Investment Hedge Funds
Literature review
2.1 SIZE AND GROWTH OF THE HEDGE FUND INDUSTRY
Alfred Jones 'in 1949' started an investment partnership which is believed to be the first hedge fund. Jones's ideas and fundamentals of hedge funds are still remain in practice and effective after 60 years.
Jones prepared a structure to avoid his investment from SEC regulations described in , regarding investment in Investment company Act of 1940.
Jones kept his own investment in partnership and based his remuneration as a performance incentive fee , 20%, of profits. As a result theses practices encourage interest alignment between manager and investor and are still used by most hedge funds.
Jones also hired other managers , delegated authority for portions of funds, and thus introduced the multi-manager fund. Then it later evolved into to the fund of hedge funds[ Tremont,2002].
By mid 60's , managers who worked with Jones got inspired from his model and started their own funds. A report published by SEC , reported 140 live hedge funds in 1968.[president working group,1999].
During the stock boom in late 60's , led by a group of stocks branded the Nifty Fifty, and hedge funds that followed the Jones model appeared to underperformed the overall market. During the subsequent market of 1972-4, the S&P declined by a third and hedge fund with leveraged with long-bias strategy were badly hit. Consequently many hedge fund went bust and hedge fund become least favourable for next decade.
In 1984 a survey by Tremont identified only 68 live hedge fund[Lhabitant,2002].
The mid-80's recovery of hedge funds attributed to Julian Robertson's Tiger fund. It was one of the global Macro fund(funds that made leveraged investments in securities and a currencies, based upon the assessment of global macro economic and political conditions. In 1985 , Robertson correctly predicted the end of 4 year trend of the appreciation of the US dollar value against European and Japanese currencies. An article published by Institutional Investors viewed that since its inception in 1980, Tiger fund has a 43% average annual return[Eichengreen,1999].
Investors began to admire hedge funds due to its higher profitability but the same time it were also being blamed for the world financial crises. In 1992 during the European ERM(Exchange rate mechanism) crisis George Soro's Quantum fund (global macro hedge fund ) pocketed over 1 billion dollar from shorting sterling. During the Asian contagion currency crisis, Thai Bath fell 23% in july 1997. Quantum fund had shorted the Thai Bath and gained 11.4% that month[Fung and Hsieh,2000].
As Dr Mahtir Mohammad put it All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruin things. [The colour of money,1998].
In late 90's again hedge fund became the centre of attention. In 1998 Quantum made a loss of $2 billion during the Russian debt crisis. Tiger fund also lost around $2 billion due to incorrectly bet upon the depreciation of Yen versus Dollar. In Dot-Com boom, Quantum had to lose $3bn due to shorting high-tech stock and then later reversing its strategy and purchasing stock near the market top[Deutschman, 2001].
In 1998, John Meriwether, the anti-hero of Michael lewis book Liars poker, bet his firm, Long Term Capital management(LTCM), on the suggested theories of his partners, economists, Robert Merton and Myron Scholes, and eventually lost. LCTM was established by Meriwether in 1994, using arbitrage pricing differentials in the bond market, through betting on convergence in the prices of similar assets. It worked for some time, but when differentials went off , the firm's highly leveraged position quickly lost money. At the end LCTM had to bailed-out by banks. It made a huge loss in bad investment. It had $2bn left pay off its debt. LTCM borrowing, averaged 50-100% time its asset base[Eichengreen,1999].
The term hedge funds has been somewhat high jacked in recent years. According to Mark Dampier(2008) It is wrong to tar all hedge funds with that brush - those that have gone horribly wrong are not proper hedge funds at all, but in fact little more than gambling funds. True hedge funds will seek to preserve investor's capital above all, and endeavour to make positive gains through the market cycle.
Nick Clark(2008) reported that , hedge fund suffered their worst start in nearly 20 years. He quoted Hedge fund research 'A US based analysis group' that the industry index it complies was the worst in the first 6 months of the year since it began tracking in 1990. According to the report, on average every hedge fund declined by75% this year. This compares with the first 6 months of 2007, when the industry advanced 7.45%. However John Godden, a hedge fund adviser, disagreed with the figures reported. He argued that HFR figures was too US-centric , which tended to skew the figures, as US managers hold equities, causing their performance to fall with the market. As he put it To be only 75 basis points down in a year where everything else is offer over 10% is just awesome. Most investors would be happy with that, and we are still seeing huge inflows into hedge funds.
Alternative investments have converted much of the traditional investments. Particularly hedge funds industry has grown up enormously. In 1998, As Barry(1999) cited , Data From Managed Account report Inc, total number of hedge funds were standing at 914 and managed capital of $110bn.
According to Earnest and Young 2007 (E&Y) report, The global hedge funds now manages US $ 2.48 trillion of Assets and the number of hedge funds are 10,000.
Hedge Fund Intelligence(2008) posted that hedge fund global assets has increased by 27% during 2007, making total assets to US$2.6trillion. this report showing , top 350 funds manage 75% of global assets.
HFM Week (2008) showing different figures in their report .According to HFM Total combined assets in the industry now rest at $4trn -a long way from the $745bn reported in the inaugural administrators survey in 2003. . They have broken down the figures further, Asset under administration(AUA) of single- manager is now at $2.7trn, up from the $2.5trn reported six months ago and the $1.5trn reported in Nov 2006. Total Fund of hedge fund (FOHF) AUA is now at $1.3trn , up from $950m reported 12 months ago. Despite the turbulent times in the history of financial markets, Hedge fund industry reported double digit growth.
From the above various reports mentioned, although Hedge Funds industry is growing at a very fast rate, but it is very much difficult for financial experts, academics to analyse the industry figures and predict the risks involved with such investments. According to Fung and Hasieh (2000) the problems is not only with their being unregulated but also the structure of the hedge funds and commodity industry is such that complete and accurate information on funds and their histories is almost unobtainable.
The structure of hedge fund has been built up in such a way to avoid regulations. It is not mandatory to disclose the existence of hedge fund. Data on hedge funds normally gathered by hedge funds themselves because there is no such regulatory authority to collect the official data on hedge funds. this makes the reported industry figures doubtful, since only those funds may report their figures who are successful, others may not to choose to report their figures. Some data base reports combine figures, hedge funds with other commodity trading advisers (CTA's) and others show them individually. There is also inconsistency exists in defining hedge funs leverage, which affects the determination AUM (assets under administration), so aggregate hedge fund data are best views as estimates (Brown, 2001).
The Definition of hedge fund:
The definition of hedge fund is far from clear. There is no legal definition of hedge fund in the UK and Europe. The feature which distinguish hedge funds generally accepted to be:
1.They tend to be unregulated collective investment schemes-But share this characteristic in the UK, with , for example, some occupational schemes;
2. They make extensive use of derivatives- but shares this characteristic with banks, insurance and securities companies;
3. They use extensive use of leverage- again not a characteristic unique to them. (Callum Mc Carthy,2006).
Security exchange commission (SEC ,US), also in the view that there is no universal definition of Hedge fund as per the legal term. According to Brown and Gotezmann(2001) statement that despite their public acclaim and their profound influence, surprisingly little is understood about hedge funds and what is it they do?.
Various investment strategies form a part of hedge funds, therefore as McCarry(2002) explained Because the range of business types and investment strategies that can be classified as hedge funds is quite large. However, in order to grasp the concept of hedge funds which is the core of this research, we should be able to point out what the term 'hedge' means and why are they used?.
In simple view the word hedge signifies The taking of position, acquiring either a cash flow, an asset, or contract that will rise(fall) in value and offset a fall(rise) in the values of existing position. Eitman et.al(2005). Hedge technique are used by investors to protect their investments form unforeseen losses. It appears that the nature of hedge funds doesn't match the above statement of hedging. According to Edward's(1999) hedge funds typically do just the opposite of what their name implies: They speculate.
Although hedge funds are developed to minimise the related risk with investments but in reality , such investments faced a greater degree of risk as its involve leveraging which is the main part of hedge fund investments strategies.
Many authors have defined hedge funds using different approaches, which have led to wide opinions . Eichengreen(1998) defined hedge funds as eclectic investments pools, organised as private partnerships and often resident offshore for tax and regulatory purposes whose managers are paid on a fee-for-performance basis.
It appears from the literature that including various dimensions in hedge funds have led the hedge fund to an open definition. Goldman Sachs JBwere view hedge fund as Hedge funds generally are private investment funds, including unit trusts that allow investors to seek to take advantage of perceived mispricing in shares, bonds, currencies and commodities. T.Cole et al(2007) taking hedge funds as traded instruments and defined hedge fund as private pools of fund that invest in traded instruments (both cash, securities, and derivatives); can employ through various means , including the use of short positions; and generally are not regulated.
In the absence of legal definition, However, it can be summarised by taking IOSCO (International Organisation Of Securities Commission)view , from their report published in February 2003, Hedge fund have at least some of the following characteristics
Borrowing and leverage restrictions, which are typically included in collective investments scheme (CIS) regulations, are not applied and many (but not all) hedge fund use high levels of leverage;
significant performance fees(often in the form of percentage of profits )are paid to the manager in addition to an annual management fee;
often significant 'own' fund are invested by manager;
derivatives are used often for speculative purposes, and there is an ability to short sell securities;
More diverse risks or complex underlying products are involved.
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