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PART One
Evolution of the Hedge Fund Industry and Investing
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CHAPTER 1
The Truth about Hedge Funds
From Misunderstood Investment Vehicle to Household Word
If you read the business press, watched television, or eavesdropped on a congressional finance committee hearing at almost any point since 1999, but especially in 2008, you might define hedge funds in several ways:
⢠Mysterious, secretive, risky pools of capital managed by swashbuckling, cowboy investment managers.
⢠Lying, thieving, Ponzi-scheming criminals.
⢠The cause of the whole breakdown of the financial system.
Alexander Ineichen, a leading research analyst and author, has said, âThe reputation of hedge funds is not particularly good. The term âhedge fundâ suffers from a similar fate as âderivativesâ due to a mixture of myth, misrepresentation, negative press, and high-profile casualties.â1
Ineichen made a similar observation in another publication: âThere is still a lot of mythology with respect to hedge funds. Much of it is built on anecdotal evidence, oversimplification, myopia, or simply a misrepresentation of facts.â
But in that instance, he asserted a hedge fund definition that is simpler and more germane to serious, sophisticated investors: âHedge fund managers are simply asset managers utilising other strategies than those used by relative return long-only managers.â2
While the term
hedge fund is used broadly, it is often used to describe a vehicle with a 1 and 20 fee structure. In our book
Foundation and Endowment Investing, we summarized hedge funds as follows:
Hedge funds are private investment vehicles structured as limited partnerships with the investment manager as the general partner and the investors as limited partners. âHedge fundsâ is not a traditional asset class but rather an amalgam of investment managers and traders who are compensated by a performance fee, have an opportunity to invest in any number of strategies across various asset classes, and use return-enhancing tools such as leverage, derivatives, and short sales. The defining characteristic of hedge funds is their goal: to generate an absolute return over time with little systematic or public equity market exposure.3
This chapter will further define and describe hedge funds, provide historical context behind their rise to prominence, and discuss issues facing the industry and investors in the future.
HEDGE FUNDS IN THE SPOTLIGHT
Hedge funds have become part of the collective consciousness not just because the media can easily exploit misinformation, but also because they have grown as an investment allocation in institutional portfolios. They now comprise a larger percentage of portfolio asset allocations and investment industry assets under management and influence most market trading activity.
Institutions Spur Hedge Fund Growth
Foundations and endowments led institutions into investing in hedge funds in the mid to late 1990s. At the end of 1999 total hedge fund assets under management were estimated at $450 billion.4
Writing
Foundation and Endowment Investing in mid-2007, we said,
The main reason hedge funds have received so much attention in recent years is their performance during the equity market downturn of 2000-02. At that point, ten-year average returns ending December 2006 beat both the US Public Equity (Russell 3000) and Bonds (Lehman Aggregate), by 200 and over 400 bps per annum, respectively.5
Observing the success foundations and endowments experienced in hedge funds and the ability hedge funds had to perform in adverse market conditions, pension plans began allocating to hedge funds in greater numbers. Broader acceptance of hedge funds among institutions representing much larger pools of capital fueled the growth of hedge funds.
Greenwich Associates reported that by 2007 45 percent of all U.S. institutional investors had invested in hedge funds, accounting for 2.6 percent of total institutional assets and close to double the number reported two years earlier. European and Japanese institutions had embraced hedge funds even sooner than those in the United States, with U.K. and Canadian institutions lagging.
The velocity and size of the growth in assets meant that by mid-2008, $2 trillion was estimated to be invested in over 10,000 hedge funds. At the end of 2008 hedge fund assets under management stood at approximately $1.8 trillion.6
Hedge Funds Are Here to Stay
In Foundation and Endowment Investing, we wrote, âAlthough many individual funds have underperformed, as a whole they (hedge funds) truly have provided an absolute return due to a neutral exposure to the equity market.â7
Despite the extreme market upheavals and hedge fund losses since then, that statement still largely captures the reasons why hedge funds have become so important and why investors want to understand them and learn how to invest in them.
More investors need to know about hedge funds, because more investors have either invested in them in some wayâeven if only through a company pension planâor will decide to invest in them. Since hedge funds play such a large role in the markets, investors that have not or will not become hedge fund investors need to know how hedge funds impact their existing portfolio.
WHAT IS A HEDGE FUND?
Hedge funds are almost easier to define by what they are not, rather than by what they are. Put another way, they are best defined at every levelâfrom philosophy to legal structureâby what they are relative to traditional long-only investment strategies.
Philosophy
Hedge funds differ from long-only strategies at the philosophical level in terms of their investment objective, managerâs skill, and approach to risk.
Return Objectives One way to compare long-only investment strategies to hedge funds is by their investment objective. Ironically, long-only strategies seek relative returns. They aim to perform better relative to a benchmark, usually within their own asset class. In a very simple example, a long-only strategy investing in U.S. equities is managed to perform better than the S&P 500. As a result, a long-only fund can lose money, but if it loses less money than the benchmark, then it still is considered to have outperformed. In that same example, if the S&P 500 drops 40 percent in one year, as it did in 2008, a long-only strategy that falls 38 percent in that same period has done well.
Hedge funds seek absolute returns. They aim to make money regardless of market conditions and to beat the risk-free rate.8 Hedge funds balance profit seeking with loss avoiding by identifying and exploiting investment opportunities while managing risk to protect against the loss of principal.
Manager Mindset Hedge funds are considered skill-based strategies, meaning they depend on the skill of the individual manager to earn returns.9 Because the managers tend to invest a significant amount of their own money in their funds, they have incentives to make profits and thus approach risk management much differently.
Investment professionals describe the differences in terms of alpha and beta. Beta is the return generated from the allocation to an asset class or exposure to a risk factor, which could be implemented passively, such as in an index. Beta is the return from the market. If the S&P 500 is up 10 percent in a year, an investment fund benchmarked against the S&P 500 that has returned 10 percent has delivered market beta. Alpha is the excess return generated by active investment managers above what could have been generated by investing in a passive exposure to a particular asset class.10 Using the same example, if the investment fund had been up 12 percent when the S&P 500 had been up 10 percent, the 2 percent of excess return is considered alpha. Hedge fund managers focus on reducing beta and increasing alpha.
Risk Management Approach The difference in risk management philosophy between long-only and hedge fund strategies is, at the core, the purest definition of hedge funds. As stated previously, in trying to achieve absolute returns, hedge funds manage their portfolio to profit both when market conditions are good and when they are poor. They do not try to lose less money than everyone else during a downturn; they try not to lose money at all. They employ hedging techniques, typically pairing long and short positions against each other, in order to manage the risk in their portfolio. Hedge funds hedge.
Hedge fund managers care about total risk, or as described by Ineichen, âthe probability of losing everything and being forced to work for a large organization again.â Long-only managers look at risk relative to their benchmark. An S&P 500 index fund is seen as without risk; taking action that deviates from the benchmark portfolio construction is seen as adding risk.
In an extreme example, if the S&P 500 somehow dropped to $0.50, a long-only fund would not be taking risk if it continued to replicate the index portfolio construction. It would be taking active risk if it deviated from the benchmark construction, even if that action resulted in losing less money. If such calamitous conditions actually were occurring, a hedge fund manager would be actively buying, selling, and hedging the securities in the portfolio in an attempt to preserve capital if not earn a profit. In their approach to risk and its impact on performance, hedge fund managers hate to lose money, period, and focus on protecting the portfolio from downside risk. A long-only manager does not like or want to lose money, but if the fund loses less money than the benchmark, it has managed risk well.11
The approach to managing volatility, represented by the standard deviation of returns, is another important distinction between long-only and hedge fund risk management philosophies. Hedge funds focus on achieving risk-adjusted returns or getting the best performance possible relative to the amount of capital at risk. The Sharpe ratio measures risk-adjusted return.
Managers strive to achieve a Sharpe ratio of 1 or better.
To give a very simple example, a long-only fund benchmarked against the S&P 500 will have the same level of volatility. If the volatility of the S&P 500 is 25 percent, so is the volatility of the fund. If that fund returns 15 percent on 25 percent volatility it will have a Sharpe ratio of 0.6. An equity long/short manager with the target return of 15 percent would use hedging techniques to attempt to limit the volatility of the portfolio to 12 to 15 percent for a Sharpe ratio between 1 and 1.25. In that scenario, the long-only fund has taken double the risk to get the same return. The hedge fund would have to return less than 7.2 percent to match the risk-adjusted return of the long-only fund. Over the long run the total compounded return is much better when risk-adjusted return is factored into portfolio performance.12
One of the great ironies of hedge funds versus long-only funds is that they are perceived as risky, yet hedge funds manage and control risk and deliver a less risky investment to their investors.
Investment Structure and Techniques
The main area of difference between hedge funds and long-only funds is the structure of the investment vehicle and the types of investment techniques that hedge funds are allowed to employ within that structure
Almost any description of a hedge fund starts with the phrase âHedge funds are an investment vehicle that. ...â This description has more to do with the hedge fund legal structure than its investment techniques. A long-only fund is described as âa long-only fund.â Hedge fu...
