Hedge Funds

The key focus areas of this chapter will be the features of hedge funds. The chapter will also do a comparison between mutual funds and hedge funds. Biases that are often prevalent in hedge funds’ databases will be studied. We will then study how the hedge fund industry has evolved. This explanation will include major events that triggered the evolution of the industry.

The next section will be about what role is played by investors as far as the industry is concerned. Furthermore, this section will seek to answer the following questions:

  • How is risk related to alpha?
  • How do the various strategies of hedge funds compare with one another?
  • How do equity indices compare to hedge funds’ performance trends and historical construction of portfolio?
  • What are the challenges associated with risk sharing asymmetry in the industry among agents and principles?
  • How do institutional investors affect the hedge fund industry?
  • Why is there an increased concentration of assets under management in the hedge fund industry?

The Hedge Fund Business Model

The main role played by hedge funds is managing privately owned wealth. Hedge funds are quite different from mutual funds. As compared to publicly traded mutual funds, fewer regulations are imposed to hedge funds. This is due to the fact that they are private investment vehicles that are not open to the general public. Therefore during market downturns, they can preserve their capital by holding substantial short positions.

Furthermore, profits in hedge funds can be generated from long positions and short positions, all in equal measure. By taking short positions, the hedge fund managers can dampen sensitivity to the general market direction and also consider large positions as they await the prices of assets to either fall or rise. This can make their balance sheets’ size exceed their equity capital. This also another factor that differentiates the hedge funds from the mutual funds.

The hedge fund managers are required to have exquisite skills of timing the market. Therefore they recognize the best opportunities to either long or short an asset’s price. Furthermore, they should be conversant with the structure of the organization if they are to engage in short positions for longer timeframes. As an addition to their risk management skills, these managers should know how to fund leveraged positions as the positions are complex and the market might be volatile.

Both the investors and managers consider hedge funds to be very suitable to them due to their private nature. On very few occasion will wealthy investors impose specific mandates concerning the management of their investments. In most cases, the investors will insist that their investment on the vehicle be as private as possible while carrying limited liability.

Most hedge fund managers will offer very limited information concerning their strategies as other traders may mimic or even front run their trades.

In the US, the legal restrictions on compensation do not apply to hedge funds as they do to publicly traded mutual funds. On the other hand, consequences might arise due to this little or lack of regulation. To start with, there is no standardization of hedge funds’ performance records. Measurement errors may affect available reports.

It is not a requirement that hedge funds share information to the public. For most hedge funds, the reporting of samples is done on a selective basis. Others rarely report to any database. This, therefore, makes it hard for researchers to make deductions about the industry.

Empirical Evidence of Hedge Fund Performance

Various studies done in the past on hedge funds agree that biases and errors in hedge funds can be attributed to the fact that a performance reporting standard is missing among all hedge funds and how data is reported to database vendors in a self-selection manner.

As a result, performance metrics are affected in various ways due to these biases. It is important that we analyze these biases to study the historical hedge fund returns.

Were the expectations of early hedge fund investors fulfilled?

There has been a marked improvement in the popularity of hedge funds since 1994 among investors who happen to be equity-oriented. However, very little is known about what propelled the growth of popularity of the industry of hedge funds before 1994. It is important that we establish whether hedge funds deliver on alpha, adjusting for measurement biases and risks. Another factor that should be established is the reference risk factor(s).

When commercial hedge fund databases arrived, it led to the availability of broad-based indices of hedge fund performance. Around the year 1996, the reliability of hedge fund index returns increased as suggested by the combined empirical evidence. Performance data are very informative since insights can be drawn from them.

When the hedge funds industry started, some few large hedge funds had the lion’s share of the assets of the industry. There was selective in the financial press in favor of the large hedge funds that were more news-worthy. This was prior to the arrival of commercial databases.

Even though there was a possibility of seeing opaque investment vehicles, the SNP and large hedge funds have a sizeable gap that is difficult to account for solely by performance biases. Furthermore, between large funds that are successful and the ones that struggled to growth assets exist a sizeable performance gap.

The arrival of institutional investors

Around the year 2000 and 2001, there was a marked improvement in the number of investments in hedge funds, with 19.82% net asset inflow in the industry. This was during the dot-com bubble burst. This was the same time that a massive shift was witnessed in the hedge fund industry’s structure.

In 1996, the hedge funds’ total performance surpassed the performance of the S&P index, while the return standard deviations of the hedge funds were slightly over half that of the S&P index’s. This led to institutional investors becoming interested as well. These investors range from pension funds and foundations to insurance companies and endowments alike.

Hedge Funds Performance – The Post Dot Com Bubble Era

As opposed to wealthy private investors, there is a tendency by institutional investors to have moderate return expectations, and not tolerating high fees and risks. According to evidence provided between the period 2002 and 2010, it is apparent that institutional investors were rewarded based on their action of allocating capital away from low-cost equity investment to hedge fund vehicles demanding fees that are relatively quite high.

Intermediaries like hedge fund managers were not quite as common when institution investments first ventured into the industry. The role of these intermediaries is creating a portfolio of hedge funds that are diversified and ensure that the institution’s investment objectives are met by the portfolio.

Absolute Return and Alpha

When institutional investors emerged as the investor category that dominated the hedge fund industry post the dot-com bubble, there was a major shift in the industry as far as the structure of its clientele was concerned. However, it must be understood that the move by institutional investors to hedge funds was not an escape from the equity markets. Absolute return performance has been termed by many as the reason while others consider the industry as a better alternative of returns based on a broader reference portfolio mix as compared to equity only.

However, most institutional investors agree on the necessity of establishing the reasons, the amount to be allocated to the different hedge fund strategies, and if uncorrelated returns are delivered by these strategies to a specified reference portfolio mix.

It is also crucially important to note that strategy benchmarks have short histories that make it difficult for performance behavior to be evaluated by investors over different cycles of the economy despite the fact that they can aid investors to do a comparison between returns of a specified fund to its peers – peer group alpha.

An instance where the investors have their reference portfolios significantly exposed to high-yield bonds, there is very little that peer group alphas can do to help. In case a large loss is suffered in the credit crunch is suffered under fixed income arbitrage, the knowledge of outperformance by a given fixed income arbitrage over his/her peers will be of little or no help at all.

There have been attempts by researchers, around the mid-1990s to associate market risk factors having performance histories longer than hedge funds to hedge fund returns. To understand this better, let’s assume that a connection can be established between the Fixed Income Arbitrage strategy’s returns to Credit spreads whose basis is observed data.

It will, therefore, be possible for investors having significant exposures to credit risk in their reference portfolios to apply their outlook on the credit market, for consistent expectations to be formed based on the performance of fixed income arbitrage hedge funds. In this regard, the knowledge of a strategy’s credit spread beta is a crucial indicator of the performance of the strategy can be affected by a credit strategy.

It is, therefore, possible for an investor to estimate the amount of a Fixed Income Arbitrage performance of a hedge fund that is constantly unrelated to the main risk driver of this strategy – factor-based Alpha.

It is an established fact that there lacks an objective definition of absolute return from a risky investment. However, it has been generally agreed that the absolute return that is non-negative regardless of whether the market is bullish or bearish is the best description of absolute return.

With some predetermined market conditions – including risk factors and evaluation periods – the concepts of absolute return and alpha share some similarities that can be identified. In case of the possibility of separating factor-based alpha and strategy’s factor beta while applying the techniques of hedging, then the features of absolute return investment will be very prevalent.

 

The Risk in Hedge Fund Strategies

From Passive Index Strategies to Active Hedge fund Styles

The characteristics of returns of a conventional asset class are a reflection of a passive-buy-and-hold strategy’s return features used on the said asset class. To capture active management strategies used on a conventional asset class, the style model concept is applied in Sharpe’s model where linear combinations are introduced in an extended investment style. The linear combinations are drawn from an expanded asset class indices that are extended to permit sector specialization.

In Sharpe’s formulation, here is a difference between investment styles. This difference is marked by the selection of the market leverage – that is asset-class indices and exposure (β) to each index. Sharpe’s model has been extended to hedge fund styles. To start with, the set of investment opportunity is extended past conventional asset classes to mirror the ability of the hedge fund manager to undertake the short selling of securities. This will allow for negative betas.

Next, allowing for variation of betas over time, there has to be an extension of exposure to a given asset class thereby mirroring the dynamic nature of hedge fund strategies. Thirdly, there has to be a broadening of the range of asset class betas for the application of both the financial and market leverage.

Peer-Group Style Factors

Hedge funds are categorized on the basis of the individual manager’s description of the strategies applied by each fund in order for investors to be assisted to better understand hedge funds. The style index is achieved by averaging the returns of the fund in each group. To date, this has been the most popular method of creating the hedge fund index where peer-group averages are qualitatively determined.

It is necessary for hedge fund managers to advance their business scope as the market conditions keep varying with time. However, there is no relationship between quantifiable market factors and qualitative style indices.

Return Based Style Factors

Rather than expecting hedge fund managers to disclose their strategies, groups of hedge funds with similar returns traits can be constructed. The basic idea here by Fung and Hsieh is that when similar strategies are applied by funds, then chances are that highly correlated returns should be achieved relative to those that apply different strategies. The principal components of their historical returns are key to identifying this trend. This fact can be attributed to the following reasons:

  1. The common risk-return characteristics of the applied strategies and the markets whereby transactions are conducted should be approximated by the statistical clustering of returns.
  2. A lot of peer group based style factors can be reduced by the principal component analysis to a set that is more manageable.
  • To determine these statistically constructed components that are interpreted as return-based style factors, we can apply qualitative self-disclosed strategy information from hedge fund managers.

Top-Down versus Bottom-Up Models of Hedge Fund Strategy Risk

The main markets under which managers of hedge funds transact can be identified by the application of return-based style factors. The bottom-up model is a micro approach modeling the return generating process that can assist us to establish the determination of bets, thus helping us explicitly determine which market factors drive performance.

Directional Hedge Fund Styles: Trend Followers and Global Macro

The trend-following strategy is applied by most hedge funds. Historical price data and market trends are the main factors that are relied upon by systematic trading programs employed by managed futures fund managers. Because futures contracts are largely applied in the strategy, a significant amount of leverage is often employed.

There is always that tendency by managed futures trends not to have a particular bias towards being net long or net short in any given market. It has been shown that a market timer switching between stocks and treasury bills generate a return profile that is similar to that of the call option on the market.

According to empirical evidence, there is a strong correlation between bonds, commodities, and currencies, and trend follower returns at a level well beyond previous returns. Furthermore, trend following returns has been majorly determined by market volatility.

One group of very high dynamic traders is Global Macro Fund Managers. These are highly active asset allocators who take highly leveraged bets on directional movements in exchange rates, interest rates commodities, and stock indices.

Global Macro and Managed Futures have one common similarity that is often quite interesting and that is their tendency of following the trend. Furthermore, these managers act as if they are asset allocators who bet in various markets and apply various strategies opportunistically. From this, it is not a surprise that they generate low return correlation to equities.

Event Driven Hedge Fund Styles

They are also known as Merger Arbitrage. In this case, during a merger or acquisition transaction, the Risk Arbitrage Event Driven hedge funds will try to capture the spreads after the announcement concerning the terms of the transaction. So as to account for the risk of failure to close the transaction, the target stock trades at a discount to the bid.

When the deal involves cash, typically the manager buys the stock of the target only to tender it for the offer price at closing.

When the deal involves a fixed exchange ratio stock merger, the long position will be taken on the target stock whereas the short position will be taken on the acquirers stock, in accordance to the merger ratio, in an attempt to isolate the spread and hedge out the market risk. In the event of the deal failing to close, the principal risk happens to be the deal risk.

The distressed hedge fund is the other strategy category, other than risk arbitrage, that is applied by hedge funds in the DJCS event-driven hedge fund style index. In this case, the Dow Jones Credit Suisse Event Driven Distressed Hedge Fund Index measures the aggregate performance of event-driven funds focusing on distressed situations. The attraction of these funds is the capital structures of companies that are on the verge of bankruptcy or operational distress.

The idea is that distressed managers try to gain on the ability of the issuer to improve its operations, or the bankruptcy process succeeding, in which case they will have an exit strategy. The strategy is mainly characterized by corporations having quite low credit ratings being exposed to long credit risk.

There is a possibility of distressed hedge funds earning extra liquidity premium over high yield bonds while incurring a higher funding cost carrying very liquid securities due to the fact that they own securities that are much less liquid as compared to high-yield bonds.

It is important to note that both these strategies display a nonlinear returns behavior. This behavior mainly occurs in the form of tail risk. The tail risk happens to be a large drop in equities when dealing with risk arbitrage, and it is in a large move of short-term interest rates when distressed hedge funds are the strategy.

Relative Value and Arbitrage-Like Hedge Fund styles: Fixed Income Arbitrage, Convertible Arbitrage, and Long/Short Equity

The hedge fund managers’ market focus separate the three main strategies in this category. The first one is the managers whose market focus is a fixed income. The aggregate performance of fixed income arbitrage funds is measured by the Dow Jones Fixed Income Arbitrage Hedge Fund Index. In this case, profits are generated by taking advantage of the inefficiencies and price changes between fixed income securities that have something in common. Both long and short positions are leveraged in fixed income securities with either mathematical or economic relations.

The aggregate performance of Convertible Arbitrage funds is measured by the DJCS Convertible Arbitrage Hedge Fund Index. In this case, generation of profits involves entering a long position for the convertible securities and a short position for the corresponding stock in the event that a pricing error takes place when the security’s factor is being converted.

Finally, the aggregate performance of long or short equity funds is evaluated by the DJCS Long/Short Equity Hedge Fund Index. In this strategy, the investment involves both the long and short positions in the equity markets. The hedging or diversification takes place across specified sectors, market capitalizations or regions. Managers can change their focus from value to growth, net long to net short, and small to medium to large capitalization stocks.

The trading can range from assets like equity features, options, and securities that are equity-related and debts. Their portfolio built-up might be more concentrated in comparison to the traditional ones that were long-only equity funds.

Niche Strategies: Dedicated Short Bias, Emerging Market, and Equity Market Neutral

The aggregate performance of dedicated short bias funds is evaluated by the DJCS Dedicated Short Bias Index. There are relatively more short positions that are funded in this strategy as compared to their long counterparts. When net short exposure is maintained in the long and short equities, then returns can be earned. The stock is borrowed from a counterparty and shorted in the market. A forward sale may sometimes be crucial for the implementation of the short position.

On the other hand, the aggregate performance of emerging market funds is evaluated by the DJCS Emerging Markets Hedge Fund Index. The investment in emerging markets ranges from currencies and equities to debt instruments and other instruments from countries whose markets are emerging or developing.

A long bias is usually common in emerging markets due to the difficulties involved in when securities in emerging markets are being shorted.

What Next for Investors after these Steps

Portfolio Construction and Performance Trend

Performance data was not easily accessible to early hedge fund investors. They, therefore, had to rely on tools that were specifically made to evaluate long-bias funds – predominantly investing in conventional asset classes that were considered conventional.

In this regard, portfolio construction and risk management often reduce to spreading risk capital across hedge fund managers who have different strategies. Due to the fact that hedge fund managers are active managers, the average exposures of the factor bets (betas) of these managers can only be captured by a static regression model over a specified period of time.

To determine how the factor betas vary with time, the sample period is divided into sub-periods. There should be consistency in the results with dynamic adjustments to factor betas that correspond to market variations.

Alpha-Beta Separation, Replication Products, and Fees

The concern is whether risk premiums from different factors can be captured through lower cost alternatives to hedge fund vehicles. To address this concern, it is important that we point out that some of the hedge fund strategies that are considered as more mature can be replicated with rule-based models that apply liquid assets which are readily executable in the marketplace.

Hence, a given hedge fund’s strategy rule-based representation can be considered as the strategy beta factor or the beta factor of the strategy. The strategies are often called alternative betas, in a collective manner.

When we observe the experience of early institutional investors in hedge funds at the turn of the century, we can gain insight on the historical trends on the cost of hedge fund investing. A big percentage of the portfolio management functions was outsourced to funds-of-hedge-funds (FOHFs) by early institutional investors.

The managers’ selection is delivered by FOHFs by offering a one-stop vehicle. Among other services that are delivered by these FOHFs, in addition to manager’s selection, include portfolio construction, due diligence, administration, risk management, reporting, and dynamic strategies transaction in global financial sectors. As expected, such services are valued in accordance to a comparison of the lower net return to an investment against the cost of engaging the services of FOHFs.

According to Fung et. al. (2008), only a small proportion of FOHFs delivered positive and significant alphas over and above the seven-factor model of Fung and Hsieh (2004). The implication here is that most FOHFs lacked alphas. This is not a bad thing if mutual funds are anything to go by where negative alphas were produced relative to their respective benchmarks.

It is possible for investors to determine whether managers, on average, add value to a portfolio of beta bets, by comparing an investable index that happens to be a passive rule-based multi-manager portfolio to an appropriate portfolio of labs.

Because the hedge fund industry is growing and maturing, the quality and depth of performance benchmarks have been improved due to the availability of performance data. This has now led to the development of passively investable index-like products.

Practice Questions

Which of the following hedge fund strategies can be described as event-driven?

  1. Trend follower and global macro
  2. Equity long/short and risk arbitrage
  3. Global macro and equity long/short
  4. Distressed securities and risk arbitrage

The correct answer is D.

An event-driven strategy relies on the outcome of a specific corporate event like mergers and acquisitions, restructurings and litigation to earn profits. Event-driven strategies include investing in distressed securities and risk arbitrage.


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