Hedge Funds

Quantitative Insights

François-Serge Lhabitant

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470856673
• eBook ISBN: 9780470687772
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

"An excellent and comprehensive source of information on hedge funds! From a quantitative view Lhabitant has done it once again by meticulously looking at the important topics in the hedge fund industry. This book has a tremendous wealth of information and is a valuable addition to the hedge fund literature. In addition, it will benefit institutional investors, high net worth individuals, academics and anyone interested in learning more about this fascinating and often mysterious world of privately managed money. Written by one of the most respected practitioners and academics in the area of hedge funds."
—Greg N. Gregoriou, Professor of finance and research coordinator in the School of Business and Economics at Plattsburgh State University of New York

"This is a landmark book on quantitative approaches to hedge funds. All those with a stake in building hedge fund portfolios will highly profit from this exhaustive guide. A must read for all those involved in hedge fund investing."
—Pascal Botteron, Ph.D., Head of Hedge Fund Product Development, Pictet Asset Management

"François-Serge Lhabitant's second book will prove to be a bestseller too - just like Hedge Funds: Myths and Limits. He actually manages to make quantitative analysis 'approachable'- even for those less gifted with numbers. This book, like its predecessor, includes an unprecedented mix of common sense and sophisticated technique. A fantastic guide to the 'nuts and bolts' of hedge fund analysis and a 'must' for every serious investor."
—Barbara Rupf Bee, Head of Alternative Fund Investment Group, HSBC Private Bank, Switzerland

"An excellent book, providing deep insights into the complex quantitative analysis of hedge funds in the most lucid and intuitive manner. A must-have supplement to Lhabitant's first book dealing with the mystical and fascinating world of hedge funds. Highly recommended!"
—Vikas Agarwal, Assistant Professor of Finance, J. Mack Robinson College of Business, Georgia State University

"Lhabitant has done it again! Whereas most books on hedge funds are nothing more than glorified marketing brochures, Lhabitant's new book tells it how it is in reality. Accessible and understandable but at the same time thorough and critical."
—Harry M. Kat, Ph.D., Professor of Risk Management and Director Alternative Investment Research Centre, Cass Business School, City University

"Lhabitant's latest work on hedge funds yet again delivers on some ambitious promises. Successfully bridging theory and practice in a highly accessible manner, those searching for a thorough yet unintimidating introduction to the quantitative methods of hedge fund analysis will not be disappointed."
—Christopher L. Culp, Ph.D., Adjunct Professor of Finance, Graduate School of Business, The University of Chicago and Principal, Chicago Partners LLC

Part I

Measuring Return and Risk

1

Characteristics of Hedge Funds

I don’t play the game by a particular set of rules; I look for changes in the rules of the game.

A global macro manager

While their mainstream popularity seems to be a new phenomenon, hedge funds have been around for more than 50 years. Indeed, Alfred Winslow Jones, journalist, sociologist and fund manager, is credited with establishing the first hedge fund as a general partnership in 1949.⁴ He operated in complete secrecy until 1966. Then, an article penned by Carol J. Loomis in the April edition of Fortune Magazine, entitled “The Jones that Nobody Keeps Up With”, exposed to the public his unique and highly successful strategy (“speculative instruments for conservative purposes”), along with his truly astounding return rates. Since then, the number of hedge funds and the size of their assets have soared, particularly since the early 1990s. Estimates suggest there are now over 6000 active hedge funds managing around $600 billion in assets, compared with the 68 funds that existed in 1984.

Several factors may explain the extraordinary development of hedge funds over recent years. First of all, there was the unprecedented wealth creation that occurred during the equity bull market of the 1990s. That significantly expanded the base of “sophisticated” investors, especially high net worth private investors, and fundamentally altered the way people in the workaday world viewed their money and finances.

In addition, there was an unprecedented generational shift of wealth through inheritance, as the parents of baby boomers progressively left their assets to their children. These new investors were typically more sophisticated and had a higher tolerance for risk than the previous generation, but were also more demanding in terms of investment performance. This boded well for hedge funds and other alternative investments, which generally targeted higher absolute returns thanks to their flexibility and lack of constraints.

It was also at this time that the first institutional investors started showing a greater interest in hedge funds. In particular, in September 1999, the pension fund CalPERS raised the ceiling on its alternative investments allocation to $11.0 billion, that is, 6% of its total assets. This amount included about $1.0 billion specifically allocated to hedge funds.

After March 2000, the growth of the hedge fund industry continued. However, the motives for investing had changed dramatically: investors were then looking for an effective means of diversification to protect their capital from falling equity markets and depressed bond yields. In addition, sub-par performance in traditional asset categories started luring institutional investors toward absolute return strategies, and more specifically hedge funds. Until then, alternative investments had primarily focused on private equity and real estate.

The needs of these new investors - quite different from those of the wealthy private clients - triggered a process that led to several changes in the hedge fund industry. Many hedge funds became more mature, and put in place stable investment processes, lower leverage, improved transparency and effective risk management to satisfy the high standards and rigorous selection processes of large institutions. In addition, many traditional financial institutions began to develop funds of hedge funds as part of their global product range, and offered them to their retail and affluent clients.

The total assets now managed by hedge funds may still seem small with respect to the $3.8 trillion allocated to more traditional strategies by institutional investors alone, or the $6.3 trillion of assets under management in the mutual fund industry. But the double-digit growth in asset size and the increasing popularity of hedge funds have also brought about a change in the attitude of regulators, who now regularly scrutinize the secretive world of alternative investments on both sides of the Atlantic Ocean. Nevertheless, the increased market volatility, the corporate activity and the extreme valuations (both on the upside and on the downside) continue to offer unrivaled opportunities for talented portfolio managers to exploit anomalies in the markets. As a consequence, the number of hedge funds should keep growing, and their strategies become more prominent and more popular in the near future.

1.1 WHAT ARE HEDGE FUNDS?

Originally, hedge funds were so named because their investment strategy aimed at systematically reducing risk with respect to the direction of the market by pooling investments in a mix of short and long market positions. However, in today’s world, many “hedge funds” are not actually hedged, and the term has become a misnomer.

Surprisingly, though, there is no commonly accepted definition of what exactly a hedge fund is. To confuse matters further, the term “hedge fund” has different meanings on each side of the Atlantic. In Europe, a “hedge fund” denotes any offshore investment vehicle whose strategy goes beyond buying and holding stocks or bonds and that has an absolute (i.e. non-benchmark-related) performance goal. In the United States, a hedge fund is typically a domestic limited partnership that is not registered with the Securities and Exchange Commission (SEC) and whose manager is rewarded by an incentive fee and has a broad array of securities and investment strategies at his disposal.

In this book, we have adopted the following pragmatic definition as a starting point:

Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public

The private nature of hedge funds is the key issue in this definition, and we believe that most of the other characteristics of hedge funds follow directly from it. Indeed, as long as the general public has no access to a private pool,⁵ regulators do not consider the pool as a traditional investment vehicle (e.g. a SICAV, an OPCVM, a mutual fund, etc.) and conclude that there is no need to regulate it or require regular specific disclosure. This makes sense, because the pool only caters to high net worth individuals and institutions through private placements, and these investors are likely to be educated enough to assess the risk of their own investments.

Consequently:

• The pool is not subject to the requirements imposed on registered investment companies and, therefore, its manager may pursue any type of investment strategy. In particular, he may concentrate its portfolio in a handful of investments, use leverage, short selling and/or derivatives, and even invest in illiquid or non-listed securities. This is in total contrast to mutual funds, which are highly regulated and do not have the same breadth of investment instruments at their disposal.

• The pool manager has the primary goal of achieving a target rate of return, whatever happens on the market. This is what is meant by “absolute return”. Falling markets are no more an excuse for poor performance, as the manager has the latitude to go short if he wants to.

• To attract the most skilled managers in the industry, the pool offers some performance fees (typically 20% or more of the hedge fund’s annual profits) rather than asset-based fees (typically 1% or 2% of the assets). Assuming a 5% net trading profit for a hedge fund, the total fee would be equal to 200 basis points (1% management fee, plus 20% of the 5% performance) per annum. This would amount to more than five times the fees for most traditional, active equity products. But high fees will also attract managers with poorly established and executed strategies, potentially resulting in grim surprises for their investors. Hence, most hedge funds request their manager to invest a large fraction of his personal wealth in the fund alongside other investors. In addition, a hurdle rate of return must usually be achieved or any previous losses recouped before the performance fee is paid.

• To allow managers to focus on investments and performance rather than on cash management, the pool may impose long-term commitments and a minimum notice time for any redemption by its investors. This feature also provides the hedge funds with the flexibility to invest in securities that are relatively illiquid from the long-term point of view.

• Finally, as it is almost unregulated, the pool does not have to report and disclose its holdings and positions.⁶ This feature contributed significantly to the mystery that surrounded hedge funds, a trait that attracted individual investors while at the same time keeping institutional investors away. However, institutional investors are gaining ground in obtaining greater transparency and thus are getting increasingly involved in hedge fund investing.

1.2 INVESTMENT STYLES

Although the term “hedge funds” is often used generically, in reality hedge funds are not all alike. In fact, there exist a plethora of investment styles with very different approaches and objectives, and the returns, volatilities and risk vary enormously according to the fund managers, the target markets and the investment strategies. Some hedge funds may be non-directional and less volatile than traditional bond or equity markets, while others may very well be completely directional and display a much higher volatility. Many managers even pretend to have their own, unique investment styles. Therefore, “one size fits all” does not apply in the evaluation process or in the arena of risk management.

As it is critical to have a basic understanding of the underlying hedge fund strategies and their differences in order to develop a coherent plan to exploit the opportunity offered by hedge funds, consultants, investors and managers alike often segregate the hedge fund market into a range of investment style...

Table of contents

• Wiley Finance Series
• Title Page
• Copyright Page
• Foreword
• Introduction
• Acknowledgements
• Part I - Measuring Return and Risk
• Part II - Understanding the Nature of Hedge Fund Returns and Risks
• Part III - Allocating Capital to Hedge Funds
• Online References
• Bibliography
• Index