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- Hedge Funds: Structure, Strategies, and Performance
- The Complete Guide to Hedge Funds and Hedge Fund Strategies
- Hedge Funds
- Hedge Funds
Hedge Funds: Structure, Strategies, and Performance
This section presents an overview of the hedge fund industry, focusing on its current structure and recent performance. It provides a brief history of the evolution of hedge funds, considers available data on the size and structure of the industry, examines the performance of hedge funds, and discusses the behavior and individual performance of some of the large macro hedge funds against the backdrop of major macroeconomic events in which these funds have been ascribed key roles.
The section ends with a summary of the main conclusions. In , A. Jones established in the United States—first as a general partnership, later converted to a limited partnership—what is regarded as the first hedge fund. Jones combined the two investment tools—short-selling and leveraging—to create what was in fact a conservative investment system. One of his insights was that there were two distinct sources of risk in equity investment: from individual stock selection and from general market risk.
He sought to separate out the two. He viewed maintaining a basket of shorted stocks as a required asset allocation to hedge against a drop in the general level of the market. Thus controlling market risk, he used leverage to amplify his returns from picking individual stocks. The strategy was to buy particular stocks, that is be long these stocks, and sell others short.
The fees payable to the general manager were set at 20 percent of realized profits. Unlike mutual funds of the time—and for that matter of today—there was no asset-based management fee. Jones operated his fund with spectacular success and in relative secrecy until the mids. As the rapid growth of hedge funds coincided with a strong equity market, many managers found that hedging a portfolio with short sales was difficult, time consuming, and costly.
Consequently, many managers increasingly resorted to strategies of using high margins to leverage up their long equity positions, with only token hedging. The subsequent decline in the equity market —70 wreaked havoc on the industry. It is reported that for the 28 largest hedge funds in the SEC survey at the end of , assets under management declined by 70 percent from losses and withdrawals by the end of , while 5 of them were closed.
The stock market decline of —74 then caused another sharp contraction of the hedge fund industry. In the decade following , hedge funds appear to have returned to operating in relative obscurity. The growth of the hedge fund industry since the late s has not, however, been limited to the macro funds, which, if anything appear to have declined in importance see below , and the present hedge fund industry is comprised of a diverse set of funds.
Hedge funds are now probably best described as eclectic pools of capital created as private limited investment partnerships, with a performance-based compensation scheme for the principal partners or managers who are free to use a variety of investment techniques and leverage to raise returns and cushion risk. Their small size and internal organizational structure permit rapid decision making.
It is important to recognize that the line dividing hedge funds and certain other types of institutional investors is an arbitrary one. In particular, the operations of the proprietary trading desks of large commercial and investment banks resemble those of hedge funds. Considerable caution needs to be used in examining statistics for the hedge funds industry and its various segments.
The available data offered by a number of vendors—Managed Account Reports Inc. For present purposes, however, where the objective is to get a broader perspective on the size, structure, and returns in the hedge fund industry, they suffer from a number of deficiencies.
Since all information available on these databases is voluntarily reported by hedge fund managers to these services and is not based on any publicly disclosed information, funds whose managers choose not to report are necessarily missing from the databases, and the data are obviously, therefore, incomplete. Voluntary reporting means also that all statistics suffer from a self-reporting bias, as hedge fund managers would have an incentive to report results in a favorable light. Return statistics suffer from a strong survivor bias, in that only returns of funds that remain in business are reported.
Investment strategies range from the non-leveraged, hedged and arbitraged to highly leveraged and directional. The choice of this data set was largely arbitrary, though it does represent the first commercially available database on hedge funds and has the advantage of having longer time series. This is particularly useful in examining the performance of the large macro hedge funds see below.
These are 6. All estimates suggest that the hedge fund industry has experienced explosive growth since the mids, measured either by the number of funds or by assets under management, and continues to grow robustly. During this period the number of global funds, which have consistently represented between 40—50 percent of all hedge funds, rose almost tenfold from 40 to , and such funds now account for about half the industry.
Market-neutral funds, which currently represent about a quarter of the funds in the industry, also grew tenfold in the s, rising from 18 in to in Event-driven investment funds, which represent about 15 percent of funds, experienced only slightly more modest sevenfold growth in the number of funds during the s.
Macro funds have represented a relatively small fraction of the funds in the hedge fund industry, and though the number of such funds has grown over time from 13 in to 61 in , the share of such funds in the industry has been declining steadily. Macro funds currently represent only 7 percent of the funds in the industry.
One other notable area of expansion has been the funds of funds category, with such funds currently representing—after the global category—the second largest concentration of funds. When measured by assets under management, the importance of U. This difference is accounted for mostly by the large macro funds, over 45 percent of whose assets under management are in funds registered offshore in the Netherlands Antilles.
The size of assets under management by the hedge fund industry reveals the same explosive growth as that evidenced by the number of hedge funds. Unlike the picture that emerged in Table 3. There has, however, been a secular decline through the s in the share of assets under their management, which fell from 65 percent in when they clearly dominated the industry, to 33 percent by The stark difference in the importance of the macro hedge funds in the industry when measured by the number of funds and size of assets reveals, of course, that the funds in this segment of the industry have tended on average to be much larger than in the rest of the industry.
Because of the problem of voluntary self-reporting and, therefore, of missing funds from the databases noted above, the vendors were asked to provide estimates of the universe of hedge funds. While there have been a number of well-publicized failures of hedge funds over the years, the available evidence does not suggest that the industry is characterized by a spectacular or even high failure rate.
HFR estimates, for example, that in any given year during —97, the peak proportion of hedge funds in existence that closed was 7 percent. VHFA estimated that 10 percent of the funds in its current sample built up over the s were defunct.
Closures of these funds have occurred for a number of reasons unrelated to performance, including mergers or restructurings of partnerships into new or existing partnerships, managers or general partners leaving the fund for a new one, and managers retiring.
There are in fact limited examples of hedge funds closing after incurring large losses. This contrasts with the mutual fund industry, where manager compensation is typically determined as a fixed percentage of assets under management.
Second, hedge fund managers, as partners in the limited investment partnerships, have their own capital invested in the funds they manage. This is again in sharp contrast to the mutual fund industry, where managers typically do not have any of their capital invested in the funds they manage. Moreover, while hedge fund managers as partners in the hedge fund must invest at least the minimum investment requirement of the fund, the norm would appear to be that most put in substantially in excess of the minimum, with many investing most, if not all, of their own investment capital in the funds they manage.
Both features have important implications for the behavior of hedge fund managers, that is, in affecting the return objective of managers and in their tolerance for risk. First, since hedge fund managers are compensated on the basis of the absolute size of the realized returns of the funds, they tend to be oriented toward achieving the highest absolute return, rather than focusing on performance measures based on averages in the fund management industry, as mutual fund managers tend to do.
Second, they have a stronger incentive to minimize the possibility of losses, since there are no fees to be earned in that event. This is particularly important when the fund is losing money. These problems are avoided in the case of a hedge fund, since the fund managers have their own money at risk in the funds they manage. It is frequently argued that hedge funds, because they are unregulated, take on more risk than, say, banks, which are regulated and supervised, and in particular are subject to minimum capital requirements.
A trader who gets fired because of substantial losses incurred from taking on high-risk investments does, of course, lose flow income. He does not, however, typically suffer an immediate loss in the stock of his existing wealth as does a hedge fund manager. Redemption periods for investors in hedge funds vary considerably but are well in excess of those for mutual funds.
One prominent hedge fund has recently instituted a staggered redemption schedule over a three-year period. The substantially longer redemption horizon permits hedge fund managers to have longer investment horizons than, say, managers of open-end mutual funds. Consider a mutual fund manager in a bull market, for example. He is aware that funds will be flowing in at a robust pace.
It is, therefore, in his interest to reduce his average holdings of cash balances, and increase, for example, the proportion of his portfolio devoted to equities. The opposite is true in a falling market when the manager is aware that there will be a substantial outflow. It is then in his interest to increase holdings of cash balances, that is, sell in a falling market. Hedge funds, with longer redemption horizons, have fewer incentives to engage in such momentum selling.
The decision-making process of most conventional organizations—including financial institutions—often requires several stages and is often opaque to the outsider. The process is also typically time-consuming, with certain investment decisions requiring the approval of fiduciary or oversight committees. The decision-making process of hedge funds, in contrast, is relatively straightforward, with the general partner and portfolio managers exercising considerable, if not total, discretion.
This leaner institutional structure increases the ability of hedge funds to move quickly. No formal information is available on the composition of the investor base for hedge funds. Discussions with hedge fund managers and investors in hedge funds, particularly fund of funds managers, reveals, however, a clear trend toward an increasingly diversified investor base.
These institutional investors include the more traditional pension and mutual funds, insurance companies, endowments, foundations, universities, and commercial and investment banks. This trend is likely to continue. Since successful hedge funds have excellent internal credit standings with banks and brokers, they have access to, and are extensive users of, leverage.
Leveraging therefore greatly magnifies the economic clout of these funds, at the same time amplifying their returns and losses. It can also create a multiplier effect in the event of losses, which could exacerbate market movements. For example, if losses lead to an increased demand by creditor banks or brokers for collateral on money lent to the hedge funds—a margin call—the funds may need to sell some of their other holdings to raise cash. This can also transmit negative shocks across markets.
In the turmoil in U. Attention was focused first by the financial press, followed by investigations by various regulatory authorities in the United States, and with formal hearings by the Committee on Banking, Finance and Urban Affairs of the U. House of Representatives. Because of both conceptual problems in how precisely to measure the total use of leverage in a portfolio and self-reporting biases, the available data on the reported use of leverage by hedge funds is particularly unsatisfactory.
Of the macro hedge funds, 80 percent fall into this category, while of the global funds about 45 percent fall into this category. This lack of coverage effectively renders any discernible patterns on the use of leverage across segments of the industry and their effects on risk and return as unrepresentative.
HFR estimates that during the s, between 60—70 percent of hedge funds used leverage, while 15—20 percent did not, and the remainder did not report.
The HFR data reveal a modest increase in the proportion of firms using leverage during the s, though this increase largely offsets a decline in the share of nonreporting funds, suggesting that this increase may simply reflect improved reporting. HFR estimates suggest that over 80 percent of the total number of macro hedge funds use leverage. VHFA reports that an estimated 70 percent of hedge funds use leverage, about half of all hedge funds have leverage ratios of less than 2, and only 15 percent have leverage ratios in excess of 2.
It should be emphasized that there are some fundamentally unresolved issues in how to appropriately measure the extent of leverage used by investors.
The Complete Guide to Hedge Funds and Hedge Fund Strategies
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This book provides an objective look into the complicated and rapidly changing world of hedge funds. The book does not attempt to promote hedge funds as an asset class but instead provides a synthesis of the theoretical and empirical literature on hedge funds. By providing objective evidence, the book dispels some common misconceptions about hedge funds involving their volatility and use of derivatives and leverage.
This section presents an overview of the hedge fund industry, focusing on its current structure and recent performance. It provides a brief history of the evolution of hedge funds, considers available data on the size and structure of the industry, examines the performance of hedge funds, and discusses the behavior and individual performance of some of the large macro hedge funds against the backdrop of major macroeconomic events in which these funds have been ascribed key roles. The section ends with a summary of the main conclusions. In , A. Jones established in the United States—first as a general partnership, later converted to a limited partnership—what is regarded as the first hedge fund. Jones combined the two investment tools—short-selling and leveraging—to create what was in fact a conservative investment system.
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compensate managers based on the performance of the fund, which many believe dilutes strategies. The presumption is that hedge funds are pursuing more risky strategies us97redmondbend.orgus97redmondbend.org So for this type of operation structure, hedge funds establish.
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading , portfolio -construction and risk management techniques in an attempt to improve performance, such as short selling , leverage , and derivatives. Hedge funds are regarded as alternative investments. Their ability to make more extensive use of leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, such as mutual funds and ETFs. They are also considered distinct from private-equity funds and other similar closed-end funds , as hedge funds generally invest in relatively liquid assets and are generally open-ended , meaning that they allow investors to invest and withdraw capital periodically based on the fund's net asset value , whereas private-equity funds generally invest in illiquid assets and only return capital after a number of years. Although hedge funds are not subject to many restrictions that apply to regulated funds, regulations were passed in the United States and Europe following the financial crisis of — with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.
Historically, there have been two competing investment theories. On the one hand there is the traditional efficient markets theory, which states that share prices fully reflect market information and therefore only temporary mispricing occurs. The traditional investments to buy and hold equity and bonds, which benefit principally from market direction is based on this theory. On the other hand the second theory argues that greater inefficiencies occur, and therefore opportunities can arise that enable investors to exploit mispriced securities without facing excessive levels of risk.