Morgan Stanley
Hedge Funds: An Introduction
John F. Marshall, Ph.D.
631-331-8024 (tel)
631-331-8044 (fax)
marshall@mtaglobal.com
Copyright © 2001
Marshall, 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 screenbased 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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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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.”
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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.
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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Hedge Funds
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.
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Hedge Funds
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.
2.
3.
4.
5.
6.
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types of positions and strategies employed
the number and size of the investors allowed
registration requirements
ease of investor entry and exit
method of investment manager compensation
performance measurement and reporting
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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!]
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
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 highwater marks.
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Hedge Funds
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.
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Hedge Funds
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).
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Hedge Funds
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.
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Investors in Hedge Funds
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Hedge Funds
Investors in Hedge Funds
High net worth individuals (accredited and qualified investors)
Institutional investors
Endowments
Pension plans
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Types of Hedge Funds
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Hedge Funds
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.
2.
3.
4.
5.
tools and techniques employed
instruments and markets
sources of return
measures for controlling risk
performance
Different strategies weigh these elements differently.
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Hedge Funds
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.)
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Hedge Funds
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.
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Hedge Funds
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.
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Hedge Funds
Equity Market Neutral Hedge Fund
Long stocks
Short stocks
Market value is $100 million
Average beta is 1.1
Positions = +110 million beta units
Market value is $84.6 million
Average beta is 1.3
Positions = –110 million beta units
Overall Beta = 0
(market neutral)
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Hedge Funds
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
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Hedge Funds
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.
Stripping a Coupon Bond
Bond Futures convergence to CTD Bond
Price
Arb
Coupon Bond
Zero Coupon Bonds
time
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Hedge Funds
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.
BB yield curve
yield
yield
B
credit spread
Treasury curve
C
A
duration
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maturity
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Hedge Funds
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:
Interest Rate
Component
(long)
Convertible Bond
Bond Component
(long)
long
Call Option
Component
(long)
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Credit
Component
(long)
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Hedge Funds
Interest Rate
Component
(long)
Convertible Bond
Bond Component
(long)
long
Call Option
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?
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Hedge Funds
Hedge Fund
ARB
Buy Convertible Bond
Convertible
Bond
repo rate
LIBOR + X bps
Repo Market
Finance the position in
the repo market
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Hedge Funds
Interest Rate Swap to strip away
interest rate component
LIBOR
Hedge Fund
Morgan Stanley
ARB
Fixed
Buy Convertible Bond
Convertible
Bond
repo rate
LIBOR + X bps
Repo Market
Finance the position in
the repo market
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Hedge Funds
Default Swap to strip away
credit component
Interest Rate Swap to strip away
interest rate component
Fixed
LIBOR
Hedge Fund
Morgan Stanley
Morgan Stanley
Fixed
ARB
conditional
payment
Buy Convertible Bond
Convertible
Bond
repo rate
LIBOR + X bps
Repo Market
Finance the position in
the repo market
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Hedge Funds
Option Market
or
Equity Market
Default Swap to strip away
credit component
Sell Call
or
Delta Hedge
Interest Rate Swap to strip away
interest rate component
Fixed
LIBOR
Hedge Fund
Morgan Stanley
Morgan Stanley
ARB
Fixed
conditional
payment
Buy Convertible Bond
Convertible
Bond
repo rate
LIBOR + X bps
Repo Market
Finance the position in
the repo market
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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.
Option Market
or
Equity Market
Default Swap to strip away
credit component
Sell Call
or
Delta Hedge
Interest Rate Swap to strip away
interest rate component
Fixed
LIBOR
Hedge Fund
Morgan Stanley
Morgan Stanley
ARB
Fixed
conditional
payment
Buy Convertible Bond
Convertible
Bond
repo rate
LIBOR + X bps
Repo Market
Finance the position in
the repo market
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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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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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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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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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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 longerterm 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
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Hedge Funds
The 1990’s Growth Experience
00
20
99
19
98
19
97
19
96
19
95
19
94
19
93
19
92
19
91
19
19
90
Capital in billions
500
450
400
350
300
250
200
150
100
50
0
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.
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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.)
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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.
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Hedge Funds
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
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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.
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Hedge Funds
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.
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