Wednesday, January 25, 2012

What is a Hedge Fund?

Ray Dalio ,founder of Bridgewater Associates,(world's richest Hedge fund manager with $120 billion under management)

 Hedge Funds

  A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.The first thing to know about hedge funds is that the term hedge fund is not a legal term, but rather an industry term. What a hedge fund is, therefore, is subject to some amount of interpretation. Consider a few definitions. From Wall Street Words Houghton & Miflin 1997:
    A very specialized, volatility open-end investment company that permits the manager to use a variety of investment techniques usually prohibited in other types of funds. These techniques include borrowing money, selling short and using options. Hedge funds offer investors the possibility of extraordinary gains with above average risk. From Hedge Funds Demystified, Goldman Sachs & Co.:

    The term "hedge fund" includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.

From the Hennessee Group LLC Web page:

A hedge fund is a "pool" of capital for accredited investors only and organized using the limited partnership legal structure... the general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.

As you can see, the definitions above focus on several aspects of investment companies known as hedge funds:
  • legal structure
  • investment strategy
  • investor pool
All three components are important in understanding hedge funds. To go further let's discuss first what hedge funds are and what some of their salient features are:
  • Hedge funds are legally limited partnerships.
  • Hedge funds are unregistered (i.e., unregistered with the SEC) investment companies. That is, they are not regulated by the SEC (more on this later).
  • Hedge funds can be users of a variety of investment strategies and products, including options, future, swaps and short selling.
  • Hedge funds often employ leverage, in that the amount of notional market exposure often exceeds the investment capital of the fund.
  • Hedge funds have limited liquidity. Typically investors can only get into funds on certain dates and can only get their money out of funds on certain dates.
Who invests in hedge funds?
  • Wealthy individuals. For an individual to invest in an unregistered investment company, the SEC must deem an individual to be an accredited investors (a defined by SEC rule 501 of Regulation D. The full text of this rule may be found at The rule includes the following points for an individual:
    • The individual must have at the time of investment a net worth (or joint net worth with spouse) exceeding $1,000,000, or
    • The individual must have individual income exceeding $200,000 in each of the two most recent years or joint income with spouse exceeding $300,000 in each of the two most recent years, and must have a "reasonable expectation" of reaching the same level in the coming year.
And the rule contains the following points for an organization, corporation or other such entity:
  • The organization must have total assets in excess of $5,000,000, or
  • The organization's owners must be accredited investors.
  • Endowments, e.g., the Wall Street Journal (December 8, 1998) and others report that the University of Pittsburgh made a $5 million investment in Long Term Capital
  • Pension Funds, e.g., Pension & Investments magazine regularly reports of pension fund activity investing in new hedge funds. For example:
    • Consolidated Paper's $650m pension fund added $10m in hedge fund investments in November
    • The University of Michigan hired four hedge fund managers to manage $100m of its $2.5bn pension fund, and P&I reports that University of Michigan has a total of about $300m invested with hedge funds.
  • Other Hedge Funds: Some hedge funds invest in other hedge funds, including offering Funds of Funds, that is, they strategically allocate their capital to other funds. Pension and Investments (November 30, 1998) reports that Grosvenor Capital Management invested $7m in Long Term Capital Management:
    • Grosvenor Capital Management, LP, a big, highly secretive hedge fund player, was stung by an estimated $7m investment in Long-Term Capital Management LP, and reportedly has been hit with redemptions following poor third-quarter performance.

Hedge Fund Industry
It is important to understand the magnitude of the hedge fund industry and the sizes of some of the key players in the industry. "Hedge Funds Demystified" estimates that the size of the whole industry is approximately $400bn, and that the investor pool is dominated by wealthy individuals (accredited investors), with pension fund interest increasing. "Hedge Funds Demystified" also notes that it is difficult to accurately assess the size of the industry, so this number should be read as mainly an indication of the order of magnitude. To get a sense of where this stands, consider the pension fund industry by contrast. Davis, in Pension Funds, reports that as of year end 1991, the US pension fund industry's assets were at least $2.9 trillion. In other countries, the number was less for two reasons: the pension fund industry contributes less assets as a percentage of GDP than the US (except Germany and Switzerland) and the US GDP is much larger than other countries. Nevertheless, the global pension fund industry (as of year end 1991) was estimated at approximately $4.2 trillion. The numbers since then have surely grown, but I currently do not have more up-to-date numbers.

Types of Hedge Funds

Hedge funds are generally classified according to the type of investment strategy they run. Below we review the major types of strategies, but refer members of the class to "Hedge Funds Demystified" for greater detail.

Market Neutral (or Relative Value) Funds

Market neutral funds attempt to produce return series that have no or low correlation with traditional markets such as the US equity or fixed income markets. Market neutral strategies are characterized less by what they invest in than by the nature of the returns. They often are highly quantitative in their portfolio construction process, and market themselves as an investment that can improve the overall risk/return structure of a portfolio of investments. Market neutral funds should not be confused with Long/Short investment strategies (see below). The key feature of market neutral funds are the low correlation between their returns and the traditional asset's.

Event Driven Funds

Event driven funds seek to make profitable investments by investing in a timely manner in securities that are presently affected by particular events. Such events include distressed debt investing, merger arbitrage (sometimes called risk arbitrage) and corporate spin-offs and restructuring.

Long/Short Funds

Funds employing long/short strategies generally invest in equity and fixed income securities taking directional bets on either an individual security, sector or country level. For example, a fund might do pairs trading, and buy stocks that they think will move up and sell stocks they think will move down. Or go long sectors they think will go up and short countries they think will go down. Long/Short strategies are not automatically market neutral. That is, a long/short strategy can have significant correlation with traditional markets, and surprisingly have seen large down turns in exactly the same times as major market downturns. For example, Pension & Investments reported on November 30, 1998:
Many long-short managers, which aim to profit from going long on stellar stocks and selling short equity albatrosses, typically use traditional stock valuation factors such as price-to-earnings and price-to-bok value ratios in their mathematical models to cull the winners from the losers. Unfortunately for them, when the market ran into turbulence in late July and August, investors sought safe haven in some of the largest-but expensive-stocks that these models had rejected as overpriced.Then, after the Federal Reserve Bank began easing interest rates in late September, investors rushed to buy small-capitalization, high-octane stocks that had been neglected in favor of large cap stocks for most of the year. ... As a result, some market long-short managers got hit with a double-whammy.

Tactical Trading

Quoting from "Hedge Funds Demystified":
    Tactical trading refers to strategies that speculate on the direction of market prices of currencies, commodities, equities and/or bonds. Managers typically are either systematic or discretionary. Systematic managers are primarily trend followers who rely on computer models based on technical analysis. Discretionary managers usually take a less quantitative approach and rely on both fundamental and technical analysis. This is the most volatile sector in terms of performance because many managers combine long and/or short positions with leverage to maximize returns...

The Hedge Fund Industry and Quantitative Methods

Quantitative methods have been successfully applied in the hedge fund industry to improve returns, and control risk. That said, there have been striking failures of seemingly quantitatively driven funds (such as Long-Term Capital). Some of the most quantitatively driven strategies occur in the Market Neutral/Relative Value Sector of the Hedge Fund World, so we will exam this sector in more detail by discussing some of the specific types of strategies they employ. The following is a list of important and quantitatively driven market neutral/relative value strategies. I refer you to "Hedge Funds Demystified" for a detailed description of each:
  • Fixed income arbitrage
  • Covertible bond arbitrage
  • Mortgage backed security arbitrage
  • Derivatives Arbitrage
  • Market Neutral Long/Short Equity Strategies

  Hedging Strategies

A wide range of hedging strategies are available to hedge funds. For example:
  • selling short - selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop.
  • using arbitrage - seeking to exploit pricing inefficiencies between related securities - for example, can be long convertible bonds and short the underlying issuers equity.
  • trading options or derivatives - contracts whose values are based on the performance of any underlying financial asset, index or other investment.
  • investing in anticipation of a specific event - merger transaction, hostile takeover, spin-off, exiting of bankruptcy proceedings, etc.
  • investing in deeply discounted securities - of companies about to enter or exit financial distress or bankruptcy, often below liquidation value.
  • Many of the strategies used by hedge funds benefit from being non-correlated to the direction of equity markets

Hedge Fund Returns

As hedge funds are often viewed as providing returns that are "cheap" relative to risk, their performance is usually evaluated on a risk-adjusted return basis. The common number that is quoted is the Sharpe Ratio which is the ratio of annualized excess returns to the annualized standard deviation of returns. The following repeats the data in Table 7 of "Hedge Funds Demystified" and gives an idea of the relative performance of hedge funds compared with some standard indexes over the period January 1993 - December 1997. The table represents returns on each Hedge Fund Sector, that is, the returns and standard deviations in each column represents the returns that were realized on an equal weighted investment portfolio of all the hedge funds in a given sector.

One important item that none of the definitions covered was hedge fund fee structures, which is, in my opinion, a key distinguishing feature of hedge funds versus in particular mutual funds. Hedge funds almost always have a fee structure that includes both a fixed fee and a management fee. The fixed fee usually ranges between 1 and 2% of assets under management and the management fee ranges between 20 and 25% of upside performance. As hedge funds are unregulated, these ranges are often exceeded, and can be as high as 5% fixed fee and 25% management fee. Hedge fund fees are often quoted in language such as "2 and 20" meaning 2% fixed fee and 20% management fee. There are two additional important points about hedge fund fees:
  • the benchmark
  • high water mark
The performance fee is sometimes calculated net of a benchmark. That is, the returns that fees are paid on are sometimes only those returns in excess of some benchmark. Sometimes the benchmark is a risk-free interest rate such as LIBOR (often called the cash benchmark, meaning performance fees are paid on the profit that would be made in excess of an investment in cash) and other times it is a market index such as the MSCI World Index or the S&P 500 index.

The biggest risk in pricing models is Assumption Risk. The trouble with bull and bear markets is that the price behavior and the width of bid-offer spreads can be quite different under the two regimes. If you are in roach motel assets getting out can become expensive. Bear Stearns was leveraged long CDOs of illiquid securities and "hedged" by shorting liquid ABX indices. As with similar problems in the past, the funds were long illiquid, short liquid. If a fund is leveraged and can only sell to a limited number of counterparties that KNOW it has a problem, getting out becomes difficult. Software for measuring risk doesn't help when risks are unmeasurable. And aren't you supposed to have proper risk management in place BEFORE you lose money not AFTER the fact?

You really have to know what you are doing when designing models of prepayment and mortgage default risks; nothing in the academic literature or public domain works. Credit is neither stochastic nor continuous and when it jumps it really jumps. I can count the number of good mortgage-backed securities hedge funds on one hand but I would need many more limbs for the traders who have been blown away by not having adequate trading AND quantitative abilities to manage ALL the exposures in this complex field. When a product is very thinly traded, indicative dealer prices are pretty useless. If a fund is investing in illiquid instruments the fund valuation needs to be marked to the real bid, in size. Mark to market is possible only when there is a market.

There is nothing inherently wrong with investing in "untraded" assets provided the risk-adjusted returns are sufficient to compensate. In bearish credit conditions ideally you usually want to be long the liquid and short the illiquid but weaker credit funds and less experienced managers do the opposite. Of course there have been skilled hedge funds in the areas of distressed debt and collateralised loans for a long time but their returns have justified the risks. But with some funds, even with apparently high absolute performance, often the excess RISK-ADJUSTED returns (the alpha!) was negative.

Just as with Long-Term Capital Management, being long the illiquid and short the liquid works well until the market reverses and then years of consistently positive months get given back in one massively negative month. Leverage, liquidity and valuation risks are ONLY worth taking if you are compensated for those risks and plainly this was not the case. This is where investors in a hedge fund need to look at whether the potential returns justify the potential risk. With good hedge funds it does but NOT with the many "hedge fund" journeyman.

With public equities, liquid bonds, fx and futures valuation is immediate, transparent, generally unarguable and there is plenty of alpha available in these liquid arenas IF you have the tools and expertise to find it. While liquidity is a variable even on an exchange you have access to the widest number of potential buyers and sellers. Venturing into illiquid areas raises the risk exponentially when there are much fewer counterparties to trade with. Leverage just exacerbates those problems. Funds investing in illiquid assets should be targeting MUCH higher performance than liquid funds as compensation for that extra risk. Yet some investors seems to compare them side by side without modelling the non-linear risks of gearing thinly traded securities.

What's even worse than a closet index fund? A leveraged closet index fund. And that is what most of these toxic waste CDO funds were in effect running. Making money in BAD conditions is what hedge fund clients pay the 2 and 20 for; long only funds are the ONLY products you need in good times. Having criticised some of John Bogle's thinking in my previous post let's make something clear; index equity and credit funds are the best investment IF (and only IF!) you think the asset class is going up. It is a waste of time and money to allocate to higher fee actively managed funds that simply fall apart when their underlying market falls apart.

Investors need to verify that a money management product purporting to be a hedge fund and charging hedge fund fees actually is one. Out of 10,000 funds that claim to be hedge funds, how many actually are hedge funds? The best estimate I have is maybe 25% tops. But of those how many are skilled? Perhaps 500-1000 at most. In other words probably only 10% of products that say they are hedge funds actually are GOOD hedge funds. Skill is rare by definition. While some investors might be discouraged by the bad news of 1/10 odds of picking a skilled fund, the good news is that they CAN be isolated in advance.

Identifying a good hedge fund is as rare a skill as being able to identify a good security. Some multi-manager products and weaker funds of funds have reduced their fees because they think picking hedge funds is easy! Most of them don't have the experience or analytical resources to decide what is and what is NOT a hedge fund, let alone trying to find the BEST ones. It is difficult but NOT impossible. Do "lower" fees help if an "advisor" puts you into a fund that drops 100%? There will always be semantically-challenged products that screw up which is why due diligence and alignment of interests are so important. Investors should select real hedge funds NOT leveraged beta products that SAY they are hedge funds. The industry needs to rid itself of non hedge funds who can't measure, manage or hedge their risks and ride beta when proper managers aim for alpha. Fortunately we can rely on the market to conduct these shakeouts over time. Unfortunately for some amnesiac investors it has been a long time since difficult credit conditions.

The colleagues of Ralph Cioffi may have liked the fund but how much personal cash did James Cayne have in? A necessary condition for a product to be considered a hedge fund is to verify senior management are eating their own cooking. In bull markets many unskilled traders make money; it is bear markets that tend to show who is good and who knows how to hedge. Many REAL hedge funds are MAKING MONEY out of these ongoing credit events. Marketing something is a hedge fund does not mean it is.

Andrew W. Lo ,Andrew is a Professor of Finance at MIT's Sloan School of Management and he is also the Director of Laboratory of Financial Engineering at Sloan is a leading authority on hedge funds.

Andrew W. Lo

Popular Misconception
The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don't use derivatives at all, and many use no leverage.

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