• Redemptions could be regulated. Right now, most funds that allow redemptions allow
them at the end of calendar quarters. The externality to the financial system that hedge fund
redemptions cause could be reduced if hedge funds stagger redemptions across the year.
There would be 3 cycles (more if mid-month redemptions are encouraged): (i) December,
March, June and September; (ii) January, April, July and October; and, (iii) February, May,
August and November. Again, there is a cost to investors since this staggering either
reduces investment options available to investors after redemptions (if hedge funds only
accept new funds at the times when they allow redemptions) or increases the trading costs
incurred by hedge funds (if hedge funds accept new funds at the end of each month or even
more frequently).
• The length of notice that investors must give hedge funds before they can get their money
back could also be regulated.
On first reflection, it would seem that lockup restrictions would be difficult to either enforce or
regulate, but that is not the case. Lockups help stabilize the system. If funds within a systemic
subset do not impose lockups, then they would be charged a fee, i.e., taxed. Of course, in
equilibrium, whether a fund imposes a lockup restriction or not depends on the fees it pays the
regulator if it doesn’t versus its increase in funds under management if it doesn’t (since investors
prefer funds not to be restricted). The most likely system would have unlocked funds charging
higher management fees, which would be used to help pay the regulator. In general, the costs of
the tax would be shared between the hedge fund principals and investors.
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4.2: Key Differences Between Hedge Fund and Mutual Fund
The difference between hedge fund and mutual fund can be drawn clearly on the following
grounds:
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1. A hedge fund is described as a portfolio investment whereby, only a few accredited investors
are allowed to pool their money together to buy assets. Mutual funds refer to a professionally
managed investment vehicle, where the funds are collected from several investors are pooled
together to purchase securities.
2. Hedge funds seek absolute returns. Conversely, mutual funds seek relative returns on the
investment made in securities.
3. Hedge funds are aggressively managed, where advanced investment and risk management
techniques are used to reap good returns, which is not in the case of mutual funds.
4. The owners of a mutual fund are large in number, i.e. there can be thousands of owners of a
mutual fund. However, a hedge fund owner is limited in number.
5. If we talk about the type of investors, hedge fund investors are high net worth investors. On the
other hand, a mutual fund has small and retail investors.
6. Hedge funds are lightly regulated whereas mutual funds are strictly regulated by the Securities
Exchange Board of India (SEBI).
7. The management fees depend on the percentage of assets managed in mutual funds. As opposed
to hedge funds, where the management fees are based on the performance of assets.
8. In hedge funds, the fund manager also holds a substantial part of ownership. Unlike mutual
funds where the fund manager does not hold substantial interest.
9. In mutual funds, the reports are published yearly, and disclosure of the performance of assets is
made half yearly. As opposed to hedge funds, where the information is provided to investors only,
and there is no disclosure of operations publicly.
COMPARISION OF HEDGE FUNDS & PRIVATE EQUITY
1. What am I buying here?
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Most hedge funds invest in securities like stocks, bonds, derivatives and commodities that are
tradeable on the open market and can be bought or sold on short notice. Positions in the portfolios
of these funds change often, sometimes even on an intraday basis.
Private equity funds, in contrast, invest in companies or properties with the intent to operationally
manage, grow and eventually sell these assets. These investments generally take 3-5 years, and
sometimes much longer, to become fully realized.
2. Is it an investment or a commitment?
When you invest in a hedge fund, your money leaves your bank account as immediately as when
you invest in a mutual fund. Which is as you would expect, since the majority of hedge fund
managers are constantly deploying capital in (mostly) marketable securities that trade in real time.
Sign up for a private equity fund, on the other hand, and you often will not need to make an
immediate debit from savings. Instead, you will commit an amount of capital to be paid into the
fund as needed for deals that the portfolio managers strike in the private markets. As much as
investors may want transparency into the timing of these capital calls, funds often simply don't
know the timing when you sign up. Investment opportunities can arise unpredictably, and even
deals that have been in a fund's pipeline for months or years can get delayed or accelerated as the
buying and selling parties complete their negotiations.
3. How long does the commitment last?
Private equity funds don't have an unlimited period of time to call on your committed capital.
Rather, they have an investment period that is written into the fund's offering documents. It's
generally 3-5 years, after which the fund must release you from your commitment, “use it or lose
it” style.
The remainder of the fund's life is the harvest period, where the fund returns proceeds from
investments. Some private equity funds have the ability to re-call a portion of the proceeds they
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return to you so that they can make investments in new portfolio companies. This ability is called
recycling. A recycling provision can lengthen the duration of your investment significantly, which
may not be desirable from a liquidity perspective but can yield interesting investment opportunities
and increase the percent of your capital commitment that is actually put to work.
Since hedge funds don't call capital, they don't officially have recycling provisions. Because they
are constantly trimming, increasing and replacing positions, however, you might say the essence
of their work is constantly to recycle capital to its best possible risk-adjusted use.
4. How much will I be charged?
Private equity and hedge funds both earn an annual fee on assets managed, usually 1% - 2%, as
well as incentive fees typically amounting to 20% of profits. The combination of these
management fees and incentive fees is where the oft-quoted “2 and 20” comes from.
The timing and triggers of incentive fees impact net returns and differ among fund types. Incentive
compensation at hedge funds is often driven by a concept known as an annual high-water mark,
which is different for each investor and reflects the net asset value (NAV) of their share of the fund
at the time of their investment. Picture the rise and fall of the investor's NAV as that of a literal
column of water that leaves a mark in its wake. If you invest in a fund at an NAV of $100 and it
subsequently falls to $85 and then rises to $95, the high water mark of $100 is visible above the
current $95 NAV and the manager does not earn an incentive fee that year (or ever, until it gets
your NAV back above $100). If the fund rises to $120, however, the manager is entitled to 20%
of $20, the quantity of NAV above the high water mark.
Private equity incentive fees, on the other hand, are generally based on a hurdle rate, or minimum
net return to the investor. If the hurdle is 8% annualized, for example, an investor that experiences
a 10% annualized return will be charged 20% of that entire 10%. If the return is at all below 8%,
however, the investor will not be charged an incentive fee on any portion of the return. Because a
fund could achieve above-hurdle returns early in its life and then disappoint later on, private equity
funds often have what are known as LP clawback provisions wherein part or all of a previously
disbursed incentive fee is sent back to the investor's capital account.
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5. When will I see my returns?
Generally, the liquidity terms of a fund should match those of its underlying investments.
Consistent with hedge funds' typical focus on marketable securities, they tend to be open-end
funds, meaning that as long as there is capacity for more assets in a particular strategy, investors
can invest or redeem cash within the fund's liquidity parameters. Some funds permit capital
withdrawal every day, while most restrict it to once a month, once a quarter, once a year, or less,
usually depending on the liquidity of the underlying assets. Practically speaking, if a fund has
performed well and you have held the fund through your lockup period, you can redeem with
sufficient advance notice and pocket the proceeds (minus applicable taxes). If the fund has done
poorly, on the other hand, you can redeem and reinvest the proceeds in something else.
On the other end of spectrum, private equity funds are closed-end, reflecting their long-term
investment in much less liquid assets. Rather than accept periodic investments and redemptions,
private equity firms (often called sponsors) have a discrete capital raise period for each fund during
which they target a total fund size matching the scope of the investment opportunity set they plan
to pursue. Once the fund has either raised (or exceeded) its target (or tried and failed to do so over
a maximum acceptable time period ), the sponsor holds a final close. After this happens, no
additional capital is generally granted access to the fund. All committed investors are locked into
the fund until the end of its life in typically 8-12 years. PE's long-duration investments and
corresponding closed-end structure are the driving forces behind the J-curve pattern to private
equity returns.
6. What about taxes?
Every year, hedge funds and private equity funds generate a form K-1, which reports the investor's
share of taxable gains, losses and income. With hedge funds, the proportion of short-term vs. long-
term gains depends on how often the portfolio manager holds the fund's investment assets.
Ordinary income tax may be generated by bonds and other income-producing instruments held by
the fund. Most private equity fund holdings remain in the portfolio for longer than 12 months and
are therefore considered long-term capital gains.
7. What sorts of protections am I afforded as an LP?
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Private equity and hedge funds offer different measures of protection against behaviors - by fund
managers and by other investors - that could adversely impact the value of their investment.
Managing a portfolio of private companies can be incredibly time-consuming. Often, members of
a private equity team will assume semi-permanent senior positions at portfolio companies in order
to drive change from the inside. To give investors comfort that senior talent will stay deployed
long-term, PE firms will often commit not to raise a subsequent fund offering until a certain time
period has elapsed.
Individual holdings of marketable securities do not often have as strong a claim on hedge fund
managers' time, so hedge funds typically do not offer this provision in their documents. A hedge
fund portfolio manager may run multiple strategies, but they are typically related such that time
spent conducting research for one strategy benefits the others.
Both hedge funds and private equity funds sometimes offer key man provisions to protect against
an important person ceasing to work on behalf of the fund. In the case of a hedge fund, the
occurrence of a key man event will often entitle all investors to withdraw their capital from the
fund, regardless of any lock-up or notice period requirements. The occurrence of a key man event
in the private equity context typically results in the termination of the investment period of the
fund — namely no more new investments can be made.
Both fund types also offer protections against the adverse actions of other LPs. A hedge fund's
liquidity constraints (i.e. allowing only periodic withdrawals and only after a certain number of
days' notice) ensure that the manager has adequate time to sell securities without creating a
massive, NAV-busting downward move in prices. Some hedge funds also have “gates,” whereby
only a designated percent of assets is allowed to exit the fund in any given month or quarter. Many
funds exercised their gating provisions in 2008 in order to prevent a mass exodus of assets.
Private equity investors simply cannot withdraw capital before the end of a fund's life. Those who
default on capital calls face severe penalties, an effective deterrent for behavior that in aggregate
could significantly impair a fund.
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Hedge Fund Case Study On Petters
Abstract:
Less attention is paid to Thomas Petters thanks to Bernie Madoff's enormous fraud, he successfully
played his own show over 13 years. His illegitimate asset based lending scheme seems very simple and
the promised returns were too good to be true. Then, why did so many investors miss his misconduct for
such a long time? A golden rule to avoid a potential fraud is: there is no free lunch. But, there are three
other critical steps investors could have taken to avoid the massive losses they suffered.
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CASE PROFILE:
Background:
From as early as 1995 through September 2008, Thomas Petters ("Petters"), a prominent
businessman in Minnesota, perpetrated a massive Ponzi scheme through the sale of promissory
notes to investors. While Petters' $3.65 billion fraud dwarfs Bernie Madoff's $65 billion, it is still
the third largest hedge fund fraud case as of today (Jan 2012). After failing several retail
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businesses, Petters started a wholesale brokerage business, which later became Petters Co, Inc.,
("Petters Co") in 1988, and traded closeout, overstock and bankrupt company merchandises, which
were usually traded with a huge discount. Petters Co and its affiliates bought those merchandises
and sold them to "Big Box" retailers such as Wal-Mart and Costco, but such transactions usually
took up to 180 days to complete and that the sellers or manufacturers demanded payment up front
while the retailers did not pay until the merchandise was delivered. In order to finance this 180-
day period ("purchase order inventory financing"), Petters issued a short-term (up to 180-day)
promissory note with a large coupon payment (from 10 to 18% p.a.) to at least 20 investors. There
were at least four fund operators of feeder funds, which are set up primarily to purchase secured
notes from Petters Co and its affiliates. Shortly after the arrest of Petters, SEC accused all four
operators, including their principals, for knowingly supporting the fraud scheme. According to
various court documents, these feeder funds raised more than $4 billion from their investors,
including well-known fund of hedge funds operators
Source: various court documents; figures are rounded Many feeder funds are structured to purchase
the notes from subsidiaries or affiliates of Petters Co. In order to show legitimacy of the scheme,
Petters Co. established bank lock box accounts, or "Escrow" account, over which Petters Co has
no control. All payments from the Big Box retailers shall be paid into the accounts. Each feeder
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fund had a slightly different scheme, but the fundamentals are basically the same. The following
diagram is the scheme used by Stewardship.
Source: SEC vs. Stewardship (2009)
Doug Kelly, a personal lawyer of Petters, became a courtappointed receiver in the
Petters' bankruptcy and filed about 200 lawsuits, seeking to recover about $2 billion.
As of Dec 2010, he had collected about $200 million.
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Problems:
Petters fabricated purchase orders from retailers and used them as collaterals to
borrow money through hedge funds. In reality, paying 10-18% interests on highly
secured paper sounds too good to be true and the scheme crafted by Petters was
relatively simple compared to other Ponzi schemes. So, why did many investors,
who directly purchased the Petters paper or indirectly invested in the feeder funds,
fail to detect his misconduct?
The reason he could run this $3 billion Ponzi scheme over so many years was largely
due to negligence of investors and lack of operational due diligence. The stable
return stream of the feeder funds (1.0-1.5% a month with almost no fluctuation)
was, if true, attractive not only for individual investors, but also institutional
investors who obsessively sought "low volatility, low correlation" opportunities.
The payment scheme with the lock box accounts described above should have
worked well if it were operated and monitored properly by the direct holders of the
notes (i.e., feeder funds). But, it was a sham as the feeder fund operators never
conducted due diligence as promised.
Petters and his affiliates indeed knew very well how to manipulate investors'
psychology and many investors thought they were invested with a legitimate lending
practice:
1. By being informed that all promissory notes were secured by purchase
orders from the Big Box retailers, investors made themselves believe that
Petters should have not made such obvious lies
2. Multi-layered schemes, including subsidiaries/affiliates of Petters Co and
feeder funds
3. The lock box account scheme gave false sense of security
4. Payments were made on time for over 13 years of its existence until very
late stage of the scheme
5. No audit was legally required at the level of borrowers (Petters Co and its
affiliates), even though annual audit for the feeder funds were conducted by
reputable audit firms (they might have missed several key issues during the
audits)
Recommendations:
Conduct extensive background checks on all related parties:
1. This is one of many cases in which background checks should have helped
investors to avoid investing in the scheme. But, it was important for
investors to conduct all related parties since investors tend to conduct
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background checks on principals of feeder funds for various reasons (mainly
due to the high cost to execute background checks).
2. For example, on May 22, 2005, a potential investor emailed one of the feeder
fund operators, stating that a third party "report indicated that Mr. Petters's
background includes a criminal history (fraud or forgery convictions,
possibly with prison time served), along with significant civil litigation,
including a recent $5 million fraud suit." In fact, Petters had been convicted
of several felonies, including a 1983 conviction for writing a bad check, a
1989 conviction for forgery (for which he served time in prison), and a 1990
conviction for theft by check.
3. New York hedge fund manager Richard Bookbinder of Bookbinder Capital
Management passed on an investment after he learned that Petters had lied
on a Dun & Bradstreet questionnaire about earning a degree from St. Cloud
State University.
4. Mr. Bookbinder late said, "Things popped up and we didn't feel comfortable.
When people gave money [to Petters] they didn't ask, 'Who's this guy?
What's his background?' The question is: This information was out there in
2002. We looked at it and we're a small firm; why didn't other people look
at it?"
Confirmation on the Big Box retailers and their payments to the lock
box accounts:
1. In 2005, AG Deutsche Zentral-Genossenschaftsbank Frankfurt Am Main
("DZ Bank"), a German lender, discovered that the lock box account did not
function as Stewardship represented in its offering materials. DZ Bank made
this discovery in the course of performing due diligence for a line of credit
to Stewardship's operating company called Acorn Capital Group, LLC.
2. In 2008, Acorn sought a loan from Fortress Investment Group LLC
("Fortress"), but Fortress decided not to loan Acorn money after it learned
that the Big Box retailers did not make payments directly into the lock box
accounts as explained by Acorn.
3. For an investor of a feeder fund, it could be difficult to obtain transaction
details of the lock box accounts. However, it is possible to conduct due
diligence by calling some of the Big Box retailers whether they recognize
Petters Co and its affiliates as counterparties of the transactions and whether
they recognize purchase orders, which many feeder fund operators claimed
as collaterals for the notes they purchased.
Confirmation of registration as a Registered Investment Advisor:
1. Arrowhead Capital Management LLC ("Arrowhead LLC"), and Arrowhead
Finance told their investors and potential investors that Arrowhead Corp.
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(predecessor of Arrowhead LLC) and, later, Arrowhead LLC were
registered with the SEC as investment commission. While Arrowhead Corp
did register with the SEC on
November 27, 1995, but terminated its registration on
July 7, 1997 before Arrowhead raised any capital for its
funds. A quick online check at the SEC website should have revealed that it
was not true and investors should have considered it as a red flag.
CONCLUSION
The hedge fund industry has grown rapidly over the last 15 years. As of January 2007, hedge
funds had upwards of $1.5 trillion of assets under management. However, there is very little
evidence to suggest that hedge funds caused the current financial crisis or that they contributed to
its severity in any significant way. That been said, it is possible that a particularly large hedge
fund (of the LTCM-type) or some subsets of the hedge fund industry may still be imposing
externalities on the financial system if they are capable of generating considerable counterparty
credit risk in the financial system, if they are capable of large synchronized trades that move prices
a far away from fundamentals, or if they are capable of severe and synchronized capital erosion.
All three are possible since funds following certain styles have correlated and interrelated positions
and many styles also have correlated and interrelated positions. The quantitative hedge fund
meltdown of August 2007 is a good example of how interrelated the trades and positions of the
funds in the quantitative “statistical arbitrage” hedge fund sector can be. We argue that the hedge
fund subsets imposing externalities on the financial system may require additional hedge-fund
specific regulation to manage these externalities. Just as importantly, the rest of the hedge fund
industry, which is not imposing such externalities, should not be subject to the same regulation. It
is important to always remember that hedge funds are an organizational form, not an investment
strategy.
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Conclusion
If you are an amateur to the capital market and wants to invest in one of these two funds, then you
can make a choice as per your resources. If you have a large amount of money, then you can go
for hedge funds, whereas if your investment amount is low then you can opt for mutual funds
CONCLUSION OF PRIVATE EQUITY
The differences between private equity and hedge funds are significant and reflect distinct
underlying investments and portfolio durations. This does not mean, however, that the two
categories are mutually exclusive. Hybrid vehicles exist, as do funds that run both types of
strategies. Markets are dynamic, and creativity wins, so it is not highly unusual for a manager
running a highly liquid portfolio to spot private investment opportunities that might just be too
good to resist. For the most part, though, when it comes to hedge funds and private equity, think
more along the lines of peanut butter and pizza: not exactly an iconic pairing, but each satisfying
in its own right.
