11/02/01morgan stanley: hedge funds copyright (c) 2001 by marshall, tucker & associates, llc all...

11/02/01 Morgan Stanley: Hedge Funds Copyright (C) 2001 by Marshall, Tucker & Associates, LLC All rights reserved

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Morgan Stanley

Hedge Funds: An Introduction

John F. Marshall, Ph.D.631-331-8024 (tel)631-331-8044 (fax)

[email protected]

Copyright © 2001Marshall, Tucker & Associates, LLC

All rights reserved


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Suitability

No recommendation of an investment or investment strategy should be made unless the investment or investment strategy is suitable for the client. In order to make a suitability determination, you must understand the potential risks and rewards of the proposed investment or strategy and whether those risks and rewards are appropriate for the client in light of the following information to be supplied by the client:

• the client’s investment objectives;

• the client’s financial situation, needs, and experience;

• the client’s level of sophistication

• the client’s ability to understand and bear the risks of the investment or investment strategy.

For example, given the risks of an investment in junk bonds, junk bonds may be suitable for an institution or a high net worth individual, but they would not be suitable for a low net worth individual who has conservative investment objectives, whereas an investment in U.S. Treasury instruments could well be.


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John F. Marshall, Ph.D.

John F. Marshall is a principal of Marshall, Tucker & Associates, LLC, a financial engineering and derivatives consulting firm with offices in New York, Chicago, Boston, San Francisco, and Philadelphia; and he is a member of the Board of Directors of the International Securities Exchange, the first screen-based options exchange in the United States. Dr. Marshall is the author of seventeen books on financial products, markets, and analytics including Futures and Option Contracting (South Western), Investment Banking & Brokerage (McGraw Hill), Understanding Swaps (Wiley), Financial Engineering: A Complete Guide to Financial Innovation (Simon & Schuster) and Dictionary of Financial Engineering (Wiley, 2000). He has also authored several dozen articles published in professional journals and he is a frequently requested speaker for financial conferences.

Dr. Marshall is an accomplished financial innovator. He contributed to the development of the mathematical underpinnings of cash/index arbitrage using stock index futures (sometimes called program trading), and to the development of the first published pricing models for both equity swaps and CMT swaps. He is the originator or co-originator of seasonal swaps, synthetic barter, and macroeconomic swaps. He also participated in the development of several mortgage product variants.

For twenty years, Dr. Marshall served on the faculty of the Tobin Graduate School of Business of St. John’s University where he was the youngest person ever voted to the rank of full professor at that institution. Concurrently, from 1992 to 1998, Dr. Marshall served as the Executive Director of the International Association of Financial Engineers (IAFE). During his time as its Executive Director, the IAFE grew from 40 founding members to over 2000 members worldwide. From 1997 through 1999 he served on the Board of Directors of the Fischer Black Memorial Foundation. From 1991 to 1995, Dr. Marshall served as the managing trustee for Health Care Equity Trust, a closed-end limited-life investment company sponsored by Paine Webber. From 1994 to 1996, Dr. Marshall served as Visiting Professor of Financial Engineering at Polytechnic University where he created the first Master of Science degree program in Financial Engineering under a grant from the Alfred P. Sloan Foundation. During 1992 he held the post of Distinguished Visiting Professor of Finance at the Moscow Institute of Physics and Technology, a unit of the Russian Academy of Sciences.

Dr. Marshall has been an invited lecturer at the Wharton School of Business of the University of Pennsylvania, the Stern School of Business at New York University, and the Graduate School of Business of the University of Chicago. Outside the United States, he has lectured in Zurich, London, Toronto, Bucharest, and Tokyo. As a consultant, Dr. Marshall has worked for the United States Treasury Department, the United States Justice Department, the Federal Home Loan Bank, The First Boston Corporation (now CS First Boston), the Chase Manhattan Bank, Chemical Bank, Smith Barney (now Salomon Smith Barney), Merrill Lynch, Goldman Sachs, Morgan Stanley Dean Witter, Paine Webber, Union Bank of Switzerland, and JP Morgan, among others.

Dr. Marshall earned his undergraduate degree in Biology/Chemistry from Fordham University in 1973. He earned an MBA in Finance from St. John’s University in 1977 and an M.A. in Quantitative Economics from the State University of New York in 1978. He was awarded his doctoral degree in Financial Economics from the State University of New York at Stony Brook in 1982 while also a dissertation fellow of the Center for the Study of Futures Markets at Columbia University.


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What Exactly is a Hedge Fund?


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What is a hedge fund?

The term hedge fund describes an investment structure for managing a private unregistered investment pool. Because they are exempted from registration, until recently, the number of participants was limited and these participants had to be either institutional investors or accredited investors.

Hedge funds fall within a loosely defined asset class called alternative investments. Alternative investments represent an asset class because their returns are not highly correlated with other major asset classes, such as equity and fixed income.

Hedge Funds


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A Structure not an Approach:

The term “hedge fund” describes a structure for an investment vehicle, not an approach to investing. This was not, however, always the case.

The term itself originated with an investment approach believed to have first been employed by Alfred Winslow Jones. In 1949 Jones organized a private investment fund that took leveraged long positions in stocks that were expected to outperform the broad market. At the same time, he hedged this leveraged bet by going short an equivalent amount of stock that he believed would underperform the broad market.

Hedge Funds


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Thus, Jones was long and short equivalent exposures to the market. Because his short positions “hedged” the market exposure associated with his long positions, he described his fund as a “hedge fund.” Today this would be referred to as market neutral.

In the language of modern finance, we would say that Jones was trying to capture alpha while maintaining a neutral beta.

Definitions:

Beta: A measure of the systematic market risk associated with a single stock or with a portfolio of stocks.

Alpha: A measure of the “excess return” associated with a stock relative to what the stock would be expected to return based on its beta. Alpha is obtained by making good “picks” and therefore

represents “skill.”

Hedge Funds


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Jones deliberately maintained a low profile. But, in 1966 Fortune Magazine published an article detailing his extraordinary investment accomplishments.

During the immediately preceding five year period (1960-65), Jones’ hedge fund returned 325%. For the same period, the best performing mutual fund was the Fidelity Trend Fund, which produced a return of 225%.

For the fuller 10-year period (1955-1965), Jones’ hedge fund produced a return of 670%. For the same period, the best performing mutual fund had been the Dreyfuss Fund, which produced a return of 358%.

While others had already begun to adopted Jones’s style, this Fortune article spawned an aggressive expansion of the hedge fund industry.

Hedge Funds


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Jones hedge fund was organized as a private limited partnership. As such, it did not need to register with the SEC. But, it was limited to offering its securities to a small number of investors and these investor had to meet certain SEC mandated qualifications.

Two groups qualified: institutional investors and accredited individual investors.

Hedge Funds


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The limited partnership nature of the structure allowed Jones to employ an incentive-based compensation structure that guaranteed him a percentage of the hedge fund’s profits.

Jones investment structure, i.e., the private unregistered limited partnership, was adopted by others who launched investment management businesses.

Hedge Funds

Note: Hedge funds outside the U.S. that are open to U.S. investors are called offshore hedge funds. They are not subject to SEC regulation and, therefore, often employ a different legal structure -- often a corporate structure.


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The “percentage of profits” compensation structure made possible by the private limited partnership structure and an ability to maintain a much greater degree of secrecy in the strategies employed and the positions held (due to the unregistered nature of the hedge fund), made the structure very attractive to other investment managers and others adopted it. Examples include:

George Soros (Quantum)

Julian Robertson (Tiger)

Michael Steinhardt (Steinhardt Partners)

John Meriwether (LTCM)

Jeff Vinik (Vinik Asset Management)

However, while they adopted the “structure” of Jones’ fund, they did not all adopt his strategy. As a result, the term hedge fund came to describe a structure rather than a strategy.

Hedge Funds


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How do U.S. Hedge Funds differ from Mutual Funds?

Hedge funds differ from mutual funds in a number of ways. Key areas are:

1. types of positions and strategies employed

2. the number and size of the investors allowed

3. registration requirements

4. ease of investor entry and exit

5. method of investment manager compensation

6. performance measurement and reporting

Hedge Funds


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Types of Positions:

Mutual funds, both by tradition and by investment policy detailed in their prospectuses, are generally limited to long positions in securities within a specific asset class (although some invest in multiple asset classes). They are generally prohibited from taking positions in derivatives and often prohibited from employing leverage.

Hedge funds have no such restrictions. They can take long or short positions, they can move among different asset classes, they can employ extraordinary degrees of leverage, and they can employ the full complement of derivatives. Thus, they have much greater flexibility in their approach to investing.

Hedge Funds


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Because of their greater degree of flexibility, hedge funds tend to employ much more sophisticated strategies than do most mutual funds. They look for profit in overlooked, complicated, and misunderstood places. Their strategies can involve mathematically complex relationships that are often beyond the capabilities of the average mutual fund manager.

Hedge Funds


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Number and Size of Investors Allowed:

Mutual funds, which are generally organized as corporations but which can be organized as public limited partnerships, generally make their shares available to investors with very small minimum investments (sometimes as little as $500, but more typically $2500). There is no limit on the number of investors.

Hedge funds limit their investors to institutional investors and to those individuals that meet the SEC’s definition of accredited investors. The accredited investor rules were written long ago and it is debatable as to whether they are reasonable. An accredited investor is one who (1) has a minimum annual income in each of the prior two years of $200,000, or (2) together with a spouse has a minimum annual income in each of the prior two years of $300,000, or (3) has a net worth of $1 million (excluding home and automobile).

Prior to 1997, hedge funds generally were limited to 99 accredited investors. Consequently, hedge funds generally have very high minimum investments. These minimums range from $100,000 to $10 million, but are most often in the $500,000 to $1 million range. [These are minimums!]

Hedge Funds


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Registration Requirements:

Mutual funds are investment companies that offer their shares to the general public. They are required to be registered with the SEC under the Investment Company Act of 1940. They must make available to their investors a copy of the prospectus and to provide periodic reports of various types. They are also required to meet certain criteria with regard to the way that they report their performance to their investors.

Until 1997, hedge funds were exempt from registration provided that they limited investor participation to 99 accredited investors. This is called the 3(c)(1) exemption. However, in 1997, under the National Securities Markets Improvement Act, a second exemption, called 3(c)(7), was enacted to create a new exclusion from the definition of an investment company for pooled investment vehicles, if all investors are qualified investors. A qualified investor is (1) an individual holding at least $5 million in investments; or (2) a family company that holds at least $5 million in investments; or (3) a person acting on his own or on behalf of other qualified purchasers and who holds $25 million in investments; or (4) a company, irrespective of investments held, provided that each beneficial owner of said company is a qualified investor.

Hedge Funds


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Entry and Exit:

Mutual funds fall into two broad categories: Open end and closed end. The former sell their shares directly to investors at the share’s then NAV and stand ready to buy back the shares at the end of any day at the then NAV. Closed end funds issue a fixed number of shares which then trade in secondary markets like any publicly traded stock. They may trade at a premium to their NAV or at a discount from their NAV. But, in either case the investor can liquidate the investment at any time.

Hedge funds impose two types of provisions that limit investors ability to “cash out.” The first is a lockup period that generally runs for one year. That is, for one year after the initial investment, the limited partner (i.e., the investor) cannot sell his interest in the hedge fund. Following the passage of that year, the investor can sell, subject to the second type of liquidity provision. The second type involves “liquidation intervals.” These are usually end-of-quarter. Essentially, an investor can liquidate his interest in the hedge fund at the end of the fiscal quarter, provided that a minimum advance notice requirement has been met.

Hedge Funds


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Method of Investment Manager Compensation:

In the case of mutual funds, the mutual fund company selects an investment advisor. The investment advisor must itself be registered with the SEC under the Investment Advisors Act of 1940 (separate from the Investment Company Act of 1940 which pertains to the mutual fund itself). The investment advisor is paid a management fee that is a percentage of the assets under management. The fee is usually paid in quarterly installments and is generally graduated. For example, the annual fee might be 150 bps on the first $5 million of assets, 100 bps on the next $5 million, 75 bps on the next $50 million, and 50 bps on all assets over $60 million.

The key point here is that the mutual fund management fee is not based on performance.1

1 One could make the argument that the management fee is indirectly based on performance in the sense that a successful investment manager would expect the assets under management to grow because most investors leave their returns in the fund. Additionally, a successful mutual fund would tend to attract more assets--leading to larger management fees down the road.

Hedge Funds


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In the case of hedge funds, the hedge fund manager is usually the general partner of the limited partnership (every limited partnership must have at least one general partner).1 Limited partnerships are created under state law and the laws vary a bit from state to state.

A would-be hedge fund investor must apply for admission to the hedge fund by completing a subscription agreement and tendering this, together with the proposed investment amount, to the general partner. In applying for acceptance, the would-be investors agree to accept the terms of the offering memorandum2 and the limited partnership agreement. These documents detail, among other things, the method of compensation for the general partner.

If accepted by the general partner, the investment is placed in the fund and a letter of acceptance is issued.

1 The general partner (which can be an individual or a firm) serves the role of the investment advisor, but is, generally, exempted from registration as such. However, many hedge fund advisors choose to register as investment advisors anyway.

2 The offering memorandum is also called the private placement memorandum, the disclosure document, the prospectus, and a variety of other terms.

Hedge Funds


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Most often, the compensation clause will specify that the hedge fund advisor (i.e., general partner) will be compensated in two parts. The first is a management fee based on the amount of assets under management (100 to 200 bps per annum is typical). This is usually paid in quarterly installments, but some funds use monthly installments. The second is an incentive fee in the form of a percentage of the profits generated. This fee usually ranges from 10% to 30% with 20% being most typical. The incentive fee is also known as carried interest and is usually paid annually.

Importantly, this latter fee is based on absolute performance, as opposed to relative performance. That is, the hedge fund is not benchmarked against some index with returns measured on a risk-adjusted basis.

Hedge Funds


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Because a very large portion of the hedge fund manager’s compensation comes in the form of the incentive-fee, it is important that this fee be structured to avoid perverse outcomes. There are two ways that this is done: hurdle rates and high-water marks.

Hedge Funds


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Hurdle rate: The hurdle rate is the annual rate of return that the hedge fund manager must exceed before the incentive fee kicks in. This is often the 1-year T-bill rate at the beginning of the hedge fund’s fiscal year. For example, suppose that the 1-year T-bill rate is 4% and the incentive fee is 20%. Then, the hedge fund manager would get 20% of the profits but only to the extent that the fund earns more than a 4% return.

Example:

Suppose that the fund begins with $100 million. The value of the fund grows to $120 million over the course of the year (without any additions or withdrawals by investors). Then, the hedge fund manager would be entitled to 20% of the $16 million in profit beyond the hurdle rate.

Hedge Funds


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High-Water Mark: A high-water mark refers to the maximum value (adjusted for additions and withdrawals of investor funds) that the fund has previously achieved.

For example: Suppose that the fund starts with a value of $100 million and the end of the first year this has grown to $120 million. The manager collects 20% of $16 million as previously described. Suppose that in the following year, the fund losses $5 million so that its value is $115 million at year end. Clearly, the manager does not get any incentive fee. But what is the high-water market for the following year (year 3)? [Assume that the hurdle rate each year is 4%.]

High water mark for year 3 = Value at end of year 1 + hurdle rate for year 2

= $120,000,000 + 4%×$120,000,000

= $120,000,000 + $4,800,000

= $124,800,000

Thus, the incentive fee would no apply in year 3 until the hedge fund achieved a value in excess of $129.792 million (i.e., the high water market plus the hurdle rate).

Hedge Funds


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Performance Measurement and Reporting:

Mutual funds compute their NAV at the end of each business day. This is made available to interested investors through newspapers, the internet, or telephonic recordings. Additionally, the mutual fund provides periodic, usually quarterly, reports.

Hedge funds generally do not compute a daily NAV (although some now do). Most calculate a NAV monthly and provide a report to their investors within two weeks of the close of the month. However, some only do this quarterly.

There are no set rules with respect to the nature or the layout of the report that the hedge fund provides to its investors. At year end, the investors are furnished with a K-1 report, which is utilized in the preparation of income taxes.

Hedge Funds


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Investors in Hedge Funds


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Investors in Hedge Funds

High net worth individuals (accredited and qualified investors)

Institutional investors

Endowments

Pension plans

Hedge Funds


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Types of Hedge Funds


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Types of Hedge Funds:

Because the term “hedge fund” describes a structure, not a strategy, hedge funds can be dramatically different from one another.

In understanding hedge fund strategies, we recognize that hedge funds differ from one another in five key elements:

1. tools and techniques employed

2. instruments and markets

3. sources of return

4. measures for controlling risk

5. performance

Different strategies weigh these elements differently.

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The MAR/Hedge Classification System for Hedge Funds:

The first database on hedge fund performance was launched in 1994 by Managed Accounts Report (MAR) and was called MAR/Hedge.1 It was backfilled to some degree. To be included in the database, hedge funds must provide performance measures in a format acceptable to MAR/Hedge.

To facilitate comparisons, MAR developed a hedge fund classification system. MAR/Hedge divides hedge fund strategies into a number of major categories. In some cases, these major categories are further divided into subcategories. This approach is very similar to what Morningstar and Lipper do with respect to mutual fund “investment styles.”

1 Managed Accounts Report has long been a provider of benchmarks and data on alternative investments. These include, commodity funds, hedge funds, private equity, and other investment vehicles that have a relatively low correlation with equities and bonds. (Note, in March 2001, the MAR/Hedge databases were sold to Zurich Capital Markets.)

Hedge Funds


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Market Neutral

equity market neutral (also known as statistical arbitrage)

fixed income arbitrage

convertible arbitrage

Event Driven

merger arbitrage (also known as risk arbitrage)

distressed securities

other event driven strategies

Long/Short Investing

macro investing

sector investing

equity hedge

emerging markets

short selling

Note: Zurich Capital now published various hedge fund performance benchmarks.

Hedge Funds


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Equity Market Neutral:

When an investor buys a stock based on an analysis of the stock’s fundamentals or technicals, the investor is basically saying “I think this stock will perform well relative to other stocks having similar characteristics.” Part of the subsequent performance (i.e., return) will be a reflection of what the market as a whole does (i.e., a rising tide lifts all boats), but part of the performance will be a reflection of the analyst’s ability to recognize a good relative value. The former component of return is a function of a type of risk called beta, which is a measure of systematic market risk. The second is due to the special skill of the analyst and is called alpha.

Most equity mutual fund managers buy and hold a portfolio of stocks (most of which have positive betas) and therefore have positive market exposure (i.e., a positive beta). But equity market neutral hedge funds will go long some stocks and will go short some stocks (or go short stock index futures in lieu of stocks) in such a proportion that the portfolio’s beta is zero. They go long stocks that they think have positive alphas and short stocks they think have negative alphas.

Hedge Funds


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Equity Market Neutral Hedge Fund

Hedge Funds

Long stocks

Market value is $100 millionAverage beta is 1.1Positions = +110 million beta units

Short stocks

Market value is $84.6 millionAverage beta is 1.3Positions = –110 million beta units

Overall Beta = 0(market neutral)


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Fixed Income Arbitrage:

This approach encompasses two similar (but not identical) groups of trades that are collectively called convergence trades. In both cases, the objective is to earn a profit by recognizing and exploiting a price discrepancy with respect to the prices of fixed income securities.

Pure arbitrage

Statistical arbitrage

Hedge Funds


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Fixed Income Arbitrage (Pure Arbitrage):

Pure arbitrage: Involves buying cheap securities and selling rich securities (or derivatives on those securities) in such a fashion that the two positions are perfect offsets for one another. This might involve buying a coupon Treasury and selling a strip of Treasury zeros. Or, it might involve buying a Treasury bond and selling a futures contract on that Treasury bond. Differences are small so the leverage employed is usually considerable.

Hedge Funds

Arb

Stripping a Coupon Bond

Coupon Bond Zero Coupon Bonds

PriceBond Futures convergence to CTD Bond

time


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Fixed Income Arbitrage (Statistical Arbitrage):

Statistical arbitrage: Involves buying securities and selling other securities when the prices (or yields) of the two securities seem out of line as measured by a basket of other similar securities or as measured by historic relationships. In all cases, the trade is made because it is believed that the proper relationship or the historic relationship will eventually reassert itself and the prices will converge. In these cases, convergence is not necessarily guaranteed.

Hedge Funds

yield

duration

A

B

C

yield

maturity

Treasury curve

BB yield curve

credit spread


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Convertible Bond Arbitrage

A convertible bond may be viewed as a portfolio consisting of a long position in a straight bond of the issuer and a long position in a call option on the issuer’s stock. The bond component may be viewed as itself having two components: A pure interest rate component and a credit component. That is:

Convertible Bond

long

Bond Component(long)

Call Option Component

(long)

Interest Rate Component

(long)

Credit Component

(long)

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Convertible Bond

long

Bond Component(long)

Call Option Component

(long)

Interest Rate Component

(long)

Credit Component

(long)

Suppose that a convertible bond on XYZ is trading at a price that makes the embedded call option look cheap. That is, if you value the converts’ components, the call is trading at a low “vol.” Suppose the embedded call is trading at a vol of 20 when pure call options on this stock are trading at a vol of 50. What would you do?

Hedge Funds


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Convertible

Bond

Hedge Fund

ARB

Buy Convertible Bond

Finance the position in the repo market

Repo Market

repo rateLIBOR + X bps

Hedge Funds


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Convertible

Bond

Hedge Fund

ARBMorgan Stanley



LIBOR

Fixed

Repo Market


Interest Rate Swap to strip away interest rate component

Hedge Funds


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Convertible

Bond

Hedge Fund

ARBMorgan StanleyMorgan Stanley



LIBOR

Fixed

Fixed

conditional payment

Repo Market


Default Swap to strip away credit component


Hedge Funds


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Convertible

Bond

Hedge Fund




LIBOR

Fixed

Fixed

conditional payment

Repo Market




Option Market or

Equity Market

Sell Callor

Delta Hedge

Hedge Funds


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Convertible

Bond

Hedge Fund




LIBOR

Fixed

Fixed

conditional payment

Repo Market




Option Market or

Equity Market

Sell Callor

Delta Hedge

Hedge Funds

Note: Because CB hedge funds will delta hedge the option by selling the stock short, there is often equity selling pressure immediately after a CB issuance.


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Hedge Funds

Merger Arbitrage (Risk Arbitrage):

Risk arbitrage involves buying shares of the target firm and selling shares of the acquiring firm in the hopes of making a profit if the takeover is successful. People who engage in this practice are called risk arbs (clearly an oxymoron).

Example:

Corporation XYZ has announced a tender offer for Corporation ABC. XYZ’s stock is trading at $30 a share. ABC is trading at $53 a share. XYZ has offered 2 shares of XYZ for each one share of ABC. What would the risk arb do?

Answer: Buy 100 share of ABC for $53 and simultaneously sell short 200 shares of XYZ for $30. Then tender the ABC to XYZ for 200 shares of XYZ to cover the short sale.


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Hedge Funds

Distressed Securities:

Distressed securities include securities of companies that are experiencing financial or operational difficulties. These might include bankruptcy, reorganization, distressed sales, and so forth. Many investors (particularly insurance companies and pension funds) are prohibited by law or by policy from holding such securities. This can result in the prices of such securities being depressed below their true values. Hedge funds that specialize in these types of securities buy them.


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Hedge Funds

Other Event Driven:

Whenever a corporation is experiencing an unusual event--such as a bankruptcy, a merger, or other special situation--there is a heightened level of uncertainty. This uncertainty tends to result in depressed securities prices.

While some of these situations will turn out badly, others will turn out well. These “event driven” situations are very volatile, but they represent an unsystematic form of risk. Diversification should largely eliminate this risk.

As a consequence, event drive hedge funds have had low overall volatility.

Note that merger arbitrage and distressed securities are special cases of event driven strategies.


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Hedge Funds

Macro Investing:

These strategies look to profit by identifying extreme value disparities and persistent trends in equity values, interest rates and exchange rates and often take a global approach.

They are very flexible in the markets they play and the methods they employ.

The approach is usually top down. Leverage is used to amplify the returns.


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Hedge Funds

Sector Investing:

These hedge funds specialize in a single sector of the economy but can take long or short positions within that sector and they can trade both debt and equity.

They often hedge their exposure to market risk, often using derivatives, and try to retain the alpha. They often employ considerable leverage.

Note that this approach is similar to equity market neutral, but more narrowly focused.


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Hedge Funds

Equity Hedge:

These hedge funds take core long-term positions in equities. They tend to take a longer-term view than do market neutral strategies. They will be long some securities, particularly in bull markets, and short other securities, particularly in bear markets. They often use options (calls and puts) to hedge their market exposure.


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Hedge Funds

Short Selling:

These hedge funds take primarily short positions in securities, either equity or debt. That is, they sell securities they do not own (requiring that they borrow the securities).

This is a relatively small segment of the hedge fund community.


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Growth of the Industry


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Growth of the Industry:

As previously mentioned hedge funds began with Jones in 1949.

1950’s more market neutral hedge funds were introduced

1960’s hedge funds began to appear with different approaches

1970’s there was a shakeout reflecting the prolonged recession and oil shocks

1980’s hedge fund industry grew rapidly aided by the advent of derivatives

1990’s a period of explosive growth for the industry -- talent driven

Hedge Funds


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Hedge Funds

050100150200250300350400450500

19901991199219931994199519961997199819992000

The 1990’s Growth Experience

Source: Hedge Fund Research, Inc. 1990-99 based on year end, 2000 data from mid year. These numbers represent both domestic and off-shore. Note: These are estimates only. The private nature of hedge funds makes reliable numbers hard to come by.

Capital in billions


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Fund of Funds


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Fund of Funds:

A special category of hedge fund is the fund of funds. These funds pool investments from many qualified investors and then place these funds with other hedge funds. These hedge funds are of two types:

diversified: These fund of funds invest in a broad array of hedge fund types (literally covering the entire spectrum of hedge funds).

niche: These fund of funds invest in a number of other hedge funds but within a certain hedge fund type (i..e., all market neutral).

Downside: These funds are required to pay the fees that all hedge funds charge but then impose another layer of fees of their own. This makes it more difficult to achieve extraordinary returns. (Note: Fund of Funds often negotiate a reduction in the incentive fee on their investment in a hedge fund thereby mitigating this downside to some degree.)

Hedge Funds


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The Role of Prime Brokerage


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What is Prime Brokerage?

Running a hedge fund involves a need for a great many specialists and access to markets and financing that hedge funds themselves often lack. The major broker/dealers have set up prime brokerage operations (sometimes called prime services) to offer a full-array of these needed services. In a sense, prime brokerage can be thought of as “hedge fund infrastructure in a box.”

Technically, prime brokers are broker/dealers that clear and finance customer trades executed by one or more other broker/dealers, known as executing brokers. A prime broker acts as custodian for the customer’s securities and funds.

Hedge Funds


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Hedge Fund Infrastructure in a Box:

The services the prime brokers offer to hedge funds include:

trading

brokerage

securities lending

trade reconciliation

accounting

financing

performance reporting (customized reports to the fund’s investors)

custodial

Hedge Funds


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Performance Assessment


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Performance Assessment:

Performance assessment for hedge funds is tricky at best. First, the private nature of hedge funds makes access to data exceedingly difficult. In 1994 MAR/Hedge created a data base and back filled it through 1990. However, the data base only includes those hedge funds that choose to report.

It would stand to reason that funds with good results will tend to report and those with poor results will tend not to report. Further, the back-filling process would, because it only applies to going concerns, create a very serious survivorship bias problem.

Hedge Funds


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Amin and Kat Study:

In 2001, Guarav Amin and Harry Kat released what might be the most complete rigorous study of hedge fund performance covering the period 1990-2000. It is based on data provided by MAR/Hedge. Essentially, the authors conclude that when viewed in isolation (i.e., as stand-alone investment holdings) hedge funds do not offer superior risk-return profiles. However, when these funds are viewed in the context of a broader portfolio (e.g., hedge funds make up 10% to 20% of the overall portfolio with the rest in more traditional asset classes) their results improve remarkably. This seems to be, in large part, the result of very low levels of return correlation with other asset classes. Importantly, this finding was more true of some types of hedge funds and less true of others.

Gaurave S. Amin and Harry M. Kat. “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?” Working Paper ISMA Center, The University of Reading.

Hedge Funds

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