Why Investors Invest In Hedge Funds

Abstract

Hedge funds have gained a lot of popularity in the last decade and are one of the fastest growing industries. The main aim of most hedge funds is to reduce volatility and risk. It also attempts to preserve capital and deliver positive returns under all market conditions. Not all hedge funds are same therefore it is important to know the difference between them. It differs in terms of its risks, investment returns and volatility among the different hedge fund strategies. The strategies which are correlated to equity markets deliver consistent returns and have low risk while the ones that are not will be more volatile. Main objective of hedge funds is to provide consistency in its returns for investor, lower portfolio volatility and preserve their capital investments, which is the reason why investors such as pension funds, insurance companies, institutional investors and high net worth individuals and families invest in hedge funds.

This thesis reviews various issues relating to the investment in hedge funds, which have become popular with high net-worth individuals and institutional investors, as well as discuss their empirical risk and return profiles. The concerns regarding the empirical measurements are highlighted, and meaningful analytical methods are proposed to provide greater risk transparency in performance reporting. It also discusses the development of the hedge fund industry in Asia.

Asian hedge funds have grown vastly in past few years. It is said to have grown nearly six times as many funds while managing ten times are much in assets since 2000 according to Eurekahedge. The industry is estimated to consist over 1100 funds, and managing roughly $175 billion in assets. International managers are starting up their own Asia-focused funds too. Allocators are increasingly eyeing investment opportunities in Asia. Funds with a global mandate are increasing their allocation to Asia.

The paper presents an overview of hedge funds, describing their development and characteristics. It also discussed the various issues related to the measurement of hedge fund performance, as well as examined alternative performance measures. This thesis ends with some remarks on the development of the hedge fund industry in Asia.

1. Introduction

There has several definition of hedge funds throughout the history. There isn’t one particular sentence that defines what hedge funds really means. However, according to Chicago Board Options Exchange (No Date), hedge funds can be defined as: “A conservative strategy used to limit investment loss by effecting a transaction that offsets an existing position.?

Alfred Winslow Jones was the first person to create hedge fund structure more than 50 years ago. The fund established had following feature:

He created “hedges? by investing in securities that was said to be undervalued and funded these positions by taking short positions in overvalued securities hence creating “market-neutral? position.

He designed an incentive fee compensation arrangement for fund mangers. They were paid a percentage of profit from the clients capital assets; and

He so invested his own investment capital in the fund, to make sure that his capital and that of his investors were coordinated and in line so that it is not just an individual investment but a partnership

Almost all modern hedge funds have above listed features in them, and are set up as limited partnerships with a lucrative incentive-fee structure. In most hedge funds, managers also have a significant portion of their own capital invested in the partnerships. The term “hedge fund? has been generalized to describe investment strategies that range from the original “market-neutral? style of Jones to many other strategies and opportunistic situations, including global/macro investing.

There is a large variety of hedge fund investing strategies present today and therefore no standard way to classify hedge funds separately. Many data vendors and fund advisors set up their own major hedge fund styles according to their popularity. Under the classification by Credit Suisse, the categories of hedge funds with 9 differentiated styles and a fund-of-funds category:

(a) Event driven funds are the funds that take positions on corporate events when companies are undergoing re-structuring or mergers. For example, fund managers would purchase bank debt or high yield corporate bonds of companies undergoing the re-organization which is often referred to as 'distressed securities'. Another event-driven strategy is merger arbitrage where the funds seize the opportunity to invest just after a takeover has been announced. They purchase the shares of the target companies and then short these shares of the acquiring companies.

(b) Global funds are categories of funds that invest in non-US stocks and bonds with no specific strategy reference. This fund has the largest number of hedge funds and it includes funds that specialize on the emerging markets.

(c) Global/Macro funds are the funds that rely on macroeconomic analysis and invest in long and short position in order to capitalise on major risk factors and unforeseen markets such as currencies, interest rates, stock indices and commodities.

(d) Market neutral funds refer to hedge fund strategy that involves utilizing strategies such as long-short equity, stock index arbitrage, convertible bond arbitrage and fixed income arbitrage. Long-short equity funds use the strategy of Jones by taking long positions in selective stocks and going short on other stocks to limit their exposure to the stock market. Stock index arbitrage funds trade on the spread between index futures contracts and the underlying basket of equities.

(e)Dedicated Short Bias funds are strategies that take more short positions than long positions and earn returns by maintaining net short exposure in long and short equities. Detailed individual company research typically forms the core alpha generation driver of dedicated short bias managers, and a focus on companies with weak cash flow generation is common. To affect the short sale, the manager borrows the stock from a counter-party and sells it in the market. Short positions are sometimes implemented by selling forward. Risk management consists of offsetting long positions and stop-loss strategies.

(f)Convertible bond arbitrage funds typically capitalize on the embedded option in these bonds by purchasing them and shorting the equities.

(g)Fixed income arbitrage is a strategy that bets on the convergence of prices of bonds from the same issuer but with different maturities over time. This is the second largest grouping of hedge funds after the Global category.

(h) Short/long fund-, shorts focus on engineering short positions in stocks with or without matching long positions. They play on markets that have raised too fast and on mean reversion strategies.

Long funds take long equity positions with leverage. Emerging market funds that do not have short-selling opportunities also fall under this category.

(i)Emerging Markets funds invest in currencies, debt instruments, equities and other instruments of countries with “emerging? or developing markets (typically measured by GDP per capita). Such countries are considered to be in a transitional phase between developing and developed status. Examples of emerging markets include China, India, Latin America, much of Southeast Asia, parts of Eastern Europe, and parts of Africa. There are a number of sub-sectors, including arbitrage, credit and event driven, fixed income bias, and equity bias.

(j) Fund of funds refer to funds that invests in a pool of hedge funds. They specialize in identifying fund managers with good performance and rely on their good industry relationships to gain entry into hedge funds with good track records.

Table 1 gives statistics about the various categories of hedge funds and past performance. The global/macro hedge funds provided the best mean return over the period studied, while the event-driven funds had the lowest standard deviation of returns. On a risk adjusted basis which is obtained by dividing the mean return by the standard deviation, the category of fund that ranks highest is the global/macro funds followed closely by event-driven funds. Hedge funds are not required to publicly disclose performance and holdings information unlike the registered insurance companies, which might be construed as solicitation materials. This is the reason why which makes it more difficult for investors to evaluate hedge fund managers.

TABLE 1

Jan 2000 – Nov 2009

Categories

Mean Return

(%)

Standard Deviation (%)

Risk-Adjusted Return

Event driven

8.66

5.44

1.60

Global

6.60

6.23

1.06

Global / Macro

12.28

6.07

2.02

Market neutral

2.09

13.48

0.16

Short/Long

5.50

8.88

0.62

Emerging Market

9.23

11.05

0.84

Convertible Arbitrage

6.98

8.34

0.84

Dedicated Short Bias

(1.95)

16.40

(0.12)

Fixed Income Arbitrage

3.66

6.81

0.54

Source: Credit Suisse/ Tremont hedge index

Notes:

The mean returns are annually compounded returns over the period 2000 to November 2009,

The annualized standard deviations were computed from of the standard deviation of monthly returns for each investment style.

Risk-adjusted returns are obtained by dividing the mean return by the standard deviation.

In 1990 the entire hedge fund industry was estimated at $20 billion. At the end of 2008, global hedge fund industry was estimated to be worth $1 trillion with 8350 active funds. It has gained a lot of popularity in the last decade and is one of the fastest growing industries. While hedge funds are well established in US and Europe, they have also been growing rapidly in Asia.

Hedge funds have posted attractive returns. A seven year annualised return of 2.47% posted by Hedge Fund Research (HFR) from 2003 to 2009, higher than the S&P 1200 of 1.18%. Hedge funds are seen as natural hedge to control downside risk because they employ investment strategies believed to generate returns that are uncorrelated to traditional asset classes. Hedge funds differ in strategies- a macro fund such as quantum fund generally take a directional view by betting in particular bond market or a currency movement. Other funds specialise in corporate events such as mergers or bankruptcies. They also vary widely in investment strategies and the amount of financial leverage.

In the recent financial crisis, hedge funds have been heavily criticised in terms of their strategies and also for the fact that in 2008, they have had hard time fulfilling their absolute return targets. There have been other criticisms towards hedge fund regarding this particular crisis. Stromqvist (2009) writes that ever since the growth of hedge fund industry there has always been discussions regarding the role of hedge funds in a financial crisis. The main focus of the criticism was on highly leveraged hedge funds and that they may have a large impact on price stability on both currencies and equities.

In an article written in The Times, Dillow (2008) observes that even though average return of hedge funds in 2008 has been poor, “they have not been a serious source of instability in the wider financial system?.

Regardless of the recent financial crisis, hedge funds still generate a growing number of interests all around the world. Due to their private nature, it is difficult to obtain information about the operations of individual hedge funds and reliable summary statistics about the industry as a whole.

It is a common belief that investing in hedge funds can have superior returns. Many success stories have emerged in the past and the most popular of which is the George Soros story. In September of 1992, he risked $10 billion on a single currency speculation when he shorted the British pound, which gave him an international fame. He was right, and in a single day he successfully generated a profit of $1 billion – ultimately, it was reported that his profit on the transaction almost reached $2 billion. Therefore, he is famously known as the "the man who broke the Bank of England."

The greates investor: George Soros,

http://www.investopedia.com/university/greatest/georgesoros.asp 16-12-09

As seen in Table 1, the hedge funds as a group can generate positive returns. For example, over the period 1990-1997, all the hedge funds had positive absolute returns. Global/Macro funds obtained mean returns of 28.1% p.a. with a standard deviation that is comparable to equity funds.

Traditional asset allocation makes the most of the use of equities, bonds, real estate and private equity to invest in a portfolio that maximizes returns and minimizes the portfolio risk. Therefore, in an investment portfolio hedge funds can play a vital role in maximising returns. Moreover, in a bear market, many investment and fund mangers find it dull to just beat the market index, which may have negative returns. They generally prefer to go short or avoid long positions to have positive returns. Choosing an appropriate hedge fund to invest increases the possibility of obtaining positive “absolute returns?.

It is also generally believed that hedge funds have returns that are generally uncorrelated with the traditional asset classes. In fact, hedge funds may even have a lower risk profile. For example, Morgan Stanley Dean Witter (2000) reported that hedge funds “exhibit a low correlation with traditional asset classes, suggesting that hedge funds should play an important role in strategic asset allocation?.

The answer to the question “Why invest in Hedge funds?? simply is “to make money.? The common analogy in all hedge funds strategies and the underlying rationale for investing in hedge funds is the search for absolute returns. This is sometimes called "alpha". "Alpha" is the extra return a skilled manager can produce over and above the market return (or "beta"). Whereas many conventional fund managers aim simply to outperform their chosen benchmark index, hedge fund managers seek to produce positive gains in all market conditions.

http://www.fleetstreetinvest.co.uk/shares/trend-investing/hedge-fund-investing-00128.html

Research Question

By using quantitative study, I will try to answer the following questions:

Why investors invest in hedge funds?

To answer this question I will be looking at the return, risk and performance associated with investing in hedge fund and how the fund mangers. By looking at the annualised return, standard deviation and risk adjusted returns of different styles of hedge funds their performance can be measured.

What are the issues relating the investment in terms of risk, return and performance measurement?

Although hedge funds are popular in terms of an investment vehicle, there are various issues. The issues related are its cost/ management fee structures, collection of data, survivorship bias and selection bias. Various performance measure techniques are available for hedge funds too. I will be looking at some of the performance measurement approaches.

Purpose

There are several purpose for this paper. First is to give an overview of hedge fund as an investment vehicle with a short description of different characteristics and styles of hedge funds. Second is to describe why hedge funds are attractive for investors and fund managers by presenting different theories where risk and returns of hedge funds are investigated in order to evaluate the performance measures. Third purpose is to investigate the issues related to the investment in hedge funds where several sets of issues are evaluated and various performance measures are identified.

LITERATURE REVIEW

There is no one particular definition of hedge fund as mentioned earlier. According to the Investment Company Act 1940 of the US, hedge funds were defined by their low degree of regulatory controls. In comparison to mutual funds, hedge funds were seen to have higher level of risk. This led to a 100-investor limit as well as wealth requirement of the investors. Fung and Hsieh (1999) claim that another reason for 100-investor limit is the use of leverage and short selling in hedge funds. The limit restrictions were later abandoned and wealth requirement lowered.

Many definitions of hedge funds have been cited-most of them mainly based on its characteristics. Some of them are:

“Investment companies that by their charter can buy on margin, sell short, hold warrants, convertible securities and commodities and otherwise engage in aggressive trading tactics in order to profit from forcasting market swings.?- Polhman, Ang and Hollinger (1978)

“A mutual fund that employs leverage and uses various techniques of hedging?- Soros (1987)

“hedge funds are vehicles that allow private investors to pool assets to be invested by a fund manager. Unlike mutual funds, hedge funds are commonly structured as private partnerships and thus subject to only minimal SEC regulation. Moreover, because hedge funds are only lightly regulated their managers can pursue investment strategies involving, for example, heavy use if derivatives, short sales and leverage.?- Bodie, Kane and Marcus (2008).

Murguia and Umemoto (2004) claims that the reason why there is no proper definition of hegdge funds is because they are not classified by the different asset classes but by the type of strategies employed by the fund mangers is what classifies them. Such strategies range from very aggressive to conservative, which is the reason why there is no clear definition.

Several studies have been carried out about hedge funds performance and risk issues. Fung and Hsieh (1997a) extend Sharpe (1992) style analysis and conclude that there are more diversified hedge fund strategies and suggested that hedge fund strategies are more dynamic. The literatures also conclude that option-based factors can enhance the power of explaining hedge fund returns. Brown, Goetzmann and Ibbotson (1999) examine the performance of offshore hedge funds and attribute fund performance to style effects rather than managerial skills.

Brown, Goetzmann and Liang (2003) found, in a study using the TASS database, that fund of hedge funds reduce by a third the standard deviation of monthly hedge fund returns, as well as significantly reduce the value at risk of hedge fund investment. Hence, fund of hedge funds can also provide significant diversification potential. A well-diversified fund of hedge fund manager can therefore take advantage of market-specific risks while maintaining low correlations to stock, bond, and currency markets. As a result of which the fund of hedge fund manager can provide superior returns and generate alpha which reflects managerial skills. More generally, since fund of hedge funds deliver more consistent returns with lower volatility than individual hedge funds, they are considered to be ideal for diversifying traditional portfolios. During 1993–2001, fund of hedge funds outperformed the S&P 500 index on a risk-adjusted basis (Gregoriou, 2003a).

Koh, Koh, Lee and Phoon(2004) state that traditional asset allocation optimizes the use of equities, bonds, real estate and private equity to invest in a portfolio that maximizes returns and minimizes the portfolio risk. Thus, hedge funds become vital in enhancing returns in an investment portfolio.

Following the growth in hedge fund industry, fund-of-hedge funds (FOF) have become more and more popular. Liang (2003) states that FOF mixes various strategies and asset classes together and creates more stable long-term investment returns than any of the individual funds. It invests in underlying hedge funds and diversifies the fund specific risks and relieves burdens on investor to select and monitor managers, and providing asset allocation in dynamic market environments. Fund-of-funds require less initial investment as compare to hedge funds and therefore are more affordable for small investors. To participate in the investment, small investors may be willing to pay extra fees as it might be the only way for them.

Previous studies in this area by Brown, Goetzmann and Liang (2002) conclude that combining hedge funds with fund-of-funds not only causes the double counting but also hides the difference in fee structures between hedge funds and fund-of-funds. Liang (2003) state that a hedge funds charges a management fee and incentive fee while a fund-of-funds not only charges these fees at a fund-of-fund level but also passes hedge fund level fees in the form of after fee returns to the fund-of-fund investors whether or not the fund-of-funds make a profit.

Brown, Goetzmann and Liang (2002) examine this issue and propose an alternative fee which provide a better incentive for fund-of-fund managers and reduce the cost for investors under the current fee structure, which is that the fund-of-fund managers absorb the underlying hedge fund fees and establish their own incentive fees at the fund-of-fund level. Liang (2003) conclude that because of the above issues fund-of-funds need to be separated from hedge funds in academic studies and address the difference in performance, risk and fee structures.

However, the FOF mangers can add value to the portfolio through selection, construction and continuous monitoring of the portfolio. They provide professional services and have access to the information that are expensive and difficult to obtain otherwise. The FOF mangers quite often use different investment strategies and styles through a diversified portfolio of individual fund managers. Considering these advantages for an investor, investing in fund of hedge funds is not cheap. The cost can be as high as the cost of buying a building, according to Koh, Koh, Lee and Phoon (2004). This structure allows for more diversified portfolio and much reduced risk at the fund level which comes at a price. More diversified the portfolio is it is more likely that it will incur more incentive fees.

Therefore, there are many persuasive reasons why investing in hedge funds are considered as “alternative investments?. Some uninformed investors may be misled about the risks and returns on hedge funds as it relies heavily on statistical compilation from the database vendors which is filled with data bias such as survivorship bias and selection bias.

Fung and Hsieh (2001a) found that estimates of survivorship biases differed across two commonly used databases, HFR and TASS. The survivorship bias was much higher in TASS than that in HFR. They estimated that survivorship bias would over-report hedge fund mean returns by about 1.5% to 3% per annum.

Brooks and Kat (2001) stated that around 30% of newly established funds do not survive the first three years, primarily due to poor performance. Thus, not including defunct funds is likely to lead to over-estimation of the returns and profile of hedge fund industry.