Investing in Hedge Funds

A Guide to Measuring Risk and Return Characteristics

Turan Bali, Yigit Atilgan, Ozgur Demirtas

• Publisher: Academic Press
• Year: 2013
• Print ISBN: 9780124047310
• eBook ISBN: 9780124051690
• Topic: Personal Development
• Subtopic: Banks & Banking

This book will present a comprehensive view of the risk characteristics, risk-adjusted performances, and risk exposures of various hedge fund indices. It will distinguish itself from other books and journal articles by focusing solely on hedge fund indices and emphasizing tail risk as a predictor of hedge fund index returns. The three chapters in this short book have not been previously published.- Presents new insights about the investability and performance measurement of an investor's final portfolio- Uses most recently developed investable hedge fund indexes to revise previous analyses of indexes- Focuses on 14 distinct types of hedge fund indices with daily data from January 1994 to December 2011

Chapter 1

Introduction

1.1 What Are Hedge Funds?

1.2 The History and the Future

1.3 Academic Perspective

1.4 The Aim of the Book

1.1 What Are Hedge Funds?

It is not an easy task to come up with a precise and succinct definition for the term “hedge fund.” The hedge fund world is an ever-changing one, and this is a major reason why there is no exact and universally accepted legal definition for hedge funds. One can say that they are private pools of capital in the sense that ownership claims in a hedge fund are not traded in organized exchanges, and fund investors benefit from appreciations in the market value of a hedge fund’s asset portfolio. It is well known that hedge funds present investment opportunities which provide risk and return combinations that are different from traditional equity and fixed income investments. Other than these, hedge funds vary significantly among themselves in terms of investment strategy, risk, and return characteristics. Some hedge funds are large, and others are small, measured by the assets they have under management. Some hedge funds are on the way to becoming household names, whereas others choose to operate discretely. Technological innovations have revolutionized the hedge fund industry and contributed to the heterogeneity that had been already inherent in the business. What cannot be denied is that hedge funds now constitute an alternative financial system by themselves. They act as the primary liquidity providers for relatively more obscure assets such as distressed debt, replace traditional financial intermediaries as lenders to speculative grade corporations, and function as insurers of last resort for risks that used to be hard to manage. Also, hedge funds have become the primary investors in listed companies raising equity privately. Brophy et al. (2009) report that companies financed by hedge funds are generally poorly performing firms with substantial information asymmetries. Companies that raise capital from hedge funds underperform companies that raise capital from other sources, implying that hedge funds act as equity providers for firms that cannot otherwise access equity financing.

Although there is a lot of heterogeneity in the hedge fund industry, it is possible to list some common traits that most hedge funds share. One of these traits is the flexibility that hedge funds enjoy. Indeed, this flexibility is the main factor that differentiates hedge funds from more traditional investment vehicles such as mutual funds. The performance of mutual funds is measured with respect to a benchmark, and any deviation from the benchmark is considered as risk. So, for the traditional asset management industry, risk is assessed on a relative basis. When market benchmarks are plunging in value, it is natural to expect that mutual fund returns will also go down with these benchmarks. This is not valid for hedge funds since hedge funds claim to focus on absolute returns, and, consequently, risk is also assessed in an absolute sense. What hedge funds care about is not the direction in which the overall market is moving, but the ability to spot relative price discrepancies between multiple securities and exploit these opportunities.

Hedge funds can achieve this absolute return focus thanks to their expanded toolbox compared to that of mutual funds. Hedge funds do not face regulatory restrictions regarding the financial instruments they are allowed to trade or their portfolio compositions. Unlike traditional investment vehicles, hedge funds can use derivative instruments such as options and futures, and they are able to bet on price declines by short selling securities. Chen (2011) reports that 71% of hedge funds trade derivatives, and derivatives users exhibit lower fund risks and are less likely to liquidate under poor market conditions. Although the practice of short selling has often been criticized by regulators and corporate executives who face public and investor pressure when firm values decline, short selling is instrumental for helping asset prices to revert back to their fundamental values for overvalued securities, and hence it enhances allocational efficiency in the economy. Moreover, short selling is not a costless strategy and should be used very carefully by hedge funds when they take short exposure. The risks associated with short selling will be discussed in Chapter 2 when we describe hedge fund strategies that focus on this practice. When used with caution, short selling may help hedge funds maintain an absolute return focus and generate positive returns independent of the direction of the movements in the general markets.

Another dimension of flexibility enjoyed by hedge funds is their ability to borrow money to magnify their returns. This practice is called “leverage.” The notion of leverage is a double-edged sword and increases the risks faced by hedge funds since leverage magnifies not only gains, but also potential losses. For example, if the fund portfolio is constructed by borrowing 90% of total asset value, the portfolio could become worthless after just a 10% drop in the markets. Finally, hedge funds have fewer obligations compared to mutual funds regarding their capital adequacies. All this flexibility has its benefits and costs. It is true that hedge funds can adapt to market conditions easily compared to other investment vehicles; however, they are also subject to more manager risk since a hedge fund manager has a lot of discretion over how the fund is run.

Another common feature of hedge funds is that the regulatory and tax framework surrounding them is not stringent. Many hedge funds are registered in offshore tax havens around the world, and there is not much transparency regarding their operations. The Securities Exchange Commission (SEC) passed an act in December 2004 that requires certain hedge funds to register with the SEC; however, this act was struck down by the Federal Courts in June 2006. Brown et al. (2008) investigate the hedge fund disclosures beginning with the first filing date in February 2006 and find that these disclosures contained useful information regarding the funds’ operational risks. This information is undoubtedly important for hedge fund investors. However, for hedge funds, transparency is an undesired attribute because funds that take strategic positions or short sell particular securities would not want their trades to be known by outsiders. Supporting this hypothesis, after new disclosure rules were passed in 2010, Agarwal et al. (2013) focused on the holdings of hedge funds that were requested to be confidential and found that these confidential holdings were associated with more information-sensitive stocks and produced higher abnormal returns compared to the nonconfidential holdings. On the other hand, fraud risk becomes substantial in a lightly regulated industry since investors are unable to monitor the hedge funds using conventional methods, and they do not even know in which type of assets their money is invested in. The lack of transparency has enabled some hedge fund managers to cook their numbers and lie to the public about their performance. Even if the investors are suspicious about fraud, they cannot just take their money and leave the crime scene due to restrictions for redeeming capital in the hedge fund business.

This brings us to the issue of illiquidity. Hedge funds are not liquid investments. To start with, even the wealthiest institutions and individuals need to wait for specific dates or time windows before they can subscribe to hedge funds, since most funds do not let investors in on an ongoing basis. More importantly, investors cannot redeem their invested capital from the hedge funds whenever they desire. There are lock-up periods which correspond to minimum amounts of time that an investor is required to keep his or her money invested in a hedge fund before the investor is allowed to withdraw capital. These lock-up periods are especially pronounced at the initial phase of a hedge fund and may prohibit investors from redeeming their money for up to a few years. Even when the investors are allowed to redeem their money, there are certain conditions that need to be satisfied. Redemption periods are often set at the end of fiscal quarters, but they can even be less frequent. Moreover, an advance notice up to three months should be given to the hedge fund before the redemption. Funds may also have special provisions called gates that limit the amount of capital that can be withdrawn at each redemption period, or funds may charge extra fees for redemptions. These fees often decrease in amount as the capital is kept in the fund for a longer period to incentivize investors not to withdraw their money.

The rationale behind the illiquidity of hedge fund investments is that these provisions enable hedge fund managers to invest freely in illiquid assets. Illiquid assets may turn out to be very profitable investments, but they may require a long-horizon focus because it may take time before the profits can be realized. Many valuable investment opportunities in financial markets are not compatible with the idea that hedge funds should maintain continuous liquidity for their clients. In a liquid world, hedge funds would have had to maintain cash reserves as liquidity buffers, and since cash generally earns lower expected returns compared to riskier investments, this would hurt a hedge fund’s overall performance. Another drawback of liquidity is related to the adverse impact of early withdrawers on existing fund investors because potential asset sales could spur additional transaction costs that would be borne by existing clients.

The expensive fee structure underlying hedge funds is also a common feature. Hedge funds charge their clients an annual operating fee, typically about 2% of assets under management just like mutual funds, but on top of this, hedge funds also impose additional performance or incentive fees that are generally about 20% of fund returns. This “2 plus 20” formula is common in the industry, and it is possible to encounter performance fees that are even higher and reach half the gains generated by the hedge fund. This type of fee structure may not always justify the returns generated by fund managers even if the gross returns are higher than the ones generated by traditional money management vehicles. The situation is even worse for funds since these entities invest in different hedge funds themselves and then charge additional fees to the investors. The rationale behind this fee structure is that hedge funds try to attract the brightest minds and the best talent to their businesses by compensating their managers based heavily on their success. The drawback is that this type of reward system is asymmetric, and fund managers receive a portion of the profits, but they do not share the portfolio losses. As a result, hedge fund managers may take too many risks in their investment decisions. One way to mitigate the problem of undue risks is obligating the fund managers to invest their own money in the fund.

A protection against extravagant fund fees is the high watermark system that means that hedge fund managers can charge performance fees only after the hedge fund surpasses its historical peak. In other words, past losses must be recovered first before fund managers earn the right to incentive fees. Of course, any protective system will come with its own drawbacks, and the notion of high watermarks is no exception. Employees of hedge funds that are far away from their high watermarks may opt to go and work for other hedge funds that are performing well. Worse, such funds may choose to close shop and reconstitute themselves. The problem regarding managerial incentives to take too many risks is still relevant since the objective to reach high watermarks may push fund managers even further to gamble and hope that their bets pay off. There are two possible variations on the high watermark system. First, there exist proportional adjustment clauses that allow managers to reduce the amount of loss to be recovered in order to receive incentive fees with proportion to the amount of money that investors withdraw from the hedge fund. Second, there are clawback clauses which require a certain portion of incentive fees to be deposited in an independent account so that the clients can be partially compensated if the future fund performance turns out to be poor.

The academic literature has also shown interest in the impact of managerial incentives in hedge fund behavior. However, the evidence so far has been mixed. Kouwenberg and Ziemba (2007) analyze the relationship between incentives and risk taking. They find that incentive fees reduce a fund manager’s level of loss aversion and, hence, can result in increased risk taking. A mitigating factor can be the manager’s own stake in the fund, which may curb the propensity to pursue risky strategies. Agarwal et al. (2009b) measure the extent of managerial incentives by the sensitivity of option-like incentive fee contracts to changes in the fund value, levels of managerial ownership in the fund, and the existence of high watermark provisions. Their results suggest that such incentives are positively associated with higher risk and superior fund performance. Hodder and Jackwerth (2007) occupy a middle ground and argue that the impact of incentive contracts on risk taking is dependent on a fund manager’s employment outlook. For fund managers who are close to their contract termination or who are facing a probable fund closure due to poor results, incentive-based compensation contracts cause fund portfolios to be tilted toward riskier strategies.

On the other hand, if the fund manager still has several evaluation periods in the future, then the risk-taking behavior is much more restrained regardless of the incentive system. There are also studies in the literature that find no evidence between incentive contracts and risk taking. Brown et al. (2001) cannot find any proof that fund managers engage in more risk taking to take advantage of incentive contracts, and indicate that a manager’s behavior is instead driven by the performance of peer funds. The strong linkage between performance volatility and fund termination tames risk taking, and fund termination is closely linked with the industry benchmarks even after the distance to high watermark thresholds is accounted for. Similarly, Aragon and Nanda (2012) find that managers whose incentive pays are linked to their fund’s high watermarks are less likely to increase risk.The authors argue that the popularity of high watermarks in the hedge fund industry may be driven by the demand of investors who favor the role of these instruments in tempering the managers’ behaviors. Also, the study argues that shutting down and restarting a hedge fund due to high watermarks or resetting these thresholds is costly in terms of both the legal expenses and the reputational costs.

Hedge funds are in the business of chasing after arbitrage opportunities. In today’s financial markets in which arbitrage opportunities are short-lived and fleeting, the notion of buy-and-hold is incompatible with the nature of hedge funds. Therefore, portfolio turnover is very high for many hedge funds, and trading costs such as bid-ask spreads, commissions paid to the brokers, and stock-borrowing costs can amount to about 5% of portfolio value on average.

Mutual funds can be passively or actively managed, but hedge fund managers are active by definition. The performance of hedge funds can be either beta or alpha driven. When we say beta driven, we mean that a hedge fund that exposes itself to some market or macroeconomic risk will naturally get compensated for that risk. For hedge funds, on top of traditional sources of beta such as equity market and bond market performance, there are also alternative sources of alpha such as liquidity, volatility, corporate event risk, and commodity market performance. Alpha represents the abnormal returns earned by hedge funds that cannot be explained by risk exposures. In the hedge fund business, alpha comes from either the regulatory flexibility awarded to hedge funds or the fund manager’s ability to pick the right securities to invest in at the right times. The competitive advantage of hedge funds comes from the ability to collect and analyze information more efficiently, the valuable human resources that possess special insights, the low cost access to financial markets, and superior trade execution.

Given all the advantages and disadvantages of hedge funds, the industry has grown immensely in the past. According to Hedge Fund Research, a leading hedge fund data provider, the industry had $39 billion of assets in 1990 whereas the assets under management had reached $2.375 trillion in the first quarter of 2013. This is up fourfold since 2000 and up almost twofold since the beginning of 2009, a time period before which the hedge fund industry lost a lot of assets due to the global financial crisis. During the first quarter of 2013, there was a flow of $15.2 billion of net new capital to the industry of which $9.4 billion was from fixed income-based relative value strategies, and $3 billion was from global macro strategies. In 1990, there were about 600 hedge funds, and this number increased to about 10,000 in 2007. Although many hedge funds were forced to close down during the credit crunch of 2008, the number of active hedge funds has now returned to its peak. Even with this rapid growth, the hedge fund industry makes up only 4–5% of the assets in global financial markets. However, hedge funds are responsible for a disproportionate amount of trading volume. Estimates suggest that hedge funds drive 25% of trading in organized exchanges, and this percentage is much higher for more obscure financial instruments such as distressed debt and leveraged loans.

Despite this growth trend, there may be a natural limit to the size of the hedge fund industry. After all, there are diseconomies of scale in the hedge fund business. Many hedge funds specialize in small niches of the financial markets and constantly plow these niches to generate returns. However, arbitrage opportunities are not endless in the financial markets and, as more money gets poured into the industry, the hunt for mispriced securities is going to get more competitive. There is a limit to how much cash individual trades can absorb, and any extra cash is going to get invested in second-rate bets that fund managers would have skipped over in the past. Going forward, it will not be easy to find low-risk arbitrage opportunities, and this may be one of the reasons why hedge fund returns have been going down in the last decade. As a consequence, many of the most successful hedge funds choose to close their doors to new investors due to fears of return dilution.

Many investors prefer to park their money in hedge funds because they believe that they are delegating the management of their savings to truly skilled professionals. Modern financial markets present many complex opportunities to talented players to realize returns. Hedge funds are able to bet on the changes in the relativ...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Preface
• Chapter 1. Introduction
• Chapter 2. Hedge Fund Strategies
• Chapter 3. Hedge Fund Databases, Biases, and Indices
• Chapter 4. Risk-Adjusted Performances of Hedge Fund Indices
• Chapter 5. Determinants of Hedge Fund Index Returns
• References