“Hedge Funds: Past, Present, and Future” Stulz, Rene M

Question 1

What is the main idea?

Answer 1

Discusses what hedge funds do and how they can evolve.

Question 2

What is a hedge fund?

Answer 2

Unregulated pools of money managed by an investment advisor, the hedge fund manager, who has a great deal of flexibility.

Question 3

What are the characteristics of hedge funds?

Answer 3

Hedge funds:
o Generate large gains/losses
o Active management
o Have high leverage (can use margin trading to increase ROE)
o Mostly unregulated, issue securities privately
o Investors have to be approved by the SEC (to ensure they’re knowledgeable and can bear big losses)
o Create liquidity and make markets efficient
o Mostly invest short-term
o Not required to disclose info to investors, secrecy protects strategies but hard to determine risk of a fund

They account for half of the trading on New York and London stock exchanges

Question 4

Why do hedge funds and mutual funds coexist?

Answer 4

Hedge funds and mutual funds serve the same economic function.

Hedge funds exist because mutual funds do not deliver complex investment strategies:
 Due to mutual funds being regulated
 And hedge fund strategies are too complex for typical mutual fund investor to understand

Question 5

What do hedge funds do?

Answer 5

Most hedge funds attempt to find trades that are almost arbitrage opportunities (Bet on market correcting itself and hedge all other risks).

Derivatives and short positions are critical in most hedge fund strategies and enable hedge funds to reduce mispricing more forcefully than mutual funds.

Try to pursue absolute returns rather than returns in excess of a benchmark.

Hedge funds are market-neutral over time – have average performance no matter if market does good or bad

Question 6

What are the hedge fund strategy types?

Answer 6

o Long-short equity – both long and short pos. in stocks, market risk hedged by futures or options
 Typical strategy to identify under- & overvalued stocks

o Event-driven – take advantage of transactional events (spin-offs, mergers and acquisitions, reorganizations, bankruptcies)
 Strategy to predict outcomes of transactions and find best time to invest

o Macro – identify mispriced valuations in stock markets, interest rates, foreign exchange rates, physical commodities and make bets on expected movements
 To identify mispricing, managers forecast the impact of macro and political events

o Fixed-income arbitrage – find arbitrage opportunities in the fixed-income markets

o Multi-strategy funds – combine 2 or more different strategies

Question 7

Why is it difficult to say if individual hedge funds beat the market or mutual funds?

Answer 7

(Hedge fund index doesn’t exist, so most look if individual hedge funds beat the market)

o Biased data about hedge fund performance – they don’t need to disclose their performance, poor performance isn’t disclosed

o Hard to calculate market-adjusted returns due to complex strategies – hard to measure the market exposure, as it changes quickly and the return is best viewed as a basket of exotic derivatives

o Past performance of a particular hedge fund may give a very selective view of its risk – volatility of return may be low, but probability of losing all its assets is high

o Problems of valuation – many derivatives are traded OTC, hard to value, returns are serially correlated, which may be done on purpose of managers to present low risk ant consistent returns

Question 8

How to value hedge fund performance?

Answer 8

o Controversial
o Could be done by estimating “alpha” of the strategy (on average, hedge fund should have a positive but statistically insignificant alpha after fees)
o Hedge fund managers earn at least their compensation on average
o Past history could help to pick good hedge funds

Question 9

Do hedge funds pose significant risks for the economy?

Answer 9

Regulators are concerned about the risks of hedge funds because of:

*Investor protection – 10% of hedge funds die every year

*Risks to financial institutions – Hedge funds borrow, make securities transaction, are counterparties in derivatives trades; because of leverage may default

*Liquidity risks – hedge funds need to get out quickly when prices move unfavorably, if many funds do same trades they may be unable to exit at once; if that happens prices may overreact and liquidity drop; low liquidity means hard to exit quick and more risk for the hedge fund (serious issue)

*Excess volatility risks – hedge funds could lead prices to overreact by making trades that push prices away from fundamental values and lead to excess volatility risks; not much evidence

Question 10

What is the future of hedge funds?

Answer 10

o The hedge fund industry will perform less well over the next ten years than over the last ten
 More hedge funds chasing the same price discrepancies means that these discrepancies get eliminated faster, leading to smaller profits for the funds

o The hedge fund industry will become more institutionalized
 Institutional investors must be able to justify their investments (in their portfolio) and explain the outcomes – more emphasis on disclosure, transparency, liquidity, risk management, less on managers’ skills (to make inst. inv. w fiduciary duties to invest)
 Convergence of mutual and hedge funds; hedge funds can start offering more services (like mutual funds) based on their reputation

o The hedge fund industry will become more regulated
 Mutual funds often lobby for more constraints on hedge funds
 Hedge funds and regulated financial institutions compete, but financial institutions complain that they don’t have equal rights