hedge funds

Question 1

A hedge fund can be defined as

Answer 1

an investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments.
A hedge fund is essentially a type of collective investment vehicle. Nowadays the term hedge fund is often used to refer to any investment fund that isn’t restricted to a long- only, non-leveraged investment strategy.

Question 2

General features of hedge funds

Answer 2

Hedge funds typically have less restrictions on:
 borrowing 

 short-selling 

 the use of derivatives 
than more regulated vehicles such as mutual funds. This allows for investment strategies that differ significantly from the long-only, non-leveraged strategies traditionally followed by investors. 
So it greatly increases the opportunity set of available investment strategies, thereby offering opportunities for higher investment returns. 
Typical features of hedge funds in addition to those mentioned above include: 

 The manager normally has a great deal of investment freedom. 

 Hedge fund fees typically include a performance-related component in addition to an annual management charge. 

 The minimum investment amount is often high and there may be limits on the total size of the fund. As we shall see, the strategies followed by hedge funds can often best be executed with only relatively small amounts. 

 There may be lock-up periods, ie minimum investment periods, and notice periods. 


Question 3

What is meant by a “long-only, non-leveraged” strategy?

Answer 3

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Question 4

Hedge funds were originally characterised by:

Answer 4

 the placing of many aggressive positions on different assets 

 a high level of borrowing given the limited size of the capital of the funds 
compared to the size of the individual investments 

 a mix of investments for which the price movements would be expected mostly to cancel each other out, except for the positive effect the hedge fund is looking for 
We will look at this idea in more detail when we consider the different classes of hedge funds. 

 a willingness to trade in derivatives, commodities and non-income bearing securities 

 a higher risk tolerance than other funds.

Question 5

Classes of hedge funds

Answer 5

The term hedge funds now covers a wide spectrum of investment strategies although some of the more common ones are:

1. global tactical asset allocation funds 

2. event-driven funds 

3. market-neutral funds 

4. multi-strategy funds. 


Question 6

Global Tactical Asset Allocation funds

Answer 6

These concentrate on economic change around the world and sometimes make extensive use of leverage and derivatives.
These funds will take a combination of long and short positions that reflect the hedge fund manager’s views on how macroeconomic factors such as the levels of international asset markets, interest rates and currencies will move. These views will depend on economic trends globally and major international events.

Question 7

Event-driven funds

Answer 7

These trade securities of companies in reorganisation and / or bankruptcy (“distressed” securities) or companies involved in a merger or acquisition (“risk arbitrage”).
These funds invest to try and profit from price movements caused by anticipated corporate events.
Securities, eg shares or loan capital, in “distressed” companies are often available at a price well below the par value. A hedge fund may feel able to make profits from buying these securities as:
 many traditional institutional investors will be unable or unwilling to buy these stocks so there will be less demand putting pressure on prices 

 there are likely to be price anomalies which a hedge fund can exploit through research and expertise. 
Either an active or a passive approach to investing in distressed securities is possible. 


Question 8

Explain what you think “active” and “passive” mean in this context?

Answer 8

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Question 9

If the manager of a distressed fund wanted to hedge the equity market risk, what could he do?

Answer 9

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Question 10

A risk arbitrage fund

Answer 10

may simultaneously take long and short positions in both companies involved in a merger or acquisition. This typically is a low-risk, as opposed to a risk-free, strategy.

Question 11

Example

Answer 11

Suppose a hedge fund manager believes that A plc is planning to acquire a certain target company, T plc, by offering one A share for each T share. The manager will take a long position in (ie buys) the shares of T and goes short in the shares of A. If the takeover goes ahead, the price of T will converge upwards towards the price of A. By taking a long position in one share and a short position in the other, the manager gets the profit from the relative movement of the share prices and is immune to the movement of the market as a whole.

Question 12

Event risk

Answer 12

The risk is that the merger or acquisition does not go ahead. This “event” risk is generally uncorrelated to overall market movements.

Question 13

Market-neutral funds

Answer 13

These simultaneously enter into long as well as short positions at a market or sector level , while trying to exploit individual security price movements.
These funds aim to exploit inefficiencies in the markets by making stock selection profits, eg to take a long position in (buy) securities that the manager considers to be underpriced, and so expects to appreciate in value, and take a short position in (sell) securities that the manager considers to be overpriced and so expects to depreciate. When the prices correct, the manager can take a profit. The fund as a whole is designed to be market-neutral, ie as many short positions as long positions are taken, so that the performance of the fund is not affected by general movements in the market.
The extent of market neutrality varies between funds. Funds may be beta-neutral and/or currency-neutral. They may also be neutral in some more stringent ways – eg by equity sector or by size of company.

Question 14

What does it mean to describe a fund as beta-neutral?

Answer 14

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Question 15

Multi-strategy funds

Answer 15

These invest in a range of investment strategies to provide a level of diversification.
Multi strategy hedge funds will use a combination of the above on the same set of assets. So, for example, a multi-strategy fund might short-sell equities, investing in more property, whilst simultaneously focusing on event driven strategies for its property portfolio. The idea is that this increases diversification, which can help to smooth returns.

Question 16

Structure and past performance of hedge funds Short selling

Answer 16

As hedge funds have the ability to take short positions they were often viewed as absolute return strategies which would produce positive returns even when markets were negative. The financial crisis of 2008/2009 demonstrated this was not the case and many hedge funds posted negative returns during this period.
Suppose Hedge Fund A pays B a small fee to borrow Share X, which Hedge Fund A then sells to C for cash. Once the price of X has fallen, Hedge Fund A uses some of this cash to buy X at the new lower price. This share is used to pay off B, leaving the remainder of the cash as profit for the Hedge Fund A.
In practice, many investors are not permitted to borrow and short sell securities that they do not own. However, one of the ways in which hedge funds are less tightly regulated than most investors is precisely that they are allowed to do this. It therefore makes it easier for them to make profits when markets are falling.

Question 17

Other characteristics of hedge funds typically include:

Answer 17

 opaqueness 

 illiquidity and 

 high fees.

Question 18

In what sense is does this increase diversification?

Answer 18

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Question 19

Legal structure

Answer 19

Hedge funds often have complex legal structures and the fund structures are held offshore to minimise tax and regulatory requirements. The Cayman islands and Bermuda are two popular locations for hedge funds.
Hedge funds have historically been subject to less regulation and financial reporting than mutual funds although legislation is being introduced in a number of developed markets which will require far more onerous reporting in the future.

Question 20

Past performance

Answer 20

Gaining insight into the performance characteristics of the different types of hedge funds is not straightforward. Monthly return information released by hedge funds is collated and distributed by a number of analysts. However, the data can be influenced by:
● Survivorship bias – when the data does not realistically reflect survivors and failures. When the emphasis is on survivors, average returns will be overestimated and volatility will be underestimated. Also, when a fund is added to a database, data vendors tend to “backfill” that fund’s performance history. 
We have already met this idea of survivorship bias in the discussion of private equity. Backfilling simply means adding the fund’s past history into the database. A hedge fund is more likely to choose to add its past performance to the database if that performance is good. 

● Selection bias – funds with a good history are more likely to apply for inclusion. Backfilling will then cause a significant upward bias. 

● Marking to market bias – since the underlying securities may be relatively illiquid, funds will typically use either the latest reported price or their own estimate of the current market price for valuation. The use of “stale” prices can lead to underestimation of true variances and correlation. 
The issue here is that if a hedge fund invests in securities that aren’t tradable (eg over the counter derivatives) or for which transactions are infrequent (eg certain equities) then a current market price isn’t readily available. The “price” used instead for performance measurement purposes is likely to be less volatile than the true value. The extent to which this is a problem is clearly very dependent on the investment strategy of a particular fund. Comparisons between very different types of hedge funds may therefore be distorted.

Question 21

There are other practical problems with analysing performance data for hedge funds

Answer 21

. Many hedge funds have been in existence for only a short period of time so there is a lack of data on which to base any analysis. For example, a fund that has been in existence for six months and has demonstrated good performance may have just been lucky or may be executing a strategy that has done well in the particular market conditions that have occurred over the period.
Claims of hedge fund superior performance can be questioned since return distributions are far from normal – many of them tend to be negatively skewed.
Standard measures of performance such as a portfolio’s alpha (the excess return that cannot be explained by the fund’s beta) and its Sharpe ratio (see Chapter 15) will be biased upwards as a result.
This is because the risk is in each case measured in term of the standard deviation which, being a symmetric measure or risk, does not give a true indication of the level of (downside) risk involved.

Question 22

Rather than looking at summary statistics, t

Answer 22

the investor should consider the whole return distribution.
This is a key message here. It is important to analyse the past performance data in lots of ways, rather than to rely on a single summary statistic. For example, plots of the data (eg a plot of the cumulative distribution function of the returns) may highlight the existence of outliers and the symmetry or skewness of the data.

Question 23

Fees

Answer 23

Hedge fund fees are significantly higher than the fees on more traditional collective investment vehicles. Hedge funds can charge higher fees because:
 they have historically provided higher returns 

 demand exceeds supply – the capacity of some hedge funds is limited. 
A fund of hedge funds is an investment vehicle that invests in a number of hedge funds. An investor choosing this vehicle gets exposure to all the included hedge funds. The idea behind funds of hedge funds is that an investor diversifies the risk of investing with a single hedge fund manager, without needing the time and expertise to construct his own portfolio. The fund of funds manager is responsible for selecting the hedge funds in which to invest. He commands a fee for doing this. 
Most hedge funds charge a fixed annual fee of 1–2% plus an incentive fee of 15– 25% of the annual fund return over some benchmark. Funds of hedge funds charge similar fees and, although they generally obtain rebates from the managers they invest in, the extra layer of fees puts substantial pressures on fund-of-funds performance.

Question 24

Why is the capacity of most hedge funds more limited than traditional collective investment vehicles?

Answer 24

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