This action might not be possible to undo. Are you sure you want to continue?
The Hedge Fund Boom
Do hedge funds represent a new paradigm in asset management?
Dissertation presented for Honours Degree in Commerce (2001/2002)
Dr. Peter Moles
Matriculation No. 9810572 Exam No. 1057262
The hedge fund industry is currently attracting a truly booming inflow of capital. Concerns are now being raised in the asset management industry, which is questioning whether hedge funds may become the next bubble. The intention of this paper is to put forward a resolute clarification of this tentative situation in asset management. This paper investigates the hypothesis that hedge funds produce abnormal risk-adjusted returns, and should therefore be inherent part of a portfolio of investments, thus designating a new paradigm in asset management. The analysis employed reviews the relationship between existing performance evidence and actual market conditions. This evaluates if fundamentals reflect the current pattern of investments into hedge funds. This paper presents tangible evidence of hedge funds being a new paradigm in asset management. They consistently produce superior risk adjusted returns compared to other investment classes, and yield significant value when incorporated into a portfolio. There are no indications of these value-adding performance characteristics disappearing in short-term. Furthermore, the notion of the hedge fund bubble is fallacious. Capital allocated into hedge funds far undermines what is anticipated by fundamentals. Consequently, investments in hedge funds reflect economic logic.
This dissertation would not have been possible without the help, support and inspiration from various people and institutions to whom I wish to express my gratitude:
The greatest of thanks and gratitude to my parents, who have provided me with unconditional support throughout.
I wish to express my sincere thanks to Colin McLean and Michael Nicol, Scottish Value Management, for introducing me to hedge funds, and providing me with the opportunity to work with them.
I would like to thank my close friend Nadine Vohrer for her accomplished efforts in proof reading and correcting the dissertation.
I express my sincere thanks to my supervisor Dr. Peter Moles for academic guidance.
Furthermore, I would like to thank Mag. Thomas Klatzer and Mag. Roland Klemm, Merrill Lynch Private Banking, for the opportunity to work for their team and gain resourceful experience. considerately gave me complementary Euromoney Conferences very admittance to a hedge fund
conference, for which I am grateful and express my thanks.
......................................... V 1................... Introduction ..................8 Research collection and methodology ....................4 3........................................................................44 Asset volumes........................................................10 Hedge Funds.......................16 Hedge fund investment strategies ..................................................... measurement.................................................4 6..........46 Key developments .................................................................... 4........................2 3.........................53 Conclusion .......................................................................22 Literature review ........................3 3........................................3 5....................12 Hedge funds in the investment universe ........33 Investing in Hedge Funds ........................2 1...........................................2 2.........................11 Origin of hedge funds................................................................2 4................36 Hedge funds in a portfolio .............................................. 5..........................................9 Limitations of the study ....................44 The European marketplace ..........................................17 Performance ....3 5.....................2 3.........1 1.......1 3.......................65 4 ......................28 Sources of out-performance ..58 Appendix A – Strategy classification ......22 Databases...2.39 Risk management and selection .................................................................3 2...... and research methodologies......................................30 Future out-performance .................................2.............................................. 2..............................41 The Evolution of the Hedge Fund Industry ..............................................................................................................3 2.............50 Future evolution of the hedge funds ....25 Biases in hedge fund databases............................. 6 Objectives and structure of the dissertation..................... V List of tables ....................................................................................................................................................TABLE OF CONTENTS List of figures ................................................1 5..........................................................................................................2 5.................................................................................................. 3................................1 2..63 Appendix B – Regulatory issues ................................56 References .....................3 4..11 Definitions and characteristics of hedge funds ............................................................24 Evidence of out-performance ...................1 4............................................................................................ 1..........................................1 3................36 Alternatives to hedge funds ................2.............
.................64 Degree of regulation of hedge funds in certain countries ............................2 5.1 3........................ individual strategies....................1 2.............1 4.....................LıST OF FıGURES 2............................26 Growth of the global hedge fund universe ........2 5..............................................47 Percentage of European institutions currently investing or considering investing in hedge funds ...........................63 Classification by academics.................................................44 Total number of funds in the industry ............................................ and mutual funds ...........49 LıST OF TABLES 2.......................................45 Growth of the European hedge fund market .................2 B....................................48 European asset management industry rating of the relative importance of hedge funds to profitability now and in three years ..............42 Classification by industry professionals .......1 3........................................................................3 5.1 5 ............................................. bonds.................65 A.......................25 Hedge funds in a portfolio .............1 4.....15 Performance comparison hedge funds/S&P 500 .............................13 US and European definitions...............23 Performance comparison: fund of fund.............48 Main problems cited by European institutions regarding hedge funds ..... equities......2 Definitions and statements..............................2 3................1 A......16 Performance measurements ........6 Universe of investment opportunities....4 5..............37 Process of due diligence/qualitative analysis of hedge fund investment vehicles..........................1 5.......................................................................5 5.....................................
Professional expertise on hedge funds is poor. Hedge funds remained a marginal investment vehicle until the beginning of the 1990s. Hedge fund start-ups are now even commonly closing their funds to new investors prior to the launch due to excessive demand. They can be categorised as an alternative. Contrary to asset classbased long-biased traditional investment funds. Hedge funds address new challenges to financial theory. hedge funds operate in a liberalised and loosely regulated framework. and public knowledge is still extremely limited. focus is on investment strategies. Although grouped under the name “hedge funds”. although significant investments are now placed in them. but academics are perplexed by how and why. and numerous misconceptions about their nature persist. the investment funds are an assortment of very heterogeneous types of alternative investment funds. Dramatic capital inflows have been registered with investment houses and managers. hedge funds are often misunderstood. including leverage. but frighten by their lack of transparency. This is commonly referred to as the “hedge fund puzzle”.1. whilst still continuing and escalating in the international investment management market. especially in the US. which sanctions the diversity. Academics have only recently begun to pay attention to hedge funds. they systematically beat markets and traditional funds from a return-volatility criterion. Hedge funds have existed for over half a century but have only recently attracted significant capital. ıNTRODUCTıON Hedge funds as a type of investment vehicle date back to 1949. The investment strategies employed differ greatly and the managers can utilize the full spectrum of financial instruments. Thus. Compared to traditional funds. Hedge funds fascinate by having superior risk-return yields. 6 . The 1990s observed a real boom in assets allocated into hedge fund was observed. non-traditional investment. In the late 1990s and post millennium this trend became more prevalent in Europe.
An examination of the current hedge fund boom and the underlying reasons. but can also be a new paradigm in investment management. although most of them are increasingly considering investing in hedge funds in the future1. Only 17 % of institutional investors currently invest in hedge funds. Alexander M. “SEC’s Paul Royce Issues a warning About a Hedge Fund Craze”. May 30th. The Economist. June 8th. A growing number of market observers consider the increasing allocation of capital into hedge funds to be a bubble. Bloomberg News. they will answer if the current boom is a bubble. Price Waterhouse Coopers. 9th July. and evaluate if the growth is natural or bubble-theory based. Forbes. “Examining the findings of the 2000/2001 Private Banking Survey: Private Banking and its Changing Approach to Alternative Investments”. September 1st. Authors. experts and analyst predict with rising confidence that the bubble will burst in the near future2. The current hedge fund boom could be a short-lived trend. “The $500 Billion Hedge Fund Folly”. where hedge funds become a natural part of certain investment portfolios. 2001. Financial Times. Drawn from INEICHEN. 1 7 . An outline of the objectives and structure of the dissertation. When under combined scrutiny. presents the means in which this will be achieved. 2001. and the majority opt to delay their hedge fund investments because of uncertainty and lack of credible information. Performance is key in investment management studies. July 23rd. 2001. London. 2001. Furthermore. followed by a description of the research methodology employed. “Hedge Funds May become the Next Investment Bubble” . “The Hedge Fund Bubble”. In the European market-place institutional investors are still sceptical towards hedge funds. The other main element is an examination into the evolution of the hedge fund industry. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. 2001. 2nd Annual Euromoney European Hedge Funds Conference 2001. From presentation by Bruce Weatherill. the core drivers are examined for their role in promoting further growth. Bloomberg News. will answer if the prevailing scepticism towards hedge funds is justified.The analysis will present core drivers behind the evolution. 2 Examples: “Hedge Funds – The latest bubble?”. An answer to this question could be of great assistance to the many asset managers currently considering allocating assets into hedge funds. UBS Warburg. The evaluation of performance/fundamentals is one of two main elements in the analysis. 2001.
2. and to assist professional money managers in current and future asset allocation into this type of investment. The fourth objective is to present an overview of the hedge fund industry. contest the notion that active management does not yield rewards. This gauges the probability of the current boom becoming a bubble. Asset volumes and industry trends. focusing particularly on the European market. market demand and interest. 5. and an outline of the complex investment strategies they employ. Alternatives to hedge funds will be considered and evaluated on performance. and gives insight into the future role of hedge funds in investment management. will look at whether performance will persist in other than the current market conditions. The fifth objective is to assess if hedge funds have the ability to provide added value to investors. An investigation into the sources of the returns. The first objective is to introduce the nature of hedge fund. The third objective is to examine how to invest in hedge funds and make efficient use of them in a portfolio of investments. their characteristics. 1. and their use in investment portfolios. 3. Fund selection and riskmanagement are highlighted due to their paramount importance in the investment process. and their ability to do so in the future. This will examine if hedge funds are providing superior risk-adjusted returns. and hence. and the future perseverance of these sources. 8 . The second objective is to critically evaluate the academic literature on the performance of hedge funds.1 OBJECTıVES AND STRUCTURE OF THE DıSSERTATıON The overall objective of the dissertation is to evaluate hedge funds’ position in investment management and portfolios. 4. and key developments will be comprehensively considered in order to evaluate the future outlook for hedge funds.1. This includes a review of definitions and descriptions of hedge funds found in literature.
and in many instances they can be misleading. The research methods included: collecting information from articles. and the information distributed was valuable to the research. Papers on hedge funds are published in journals that are difficult to access for undergraduate students. The author did however gain a complementary place. was collected through a lengthy period of rigorous research. and they are exclusive and expensive. There are a number of sites dedicated to hedge funds.2 RESEARCH COLLECTıON AND METHODOLOGY This dissertation draws on different sources to gather information on the hedge fund universe. as they are specialist journals few universities subscribe to. The author also attended a recognized hedge fund conference. but most are password protected and require individuals to apply for access. Nevertheless. Few articles on hedge funds feature in the popular financial press. and normally they have to be retrieved through international online book merchants. Firstly there is a very limited base of recognised literature on hedge funds. an investment house running a hedge fund. Books on hedge funds are extremely hard to come by in university and national library collections. journals. and working for the private banking division of Merrill Lynch. Informal interviewing of people involved in the industry contributed to the research process. but is priced for the corporate clientele.1. and provided inspiration for the analysis. Some specialist press exists. Some sites are restricted to investment professionals. but the majority also permit academic access. Only a very limited number exist. the author used practical experience gained from working for Scottish Value Management. Notwithstanding the inherent difficulties. Furthermore. Finding information on the subject proved to be very complicated. books and the Internet. this literature is very difficult to obtain. Secondly. the Internet is a good source of information. a major international investment bank. ample information required to comprehensively examine the questions set out in this dissertation. Conferences are still exotic in the context of hedge funds: there are few. 9 .
bearing in mind that all investment portfolios are unique. Other developments in the investment management sector. capital allocation into hedge funds should be judged with respect of the individual portfolio. and prevents public knowledge and academic efforts in the field. These developments are not taken into consideration with the same detail and comprehensiveness as hedge funds. and individual investors have different needs to consider. Investments in individual hedge funds will have very different risk/return patterns from investments in a portfolio of hedge funds. which causes misunderstanding.3 LıMıTATıONS OF THE STUDY Hedge funds can still be considered mysterious and closed natured. but are given reasonable attention. The conclusions therefore only partially apply to investments into individual hedge funds. and seek to assist the average institutional and private investor. There is a general lack of transparency. and therefore has to be closely scrutinised. and certain factors must be highlighted. 10 . Thus.1. The inherent limitation of the study is the difficulty in acquiring information. The information can often be of a misleading and ambiguous nature. might influence the evolution of hedge funds. The conclusions set out in the paper are general. There are an infinite number of factors that influence the development of the hedge fund industry. and in the global markets. which is the context in which this paper considers hedge fund investments. The gathering of information on hedge funds is a formidable task in itself.
hence the name “hedge fund”. 2001. Largely through his own common sense. Quantum. firstly gain a brief insight into the history of hedge funds and how they have evolved. and central to its investment strategy was the hedging of market risk. which eventually was offset by the bust years following the booming late 1960s. etc. he realised that the risk of investing in the market was distinct and separate from the risk inherent in investing in a stock. to understand what hedge funds are and what characterises them. and in sharp contrast to the aggressive strategies employed by well-known global macro funds in the past three decades4. This sparked a rush into hedge funds. Having operated largely in secrecy until then. In doing this he shifted most of his exposure from market timing to stock picking. “Hedge Funds: the courtesans of capitalism”. like George Soros and Michael Steinhart. Secondly. Compared to many of today’s hedge funds. The fund was the first to use short sales. This pioneering insight took academic financial economists several more years to identify and explain3. Jones hoped to eliminate part of the market risk.g. An article published in 1966 shocked the investment community. The investment vehicles used were long and short equities. In 1986 another article reported on Julian Robertson’s exceptional performance as a hedge fund manager. leverage and incentive fees in combination. John Wiley & Sons. By short-selling stocks in addition to holding long positions. Peter. the fund employed a conservative strategy.1 THE ORıGıN OF HEDGE FUNDS The first hedge fund was set up in 1949 by Alfred W. 4 E. The fund had outperformed all the US mutual funds of its time. 11 . Prominent “survivors”. HEDGE FUNDS The objective of this section is to. Chichester. it 3 TEMPLE. Jones.2. LTCM (Long-term capital management). leverage was limited. lead the way in the aftermath. and appreciate the complexity of their nature. the article described Jones’ fund and its superior performance. and could be identified and substantially reduced. Tiger. even more or less eliminated by appropriate hedging. 2.
the definition is a starting point in understanding what hedge funds are and how they operate. This is the core of what distinguishes hedge funds from traditional investment funds. and/or are allowed to go short 3. and is also the main reason they are difficult to define. and/or use significant leverage through borrowing” (Source: Cottier. 12 . hedge 5 WARWICK. clearly understand and monitor. These characteristics are generally determined and evaluated in discord to mutual funds5. In the following years the hedge fund industry entered a more mature stage. John Wiley and Sons. There are great variations in the market for hedge funds. clear and differentiating statement. the nature of hedge funds is infinitely more complicated. Ben. 2000) Although this is perhaps the best definition of a hedge fund. but nonetheless saw an exceptional rise in asset volumes throughout the 1990s. Circumventing aspects of local investment regulations. they are often not required to register with market securities agencies.lead to a renewed interest in hedge funds. Since hedge funds are private investment companies or partnerships that are formed by a limited number of investors and primarily are located offshore. A general. “Searching for Alpha – The Quest for Exceptional Investment Performance”. albeit all-encompassing definition employed frequently by the industry is: “All forms of investment funds. Nevertheless. 2000. use derivatives for directional investing 2. In contrast to unit trusts. and perceptions of hedge funds are unclear and mixed.2 DEFıNıTıON AND CHARACTERıSTıCS OF HEDGE FUNDS In literature hedge funds are often defined by an enumeration of typical characteristics rather than a defining. 2. hedge funds are less regulated and constrained in business activities and investing. companies and private partnerships that 1. New York.
2000) A hedge fund is an investment structure for managing a private. It is usually based offshore and the manager is reimbursed through an incentive fee. 3rd Edition. (SCHNEEWIES. (Source: Merrill Lynch. Many hedge funds have exploited this by using a free choice of asset classes. MLIM Alternative Investment Group. Prentice Hall London. While most hedge funds primarily invest in the debt and equities markets.) than conventional money management. (Source: CHANDLER. they have the potential to profit in any market. Common to most hedge funds is the use of leverage and both long and short positions. “Hedge Funds and Managed Futures”. some may also take significant positions in the currency and commodities markets. Hence. 2nd Edition. directional equity. use derivatives. monthly performance. used by IMF in. (Source: DUNMIRE. long only. “Background Note on the Hedge Fund Industry”. Beverly. Because hedge funds are able to take short positions. encompasses a wide variety of skill-based investment strategies such as fixed income arbitrage. Return Enhancers or Both? Isenberg School of Management & University of Massachusetts. hedging. 2000. money management …It encompasses a greater variety of investment instruments (options and futures) and a greater variety of investment techniques (short selling. Thomas & SPURGIN Richard. “Hedge Funds: Portfolio Diversifiers. Bern. Verlag Paul Haupt. 2000) Hedge fund – An absolute return investment fund designed to invest in a wide range of instruments in order to achieve a high return for a given level of risk. asset size or 13 . etc. Table 2. arbitrage. hedge funds are run as small financial boutiques and have therefore enjoyed less internal corporate constraints in investing. administered by professional investment managers. Financial Stability Forum. adapting to current market conditions and using the freedom to their advantage. including one characterised by sharply declining market. 2002.g. and not widely available to the public. loosely regulated investment pool that can invest in both cash (physical securities) and derivative markets on a leveraged basis. international markets and trading styles. global macro. risk arbitrage. “Assessing the risks of hedge fund investing. event-driven. “Investing with the Hedge Fund Giants”. 1999. e. (Source: Report of the US President’s Working Group on Financial Markets. they can go short. convertible bond arbitrage.1 Definitions and Statements The term “hedge fund” typically refers to “ any pooled investment vehicle that is privately organised. in COTTIER. They are mostly sold on a private basis and are free from the obligation to release even the most basic data. and emerging markets.) Hedge funds are considered “alternative” investments since they employ an investment strategy that differs from conventional. hedged equity. 2001.) Hedge funds – usually structured as private placements.funds are by definition not restricted to one asset class or one financial instrument. Philipp. Michael E.) Traditionally. currencies and employ leverage.
Multi manager fund of funds usually charge less. Investors in hedge funds are primarily high net worth individuals. 6 Commonly management fee rates are between 1% and 1. and 15-25 % for the performance fee. hurdle rate7. a performance oriented incentive fee is commonly charged in addition to a flat administration fee6.g. Hedge fund indices have now been created. Two other features are also very important characteristics of hedge funds. rather than performance related to a benchmark or reference index. 64 % of hedge funds have a high water mark and 17% have a hurdle rate. 64 % of single manager hedge funds charge performance fee of 20% or more. but institutional investors are increasingly allocating assets in hedge fund. e. 7 According to Van Hedge Fund Advisors. 8 TEMPLE. alpha. complicating studies of the hedge fund universe. According to the TASS database. “Hedge Funds: the courtesans of capitalism”. not only for the individual fund. 14 . 2001. Chichester. For regulatory and administrative reasons the minimum investment required is often high. A high watermark is often applied to this incentive fee.5%. John Wiley & Sons. To promote the funds credibility the manager usually also allocates a high proportion of his own capital into the hedge fund. hedge funds are marketed as being oriented towards absolute performance. Firstly. The hedge fund industry has constantly recruited arguably some of the best and most talented investment managers in the business8. distinguishing them from traditional funds. and infrequent subscription and redemption possibilities with long notification periods have become an industry norm. These data are often disclosed exclusively to existing investors and therefore poses severe limits to transparency. They are drawn by the substantial rewards hedge funds can offer through performance incentive fees and could certainly be a factor in explaining why another characteristic of hedge funds are superior risk related returns compared with unit trusts and equity indexes. Secondly. Peter.investment policy. and 51% of the multi manager funds in the same database charge 10% or less. but also for the industry as a whole. and it can be benchmarked to an index such as the UK or US treasury rate. but are still not seen as a benchmark for individual fund performance since managers cannot easily replicate them with a passive strategy.
The increased presence of US investment banks in Europe is one of the driving forces behind this development. Table 2. 15 . equities and money markets. Unlike the US. and would also retain the right to utilize or re-hypothecate the assets of the fund for its own trading purposes. and it is very difficult to clearly distinguish any general differences between European and US hedge funds.2 US and European definitions US Definition In the US hedge funds include any funds that are not conventional funds and which use a strategy or a set of strategies other than investing long in bonds. European Definition European market professionals consider that a hedge fund is any fund which adopts an alternative investment strategy seeking to generate high absolute rate of returns. including a broader category of alternative investments. and have existed in the European market since the 1970s. publication: Basis Point.Hedge funds originated in the US. It is nevertheless apparent that the European market is at an early stage of development compared to the US. there are many hedge funds which do not involve a relationship with a prime broker. No. The hedge fund industry is international by nature. Academics rarely emphasize the cross-Atlantic operational differences. Any collective investment scheme employing asset management strategies which can benefit from rising as well declining market price. 2001) The definition as outlined by Andersen does however ignore recent industry developments. could be qualified as a hedge fund. and the rapid reforms currently observed in the European markets further complicate this matter. but which are considered “hedge funds” as a result of the trading strategies adopted and the financial strategies dealt with by the fund (Source: Andersen. a hedge fund would involve the services of a prime broker which would typically provide trading and custody services to the fund. 9. In Europe it is now the norm for new hedge fund start-ups to employ a prime broker9. European market professionals do however employ the term hedge fund slightly differently than their US counterparts. In its most rigorous definition. but do concentrate on intra European differences in marketing and regulatory environment.
Today.2. 11 INEICHEN. Rao & SZILAGYI. in theory and to some extent in practice. “The Coming Evolution of the Hedge Fund Industry: The Case for Growth and Restructuring”. January 2001. Alexander M. Incorporating alternative investments in a traditional portfolio might reduce the overall volatility as well as offer opportunities for capital appreciation. New York. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. RR Capital Management and KPMG. At the other extreme are index funds. 2001. UBS Warburg. Other alternative investments have also received an increasing share of assets. 1998. Hedge Funds Review. Cover Story.1 The Universe of Investment Opportunities Investment Universe Alternative/Non Traditional Investments Traditional Investments PRIVATE EQUITY/DEBT -VENTURE CAPITAL -REAL ESTATE COMMODITIES HEDGE FUNDS STOCKS BONDS Alternative investment strategies are characterised by their absolute return objectives. Hedge 9 “What do you want from a prime broker?”.3 HEDGE FUNDS ıN THE ıNVESTMENT UNıVERSE Hedge funds are an alternative investment vehicle. London. determined by manager skill. an increasing number of investors are turning to alternative investments to diversify traditionally structured portfolios because of the non-correlation characteristics and potential above-average returns. but hedge funds have arguably seen a more dramatic development in recent years10. Figure 2. RAMA. 10 16 . Absolute return strategies charge high fees and performance is. where margins are low and performance is attributed to the market11. Jerry G.
alpha13. This predicament is further exemplified in Appendix A. Bing. Data providers. and provide reasoning for the classification employed in this paper. A wide variety of hedge fund strategies exists. 2nd Annual European Hedge Funds Conference 2001. An analysis of how one might distinguish the strategies will best explain the rationale behind classification. The investment strategy is the primarily characteristic which distinguishes a hedge fund. The recent high volatility and decreasing returns in traditional investments have further fuelled the interest for alternative investments. reduce risk and enhance returns. Yet investment management industry remains conservative in the volumes of capital placed in alternative investments. Bern. 1999. but is used by hedge funds in marketing.4 HEDGE FUND ıNVESTMENT STRATEGıES There is no accepted norm in classifying the different hedge fund strategies. 17 . “Hedge Funds and Managed Futures”. Erza. and there is a general lack of knowledge and understanding of the investment strategies they employ15. 13 LIANG. “Hedge Funds: “An Industry Overview”. 3rd Edition. Many participants in the industry still seem to be misinformed about the most basic facts on hedge funds. and there is a degree of scepticism towards hedge funds. 2. 2000. hedge funds can diversify a traditional portfolio. Studies on the performance of hedge funds have also shown that hedge funds produce above average returns.funds generally have a low correlation with traditional investments. Winter 2000. Classification of these strategies is not only of importance when conducting performance monitoring and quantitative research. Professional investment advisors do however usually discourage an allocation in excess of 10-15% of a clients’ net worth into alternative investments14. 15 COTTIER. Philipp. industry professionals and academics categorise and divide strategies into their own classifications. “On the Performance of Hedge Funds”. Weatherhead School of Management. like stocks and bonds12. 14 Merrill Lynch International Private Banking/Euromoney. and is an 12 ZASK. Verlag Paul Haupt. Hence. Journal of Alternative Investments.
and hence. Hedge fund managers will often use their own interpretations. Directional strategies are of a more opportunistic nature. By exploiting arbitrage opportunities and structural discrepancies through identifying miss-pricing and market inefficiencies. The four dimensions of hedge fund classification according to the TASS model are. Strategies also vary considerably within these boundaries and a particular strategy can also be played differently to deliver varied levels of market correlation. it is possible to divide strategies into non-directional and directional strategies (Burki.essential issue in the asset allocation process. the manager seeks to capitalise gains while keeping a minimum of market exposure. and hence. In spite of this most investors and hedge fund practitioners would argue that hedge funds have their place in a portfolio to provide returns that have a low correlation with traditional investment. these strategies are more strongly correlated with markets. Their trademark is low correlation with markets. can be used in classification. However. Non-directional strategies are also known as market neutral strategies. it is better to define broader categories. 2000). subdividing strategies further 18 . and hence. but this may not be the true in individual cases. 3) Trading Style. 2) Investment Bias. Typically. 1) Asset Class. Returns are normally more stable and have a very low correlation to the market. more prudent strategies. Directional strategies can also be called market-timing strategies. To illustrate the differences. Hedge funds in general yield returns that have a low correlation with the market. improve the risk/return relationship in a portfolio context. which are employed in this paper. but non-directional strategies can be perceived as less aggressive. Furthermore. returns are more varied and can be sensational. These features are key factors in describing a hedge fund strategy. 4) Geographical Focus. Since there are no industry standards in defining different strategies. and involve the manager timing the market and betting on movements. directional strategies are characterised by being more aggressive. classifying a strategy as directional or non-directional would be far too simple.
g. small or large cap and focus on different regions and sectors.than is presented in this paper. it also covers a multitude of sub strategies which mainly are divided up by their net exposure and geographical focus e. and levels of opportunism vary considerable. 2000). There are a number of different specifications of this general strategy. in essence the strategies are very similar but short positions are taken more to avoid specific risk or to benefit from opportunities. These funds take simultaneously long and short positions for the same amount making their net market exposure zero. rather than solely focusing on eliminating market risk. The most widely used is Equity Market Neutral. The strategies can become much more complicated and sophisticated than exemplified here and may be based on “black box” mathematical systems. Equity Hedge – the strategy employs bottom-up research and seeks to take advantage of undervalued and overvalued securities by taking up long and short positions. from Domestic Long Equity to Emerging Markets. Managers can be net long or short. The most common strategy name is Long/Short Equity. Managers commonly use leverage. This is particularly present in similar market neutral 19 . value or growth. but will also include contributions from academics and other industry professionals presented in Appendix A. The analysis is partially based on Deutsche Bank’s interpretation of the hedge fund universe (Fothergill. Long/short equity should not be confused with market neutral. In a simple form the strategy would involve a long position and a short position in two companies in the same sector within the same region. The manager tries to generate excess returns while eliminating systematic risk. this strategy is also called relative value. shorting the equity less likely perform. The manager seeks to benefit from both alphas created while remaining beta neutral. Market Neutral – Being the prime non-directional strategy.
and policy changes. Global Macro – This flexible strategy employs an opportunistic and speculative top-down approach to investing. Fixed Income Arbitrage. Being the most directional of strategies. and the funds are often highly leveraged. Capital Structure Arbitrage. Global Macro funds were made famous by high profile investors with extraordinary returns. most notably George Soros. currency and equities markets. namely. and takes advantage of market movements through long and short positions. The Distressed Securities strategy is more directional due to the financially unstable nature of the underlying financial instruments employed. Event Driven – This strategy focuses on companies that are involved in special situations. corporate restructuring and bankruptcy. and seek to benefit from overvalued individual companies and bearish markets. A variety of financial instruments. Short Selling – Investment funds that mostly or exclusively use short positions in equity and put derivatives products employ the short selling strategy. They always have a short bias greater than zero. This strategy is called Merger Arbitrage. Derivatives Arbitrage and Equity Index Arbitrage. markets. it can also be one of the riskiest. Managers invest in companies that are involved in these situations. and typically would take a long position in the target and simultaneously short the acquirer in an M&A deal. sectors and trading styles are used. Other sub-strategies include Risk Arbitrage and Multi-Event. Convertible Arbitrage. including M&A.strategies based on arbitrage. Throughout the 20 . but returns are not necessarily strongly correlated with the market. and constitutes that the principle risk factor becomes the deal rather than the market. The investment process is based on macroeconomic analysis and forecasts in global interest rates.
Reports concerning the capital allocation into the various strategies provide inconsistent evidence.217. indexing should provide the best risk adjusted return. SVM) 17 See part 3. This overview provides an introduction to the many different investment strategies employed by hedge fund managers. transparency and easier access comes at a cost. Fund of Funds – This approach involves a hedge fund investing in external hedge funds. hence “closet indexing” (Colin McLean. single or multi-strategy. the strategies are complex and can be difficult to understand. Consequently. but have lately once again emerged as an alternative strategy. but equity hedge being the broadest of strategies.1990s bull market the short sellers almost disappeared. Research has shown that it is virtually impossible to beat the market on a consistent basis. stating that no investors can beat the market without access to superior information. 21 . In the European marketplace varieties of Long/Short Equity investments have attracted the bulk of assets. Replicating an index is a fairly simple investment task. Fund of funds have also developed into a popular way of investing into the hedge fund universe. and additional layers of fees increase the cost of investing. Managers create a diversified portfolio of managers.2. The performance characteristics of the different strategies are presented in figure 3. This technique is based on the theory of efficient markets. MD. due diligence. enhanced liquidity and less risk of default.1. 16 Index investments are investments in funds that try to replicate the market portfolio. is assumed to receive around 50% of capital. and professionals use the index as a benchmark of performance. In sharp contrast to index investing and traditional active management16. to produce consistent returns with a minimum risk. However. Fund of funds provides better access to experienced management. arguably the majority of traditional fund managers that claim to carry out active management therefore employ indexing to a certain extent.
Fortunately. These databases are not comprehensive and may contain a number of biases. and both risk and return must be examined when comparing the performance of hedge funds and other investment vehicles. 20 MAR/Hedge sold database operations to Zurich Capital Markets on March 22. PERFORMANCE Empirical research on hedge funds concentrates on the evaluation of performance. Both elements possess considerably complex characteristics in the context of hedge funds. many funds release monthly data to attract new investors and accommodate existing ones. Nevertheless. 3. Performance is an assessment of the risk/return relationship. “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?”. the database available by subscription covers only 1400. This section reviews the current literature on the performance of hedge funds. Gaurav S & KAT. 22 . 19 TASS/Tremont database in co-operation with Credit Suisse First Boston. with the underlying objective of examining if the current booming inflow of assets into hedge funds can be justified by out-performance. gathering hedge fund performance characteristics is no simple task. 4000 funds. 21 AMIN. Consideration of hedge funds place in a portfolio of investment is also essential in assessing this relationship and will be examined further in Part 4. and are used to calculate hedge fund indices21. they replicate the hedge fund universe to the extent that they can be the basis for empirical studies on performance.3. and MAR/Hedge (1500 funds)20. The performance of hedge funds is measured against traditional benchmarks like the S&P and FTSE. AND RESEARCH METHODOLOGıES With the industry in some respects still in its infancy and under no obligation to disclose results. MEASUREMENT. 2001. 2001. and more innovative benchmarks. mutual fund performance and managed futures investments. Performance depends to a large extent on risk. The Sharpe ratio: (Return-risk free 18 Hedge Fund Research currently monitors approx. The most respected databases are HFR (1400 funds)18.1 DATABASES. Harry M. University of Reading. TASS (2200 funds)19.
1 Performance Measurements Frequently used return measures • • • • • Average rate of return Median rate of return Rolling 12-month rate of return Alpha coefficient Percentile Rank Frequently used risk measures • • • • • • • • • Standard Deviation Shortfall probability Median absolute deviation and semi deviation Market beta Maximum draw-down Ratio of negative V. standard deviation (P. is the most commonly used measure for this relationship. 2000) Other. historic return – risk free rate) / p.a. 22 23 . historic return – risk free rate) / p. semi deviation 3 year average annual performance / (average of the maximum drawdown experienced in each year + 10 %) Geometric annual average/largest drawdown CHANDLER. 2nd Edition.a. differential return.a.rate)/Standard Deviation. and Jensen differential performance22. (P. Beverly. profitable months Leverage Net exposure Coefficient of correlation Risk-Adjusted Performance Measures Sharpe Ratio Semi Sharpe Ratio Sterling Ratio MAR Ratio (Source: Cottier. Prentice Hall London. “Investing with the Hedge Fund Giants”.a. Figure 3. and figure 3. Treynor measure.. less frequently used risk-adjusted ratios include the Sortino ratio.1 presents the most commonly employed. Investors in hedge funds do nevertheless employ a number of measurements in evaluating return and risk. and is essential in the valuation of hedge fund performance since no uniform benchmark exists. P. 2002.
Nonetheless, the asset management industry still has difficulties with finding adequate risk adjusted performance measures. The Sharpe ratio should theoretically be comparable to any traditional or non-traditional investment since it is risk adjusted, but the ratio is based on assumptions; normal distribution of returns and historic standard deviation indicating future risk. The non-traditional universe of investment incorporates specific risk that is not necessarily expressed by the volatility of past returns. These risks are very difficult to measure and include; gap and liquidity risk, market-to-market risk, human risk, change of strategy risk, and size risk. Traditional investments may be exposed to some of these risks, but they may be amplified in the context of hedge funds. Empirical studies on hedge funds often examine investment strategies individually to gain further insight into the characteristics of hedge fund performance. Industry professionals classify their investment strategy when supplying information data to the databases, but hedge funds employ dynamic strategies. However, academics and investors consider this detailed research valuable, especially in the context of practical investing and portfolio construction23.
3.2 LıTERATURE REVıEW
A review of the literature covering the performance of hedge funds is a complex task. Much of the information required to gain a accomplished
understanding remains unavailable, and current literature is often plagued by ambiguity. Studies on hedge funds are consequently ground-breaking and informative at this early stage. Researchers have not yet completely clarified many issues: What drives hedge fund returns? (e.g. What are their risk exposures?) Are these exposures stable over time? How do we measure hedge fund performance? Is there a reliable benchmark model? Do hedge fund managers have skills that are greatly superior to other investment managers? Is performance persistent over time?
Ineichen, Alexander, Head of Derivatives Research, UBS Warburg. From presentation: “New developments in Hedge Fund Research”, given at Euromoney 2nd Annual Hedge Fund Conference, London, October, 2001.
How can biases in databases be accounted for? Nonetheless, a comprehensive investigation into these issues is beyond the scope of this paper. Current literature does give some indications to the answers of these questions, but further research remains a necessity for a more accomplished understanding. In their quest to answer the “hedge fund puzzle” of abnormal returns academics are arguing towards conclusions that are wide ranging and pioneering in the field of finance. Nevertheless, the empirical evidence currently available is ample to answer the queries raised in this paper.
3.2.1 EVıDENCE OF OUT-PERFORMANCE
The outright performance of hedge funds has been under great scrutiny by academics. Empirical research has resolutely concluded that hedge funds do provide superior risk-adjusted returns to the S&P and FTSE indices24. Table 3.1 presents a performance comparison of the “average” hedge fund, represented by a Marhedge fund of funds median, and the S&P 500 index.
Table 3.1 Performance Comparison Hedge Funds/S&P 500 Performance Comparison Total Return Compound Annualised Return Annualised Standard Deviation Sharpe Ratio Reward to Risk Ratio Profit Factor Average Monthly Return Best Month % of (+) Months Average (+) Months Average (-) Months Annualised Standard Deviation Maximum Drawdown (Peak to Valley) Average 3 Largest Drawdowns S&P 500 246.50% 11.41% 14.27% 0.45 0.48 1.70 0.99% 11.16% 64.59% 3.38% -3.36% 9.56% 23.55% -18.32% Marhedge Fund of Funds Median 221.80% 10.70% 4.61% 1.24 1.52 5.79 0.86% 4.50% 81.88% 1.28% -1.03% 4.58% 7.04% -4.79%
(For period 1990 – June 2001. Data sources: Bloomberg and Zurich Capital Markets, 2001, reproduced from www.marhedge.com)
RAMA, Rao & SZILAGYI, Jerry G, “The Coming Evolution of the Hedge Fund Industry: The Case for Growth and Restructuring”, RR Capital Management and KPMG, New York, 1998. Studies included: Hennesee (1994), Brown and Goetzman (1995), Fung and Hsieh (1997), Van (1996), and Scholl (1996)
A recognised study by Cottier25 found that single manager hedge funds posted returns of 17.86% p.a. with a volatility of 9.81%. Hedge funds outperformed managed futures on a risk-adjusted basis, and outperformed both mutual funds and traditional investments on both return and risk adjusted performance during the sample period. The study further showed that infrequent redemption
possibilities and high incentive fees have a positive effect on performance26. Figure 3.2 shows how the performance of a fund of funds index, and the performance of different hedge fund strategies, compares to equity, bond, and mutual fund returns. Hedge funds clearly produce superior risk-adjusted returns. This is amplified in a fund of funds context, which have bond levels of risk, whist still yielding 15% p.a.
Figure 3.2 Performance Comparison: Fund of funds, Individual Strategies, Bonds, Equities, and Mutual Funds.
25 20 Returns % 15 10 5 0 0 -5 Volatility (%/Std. Dev.) 5 10 15 20 25 EACM HF index Relative Value Event Driven Equity Hedge Global Macro Short Sellers Bonds S&P Composite Mutual Funds
(Source: From data presented in; FOTHERGILL, Martin & COKE, Carolyn, “Funds of Hedge Funds: An Introduction to Multi-manager Funds”, Deutsche Bank, London, 2000. EACM 100 index is a arbitrary constructed index compromising different strategies to resemble a fund of funds.)
COTTIER, Philipp, “Hedge Funds and Managed Futures”, 3rd Edition, Verlag Paul Haupt, Bern, 2000.
The Case for Hedge Funds”. funds with high watermark incentive structures significantly outperformed those without. 1999. but they examined multi period persistence of returns. and that fund age is negatively correlated to performance. This is further supported by a study by Agarwal and Naik29. high minimum investment. arguing that hedge funds follow dynamic trading strategies rather than buy-hold strategies. Vol. 1997a.2 for explanation of the survivorship bias. Vol. The study furthermore notes that fund size and lockup periods are positively related to performance. The first study found some degree of persistence. No. 27 LIANG. 29 AGERWAL. Bing. Style and Performance Persistence of Hedge Funds”. 10. August 2000. Vikas & NAIK. “Multi Period Performance Persistence of Hedge Funds”. The Review of Financial Studies. These studies were not corrected for any biases. had any positive effect on performance. nor size or age of fund. but 26 There was no convincing evidence that high manager investment in own fund. Narayan Y. 27 . 35. “Empirical Characteristics of Dynamic Trading Strategies. Vol. Vikas & NAIK. 32 AGERWAL. The second study further examined this relationship. 1999. He also concludes that hedge funds have relatively low correlation with traditional asset classes. but argues that this is rather due to losers remaining losers more than winners remaining winners.a. and found that persistence exists in the short term. Financial Analysts Journal. offshore domicile. Agarwal and Naik31 find significant positive alphas for 10 out of 10 different hedge fund strategy indices. Reward. conforming to the pioneering work by Fung and Hsieh28 that concluded that dynamic trading creates option like return payoffs which differ from traditional investments. 4. 3. 2000a. Weatherhead School of Management. Narayan Y. ranging from 6. Journal of Financial and Quantitative Analysis.12% p. Vol.Liang’s27 study finds abnormal returns for 7 out of 16 hedge fund strategies with out-performance ranging from 7. “Performance Evaluation of Hedge Funds with Optionbased and Buy-and Hold Strategies”. Working Paper.36% to 15% p. 30 See section 3. 2000b. In a subsequent paper they find abnormal returns for 7 of 10 strategies32. 31 AGERWAL. Liang concludes that the abnormal performance by hedge funds cannot be explained by survivorship bias30. 28 FUNG.2. and consequently out-performs. the average hedge fund offers higher Sharpe ratios and better manager skills than mutual funds. Whilst he does not find significant out-performance for the remaining strategies. Journal of Alternative Investments. No. “On the Performance of Hedge Funds”. William & HSIEH.a. No. Narayan Y. 55.. 2. “On taking the Alternative Route: Risk. Moreover. 2. 4. Vikas & NAIK. David A. No.68% to 15.
they examine whether manager skill can be explained by fundamental fund characteristics such as incentive fees. JPMorgan Chase Securities & Colombia University. Moreover. hedge funds are less correlated. management fees. but questions that it may subsist a selection bias in the performance measure.96% to 28. employing all common measures of risk.decreases in the long term. Franklin R. City University of New York & Colombia University. There are no recognised studies that do not find hedge funds to significantly out-performs traditional investments and commodity funds/managed futures on a risk-adjusted basis. 28 . The study corrected for survivorship bias and instant history bias. In addition. 2000. Databases are not representative of the whole hedge fund population. They find that commodity funds are less correlated to the market than the average hedge fund. 3. In bull markets. and was less evident in a multi period framework. Caglayan and Edwards33 found average out-performance ranging from 12. Working Paper. size or age of fund.2. In another study they examine hedge fund and commodity fund performance in bull and bear markets34. May 2001. for a selection of investment strategies. and therefore biases can exist. 34 CAGLAYAN. Working Paper. some academics have questioned the studies.56% p.2 BıASES ıN HEDGE FUND DATABASES Biases are a central issue in hedge fund research.a. due to the ambiguity of the data employed. “Hedge Fund and commodity Fund Investment Styles in Bull and Bear Markets”. and returns far exceed the market and the performance of commodity funds. They find that only high incentive fees have a positive relation to performance. hedge funds are found not to be negatively correlated in bear markets. The widely acknowledged conclusion is that hedge funds do generate alpha by achieving superior returns without being exposed to higher levels risk. Mustafa O & EDWARDS. “Hedge Fund Performance and Manager Skill”. but do significantly beat the market. It does not seem to be related to hedge fund strategies. However. 33 CAGLAYAN. Mustafa O & EDWARDS. Franklin R.
Fund and Hsieh35 show that the construction of hedge fund indices or portfolios may face four potential sources of biases. Weatherhead School of Management. not all hedge funds report data to the vendors. and it remains the manager’s choice to do so. As explained above. Bing. Journal of Financial and Quantitative Analysis. selection bias. Forthcoming Journal of Financial and Quantitative Analysis. Liang36 estimates the bias to be 2%. Some performance studies have incorporated this bias. and future studies should certainly take it into consideration. whilst on the other hand they might have reached their critical size37 and do not need to attract new investors. and multi-sampling bias. “Hedge Funds: The Living and the Dead”. David A. No. 10. instant history bias. for hedge funds. Instant history basis (or back filling bias). survivorship bias. Vol. the database is not representative of the whole population. 36 LIANG. Consequently. Current Version 2000. Fung and Hsieh estimate that these two opposite effects may result in a negligible bias38. The databases only provide information on funds that are currently operational.a. Fung and Hsieh estimate survivorship bias to be 3% p. The return an investor who would have invested in all of the funds available at the beginning of the period will therefore not reflect the true return. The exclusion of dead funds when computing the returns of a portfolio or index of funds biases upward performance measurement. “Performance Characteristics of Hedge Fund and CTA Funds: Natural Versus Spurious Biases”. 37 Hedge funds normally close for new investors at a certain asset volume under management. William & HSIEH. Selection bias.. Managers find it easier to market themselves with good performance and may be induced to cheat by reporting better performance during the incubation period. 3. They provide estimations for these using the TASS database. 2000. 29 . On the one side it is expected that hedge fund managers with good performance would want to be in the database. Survivorship bias. Before reporting to a vendor a fund manager undergoes an incubation period in which they trade with their own money. Estimates of this bias by Fung and 35 FUNG. in order to back-fill the database with historical returns. noting that poor performance is the main reason for a funds disappearance.
Journal of Financial and Quantitative Analysis. excluding and including incubation period. might discard the shorter time-series hedge fund returns commonly have. It does however point out that empirical long-term performance studies on hedge funds are difficult to conduct. Michael. The key to the hedge fund puzzle might be that in comparison to traditional investments these sources do not necessarily increase the risk. The bias was found to be 1. (Managing Director. 30 .4% p. “Hedge Fund Returns and their Drivers”. “Performance Characteristics of Hedge Fund and CTA Funds: Natural Versus Spurious Biases”. A study of hedge fund performance over the longterm. Valentin & LARQUE Rudolphe. Crossborder Capital Ltd. Vol. David A. No. Although these biases exist. and introduce possible biases. but it has been argued that hedge funds have return patterns that are more option like than traditional investments. and might induce academics to rethink the notion of risk. Academics have now largely moved on to examining the sources of out-performance. Fung and Hsieh estimate that this bias is very small. This remains a puzzle for academics. hence.2. for hedge funds.Hsieh were calculated by computing the difference between returns. hedge funds inherently generate risk-adjusted 38 FUNG. This bias might be related to the superior performance of younger funds argued by Howell39. 3. performance studies on hedge funds can not be disregarded. if it exists. 3. Multi period sampling bias. There are ambiguity issues related to the individual studies.a.) 40 BURKI. “The Young Ones”. June 2001. 10. AIMA newsletter.. market player rationality and other key assumptions in financial theory40. 2000. There has been considerably less research dedicated to the sources of out-performance than performance itself. they show abnormal returns for hedge funds even when accommodating for biases.3 SOURCES OF OUT-PERFORMANCE Academics have been unsuccessful in developing a financial model that can reliably explain the risk/return relationship seen in hedge funds. William & HSIEH. 39 HOWELL. Ecole des HCE. but the general assumption is clear. University of Lausanne 2001.
Conversely Cottier argues that the enormous flexibility regarding asset classes. Liang attributes the superior performance to effective incentive schemes. trading styles. 2) As the risk adjusted out-performance. instruments. the flexibility gained by the hedge fund structure must be managed. These include. superior management skills in hedge funds should therefore not be ignored as an important source of performance. He argues that the term alpha is used in two circumstances by industry professionals. or high minimum investments. UBS Warburg. In the absence of financial modelling there is a need to approach this analysis on a qualitative basis. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. 2000. This would challenge well-established theories of finance. 41 SCHNEEWIES. He finds empirical evidence linking high incentive fees and infrequent redemption to superior performance. 43 INEICHEN. He does not emphasise manager skill as a driver. Bern. Alpha. Philipp. 2001. he points out that high fees. Alexander M. Furthermore. dynamic and flexible trading schemes.alpha41. hedge fund managers have to be outstanding in their professional expertise. premiums. However. and academia is divided on this issue. offshore domicile. low liquidity. incentive fees. London. and the various financial instruments employed by hedge funds. probably is the predominant factor in explaining the abnormal returns. 3rd Edition. and it is a well known fact that investment banks are loosing their best traders and fund managers to the hedge fund industry42. markets. Verlag Paul Haupt. Thus. “Alpha. The hedge fund manger’s role as risk managers is amplified and skill is an important element of success43. It is widely agreed in the professional investment community that hedge fund managers are superior. transaction costs and sales commissions can work against high returns. Thomas. 31 . “Hedge Funds and Managed Futures”. Whose got the Alpha?”. To exploit these flexible investment criteria. Working Paper. 42 COTTIER. 1999. and certainly in the context of risk management. 1) As the return over a specified index benchmark. Isenberg School of Management & University of Massachusetts. Cottier argues that hedge funds have specific characteristics that can account for superior performance. and investment bias.
Hedge funds are drawing the top talent from proprietary desks. They now represent a component of the inherent return in hedge funds. “Hedge Funds: “An Industry Overview”. Lehman Brothers Inc. Hedge funds mainly invest in highly specialised areas which require expertise and substantial research infrastructure. Winter 2000. specialist knowledge combined with the trading advantages outlined above can be an influential criterion for out-performance46. The relative size of the fund can be an advantage as well. TASS investment research presented a comprehensive outline of “why hedge funds make money”. thereby exploiting their size. Some of the most talented individuals have left the investment banks to started their own funds. While the hedge fund structure is relatively new. large financial institutions were the only organisations with the infrastructure to carry out the strategies. London.A study by Tremont and its subsidiary. “Alpha transfer: Optimising the Benefit of Active Management”. superior market access. transferring this profitable activity to hedge funds. Historically. make it economically possible for the funds to develop some type of investment edge45.g. which may charge 60 to 100 basis points. “The Case for Hedge Funds”. These include. as well as structural and statutory benefits. their source of superior performance44. This specialist edge can be exploited. Erza. 46 ZASK. Journal of Alternative Investments. 32 . the investment activities conducted within hedge funds are not. e. These operations in investment banks can be highly profitable. Andrew R. first call on breaking news. and the banks are developing more towards being providers of instruments and leverage. There has been a tendency to outsourcing of proprietary trading. whether 44 TREMONT PARTNERS & TASS INVESTMENT RESEARCH. Financial institutions have for decades been granted “unfair” trading advantage that arguably give inherent return in proprietary trading. 2000. London & New York. but also very risky. reduced transaction costs. but this does not mean that all specialists are profitable. The higher fees in comparison to a traditional actively managed fund. Hedge funds dynamically change investment strategies to adapt to change. itself a profitable activity and less risky than proprietary trading. and the proprietary desk was very much at the top of the career ladder for a trader. 2000. Nevertheless. 45 HARMSTONE.
The regulatory network is not predicted to change in any way that will infringe on hedge funds’ ability to trade freely48. John Wiley and Sons. performance based compensation arguably creates positive manager selection. there is some concern that the performance of hedge funds might suffer in the light of increased asset allocation. and point out that there are a limited number of people in the 47 TREMONT PARTNERS & TASS INVESTMENT RESEARCH. New York.3 FUTURE PERFORMANCE Most sources of out-performance expected to remain static. “Searching for Alpha – The Quest for Exceptional Investment Performance”. “The Case for Hedge Funds”. while investment banks more often chose to be the providers rather than the players. Most industry professionals argue that proprietary trading and hedge fund management requires special skills. Empirical studies have found high incentive fees to been related to performance. when other participants can’t or chose not to trade. creating a positive agency effect. Hedge funds are among investment banks’ most profitable clients. Ben. 3. This further amplifies the “Darwinian model”. both on a financial and emotional scale. 33 . e. Only managers with established industry pedigrees have the credibility to raise initial assets and only managers who continue to deliver compelling net returns will keep or receive more capital. However. and therefore usually benefit from superior service to other clients.g. The study further argues that hedge funds make money in areas where “money is left on the table”. For the hedge fund industry as a whole. or must be on the other side of the transaction. 2000.small or large. whereas a large fund may get exceptionally low transaction costs in the macroeconomic market. a small fund is able to capture small market movements in a specialist market. Managers are more personally involved in the business. London & New York. making it stronger in hedge funds than in the financial institutions that their trading strategies emerged from47. 48 WARWICK. The inherent return has been transferred from investment banks to hedge funds. 2000.
With more capital chasing this source of revenue. New York. Journal of Alternative Investments. Harvard University and Northwestern University. 2000. Erza. 52 Actively managed institutional investment funds are often bound by contract to perform better or equal to the index. “Limited Arbitrage in Equity Markets”.business with adequate skills to succeed in this competitive environment49. It is obvious that there is not an infinite capacity for hedge funds in the financial system though. but solid industry credibility is a requirement by investors and hedge funds will continue to recruit only the best and brightest. creating further market inefficiencies hedge funds can exploit in their investment strategies. probably leading to a decline in profits at some stage. Forthcoming Journal of Finance April 2002. The financial rewards of hedge fund management are substantial and might induce more hedge fund start-ups than needed. this means they rather than truly actively managing their funds have to employ “closet-indexing”. Todd & STAFFORD. performance may decline. there should be profit-making opportunities aplenty to support the higher fees charged by hedge funds because there is limited arbitrage in financial markets50. and aspiring industry entrants have improved opportunities to educate themselves in hedge fund management. Hedge fund managers profit on market imperfections. Winter 2000. There is also an increased understanding of hedge funds and their strategies in the investment community. However. and in the near future. positive manager selection should cancel out this effect. Studies on performance from different time periods throughout the expansion of the hedge fund industry have thus far not shown declining profits. If this proves to be correct it might damage overall performance and increase the risk in investing. 50 MITCHELL. and most actively managed funds will now be required to follow the index more stringently than before52. Erik. Unilever’s successful case against Merrill Lynch asset management has sent shock waves through the investment management community. “Hedge Funds: “An Industry Overview”. 51 MORGAN STANLEY DEAN WITTER. Currently. 49 ZASK. 34 . Thus. MSDW predicts a future growth in the supply of these inefficiencies51. “Why Hedge Funds Make Sense”. and out-performance is still very much prevalent. Mark & PULVINO.
Uncertainties concerning the future performance of hedge funds should therefore not be an impediment to further investments. 35 . Part 4 examines hedge funds in portfolio context.Should there be a future decline in the profitability of hedge funds it will not be a dramatic event. and evaluates possible alternatives to hedge funds. It will provide further evidence on the performance efficiency of hedge fund investments. Essentially. the analysis will stipulate how an investor can best capture the performance advantages of hedge funds established in part 3. and will also review some of the important practical issues in hedge fund investment. Hedge funds continue to produce superior risk-adjusted returns and do have generous leeway in comparison to traditional investments.
Alternatives to hedge funds in a portfolio will be examined. Even a portfolio of hedge funds would probably not be the optimal investment. Investing in a portfolio of hedge funds would. and this will be of further assistance when evaluating the future of the hedge fund industry. to evaluate how to best utilize and capture the performance patterns shown by hedge funds. Moving on from the previous chapter. Asset managers have found that a portfolio of no more than 20 funds can replicate a 36 . and the capital committed would have to be substantial due to minimum investment requirements. In practice the preferred vehicle to gain this exposure is a fund of funds. Hedge funds are rarely used as a stand-alone investment.4. in exchange for higher returns. in theory. a stand-alone investment in a hedge fund would most certainly not be efficient.1. this chapter examines how hedge funds can best be used in a portfolio. Although it makes an interesting prospect to be fully invested in a diversified portfolio of hedge funds from an absolute return perspective. As a result. HEDGE FUNDS ıN A PORTFOLıO Drawing on modern portfolio theory. ıNVESTıNG ıN HEDGE FUNDS When investing. Some academic research on the efficient level of hedge fund investment has been published. and academics and professional asset managers consent in this matter. This requires the investor to carry out thorough and costly due diligence. the real risk and return benefits of a particular hedge fund has less to do with its own stand-alone performance than how it performs relative to an investor’s existing portfolio. An integral factor in the continued dominance of high net worth investors in the hedge fund industry is their willingness to bear the higher risks associated with investing in individual hedge funds. it is not advisable in practice. an investor constructs a portfolio of investments. be the best exposure to hedge funds. unless it was mixed with other types of investment. 4. This will be used in companion with industry research and opinions.
& FOTHERGILL. 2000.4 7. Academics and investment managers are in widespread agreement on in this matter. “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?”. William & HSIEH.90 8. London.96 6.. and Amin and Kat55 find an efficiency loss of 5.86 7. Other studies support these findings57. 2001. Table 4. 10. 2000) There is a clear pattern of increased performance with the incorporation of hedge funds in a portfolio. Carolyn. 56 The table indicates the effect on performance measurements when a standard pension fund chooses to re-invest 5.54 1.1. 2001.95 10% 13. Adding hedge funds to a portfolio of investments remains the most effective use of the investment vehicle for most investors. “Why Hedge Funds Make Sense”. This does however add another layer of fees on the investor. The broad range 53 Pension Fund 13. Hedge Funds in a Portfolio Hedge Fund allocation/performance56 Average Annual Return (%) Drawdown (%) Standard Deviation (annualised) Semi Deviation (annualised) Sharpe Ratio (annualised) (Source: Tass/Tremont. Fuqua School of Business.1 presents the result of a study by TASS/Tremont where hedge fund index performance was included in a typical pension fund index portfolio. Hedge funds can function simultaneously as return enhancers and risk diversifiers when combined in a portfolio.a.2 8.12 1.92 0.90 5% 13. Martin & COKE.98 5.05 20% 13.41 8. SAIS Group AG. Harry M.71 5. 2000. University of Reading. Switzerland. 37 .52 0.hedge fund index53.17% p. Gaurav S & KAT. 15. Lars. Deutsche Bank. “Funds of Hedge Funds: An Introduction to Multi-manager Funds”. Fung and Hsieh54 even argue that fund of funds should be used for measuring hedge fund performance.3 8. Working Paper. Table 4.5 7.66 6. 55 AMIN. The costly due-diligence process an individual investor would have to undertake would probably cancel out this loss. in comparison with hedge fund indices. Working Paper.28 8.74 1. New York. and 20% of its capital from its standard portfolio into hedge funds. “Benchmarks of Hedge Fund performance: Information Content & Measurement Biases”. Duke University.00 15% 13. and studies suggest that the inclusion of hedge funds has a positive effect on performance. 54 FUNG.1 9.27 6. David A. “The significance of Transparency and Liquidity for Multi-Manager Portfolios of alternative investment strategies”. 2000.99 7.10 From evidence presented in: MORGAN STANLEY DEAN WITTER. 57 JEAGER.
60 RZENPCEYNSKI. Carolyn. 2001. “Why Hedge Funds Make Sense”. University of Reading. Nenbauer and Henry supports that this level of hedge fund investment would suit and enhance portfolios of both risk-averse and risktolerant investors60. “Hedge Funds: Portfolio Diversifiers. and that the addition of hedge funds in a portfolio is a prudent investment strategy. London. 2000. “The significance of Transparency and Liquidity for Multi-Manager Portfolios of alternative investment strategies”. Fund of funds or portfolios of hedge funds can. 2001. 38 . They further argue that hedge funds can sculpt the risk/return profile desired by an investor in ways international diversification historically has been unable to do. 2000. Research carried out by Rzenpceynski. New York. London. Lars. Switzerland. Hedge funds’ main attraction for investors is the weak relationship between hedge fund returns and other asset classes.. in turn. Schneeweis and Spurgin61 argue that each hedge fund strategy must be judged on its own unique relationship with an investor’s portfolio. 61 SCHNEEWIES. AIMA Newsletter. Return Enhancers or Both?. & MORGAN STANLEY DEAN WITTER. Franklin & HENRY. This is a relatively new perspective in the context of hedge funds. 2001. Thomas & SPURGIN Richard. “Funds of Hedge Funds: An Introduction to Multi-manager Funds”. “Adding hedge funds to a traditional asset portfolio: what can we learn?”. SAIS Group AG. Martin & COKE. Deutsche Bank. In doing so they emphasise that individual hedge fund strategies might have different impacts on an investor’s portfolio. and can dramatically improve the efficient frontier. “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?”. John W & Co. Working Paper. return enhancer. 2000. by producing significantly higher returns and substantially reducing risk58.of investment strategies and sectors covered by a portfolio of hedge funds demonstrate very attractive risk/reward characteristics in combination with a traditional portfolio. Gaurav S & KAT. Working Paper. Mark S & NENBAUER. 59 AMIN.. Harry M. Efficient frontier analysis has found the optimal level of hedge fund investment to be between 10 and 20% of capital available for a portfolio59. be heavily weighted in some strategies to suit the requirements of different investors. and that they can be employed by investors to create a desired end-effect. risk reducers and total diversifier. FOTHERGILL. They classify hedge funds on the impact they have on an individual portfolio. For many years high-net-worth individuals primarily 58 JEAGER. Isenberg School of Management & University of Massachusetts.
Forthcoming in Derivatives Strategies. and leveraged buy-outs or re-capitalisations. University of Massachusetts. Working Paper. especially institutional portfolios. “Making Sense of Hedge Fund Returns: What matters and what doesn’t”. As presented above. 2000. growth capital. Verlag Paul Haupt. but are under-performers in most respects compared to hedge funds. Mutual funds are the obvious alternative. turnaround/reorganisation capital. 63 COTTIER. Currently institutional investors are rethinking their approach to hedge funds and discovering them as a very useful and effective investment vehicle. Funds with specific asset allocation and geographical focus can be viewed as alternatives to hedge funds. 64 MARTIN. These funds have also experienced an enormous increase in popularity. but the performance lags far behind that of hedge funds. George. Gaurav S & KAT. but rather emphasising on maximising long-term absolute returns. These features make them more accessible.2 ALTERNATıVES TO HEDGE FUNDS Other investments used for the same purpose include all other alternative investments. shorter lock-up periods. The investment process into mutual funds is often simpler. they are very likely to under-perform in comparison64. 39 . “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?”. Hedge funds gain these uncorrelated returns by not explicitly tracking a particular index. Moreover. Private Equity can also be an investment vehicle designed to diversify and enhance returns. 4.used hedge funds as opportunistic investment vehicles. Philipp. Bern. 2001. which have 62 AMIN. but would not display the same characteristics as a hedge fund portfolio. This may include venture capital. produce lesser returns. and specially constructed traditional investments. and provide poorer downside protection62. Cottier’s and other academic research conforms with this63. “Hedge Funds and Managed Futures”. they are a valuable addition to portfolios. 3rd Edition. Nevertheless. Amin and Kat find that they exhibit a stronger correlation with the traditional portfolio. sometimes employing them in a manner resembling gambling. these strategies can also be employed by hedge funds. University of Reading. with especially good correlation characteristics. 2000. Harry M. with a lower minimum investment. and easier and more frequent redemption.
but private equity is a viable alternative and this investment approach has also attracted an enormous inflow of capital. 66 CAGLAYAN. 2000. are also top performers in bull markets. These strategies. but that the strategies mentioned above possess a superior risk/return relationship while still providing good downside protection. offer 65 COTTIER. principal protected notes. He found that single manager futures funds had higher returns than hedge funds. Cottier65 examined both hedge funds and managed futures. They continue to argue that the primary reason to invest in alternative investments is diversification and downside protection. and index trackers. 3rd Edition. They can be used to create a hedge against stocks. income generating notes. 67 Includes hedging strategies for single stocks. 2000. global macro. but four hedge fund styles. on average. market-neutral. Verlag Paul Haupt. Franklin R. and short selling. but that overall. “Hedge Fund and commodity Fund Investment Styles in Bull and Bear Markets”. multi manager futures funds clearly under-performed compared to single manager funds though. and exhibit similar risk and return patterns. Bern. Mustafa O & EDWARDS. Managed futures are closely related to hedge funds. Structured products67 are specialist investment vehicles that can be used to diversify investors portfolios that have a significant proportion of their wealth tied up in few investments. and that only certain hedge fund strategies can provide this effectively. Caglayan and Edwards66 also found that overall hedge funds out-performed managed futures on a risk-adjusted basis. City University of New York & Colombia University. hedge funds out-performed managed futures on a risk-adjusted basis. Multi manager funds were less volatile than single manager funds for both investment vehicles. Multi manager hedge funds exhibited similar returns to single manager funds. event driven. Commodity funds yield better returns in bear markets and they conclude that.greater trading flexibility. Philipp. except from short selling. A hedge fund portfolio would probably be less exposed to risk and be a more effective way of diversifying. Working Paper. commodity funds may provide better downside protection. also perform well in bear markets. 40 . “Hedge Funds and Managed Futures”.
2. Investing in hedge funds. Hedge fund investment strategies are proprietary by nature. 4. The selection of individual funds and programs is usually based on a thorough quantitative and qualitative analysis. In any case. This will be further examined in part 5. and the enormous flexibility in 68 MERRILL LYNCH/CAP GEMINI ERNST & YOUNG. Structured products are more individually tailored. and the fund managers often resent disclosing information. “World Wealth Report 2001”. even to existing investors. This is especially popular in countries where tax regulation prevent efficient investing in hedge funds. many investors hire hedge fund consultants or invest through multimanager fund vehicles. or due diligence. is extremely important in hedge funds due to their private structure. Qualitative analysis. the selection of a hedge fund investment vehicle is an imperative element of risk management in the investment process. Quantitative analysis uses figures produced in past periods. which in turn has contributed to the industry’s recent success69. “Growth in the Global Hedge Fund Industry and Due Diligence of Offshore Hedge Funds”. which are used in performance measurement methods presented in part 3. and are a minor investment vehicle compared to hedge funds68. Mark-Anthony. 41 . remains very different from investing in traditional investments. By investing blindly an investor can be exposed to great risk.protection with access to volatile markets with a pre-defined risk. but hedge funds can also be incorporated into structured products.3 RıSK MANAGEMENT AND SELECTıON The problem with transparency throughout the hedge fund industry becomes even clearer in the context of the individual fund. and to a certain extent fund of funds. 2001. and the selection process is not an easy task. Nevertheless. Therefore. The near collapse of Long Term Capital Management in 1998 arguably worked as a catalyst for increased disclosure. As an alternative to hedge funds they offer very different return patterns. published 2001 by Merrill Lynch Group International and Cap Gemini Ernst & Young International. Cayman Islands Monetary Authority. this policy is in change throughout the industry. and also help to reduce an investor’s tax burden. 69 McKENZIE.
domicile. total assets under management. size of niche and impact of large money additions. competitors. subscription and redemption frequency and notification periods. memberships. acceptance of new money once capacity is reached.investment strategies and trading. how did risk management work or not work. phone number of management company. possibility of customisation to special investor needs. reporting to database providers. copies of recent broker statements in order to duplicate individual trades and positions. research. contact persons. how did risk management function in function in special market conditions. rising correlations to markets or to other funds/managers in special market conditions. affiliations. average holding periods. brokers used. address. investments based on what kind of data. independent risk control. remuneration and incentive style.2. number and turnover of employees. diversification. changes occurred during the course of the track record. types of orders. General information on specific fund/program: Date of inception. competitive edge and adaptability of traders. current assets under management and growth of these assets. and leverage limits. An outline of the elements of this process that should be considered is presented in Table 4. strengths and weaknesses of strategy. sales commissions and kick-backs. typical investors. Bern. previous employers. investments based on what signals. different funds and programs traded. Conditions: Fee structure. markets and instruments used. sample of reports sent out to clients. custodian. loss. counter parties used. back office infrastructure and systems used. should assist in the evaluation of the hedge fund’s/fund of funds’ relationship with the investors existing portfolio. position. and registrations. Strategy: Investment philosophy. major shareholders. administrator. “Hedge Funds and Managed Futures”.2 Process of Due diligence/Qualitative Analysis of Hedge Fund Investment Vehicles Business information on management company: Name. value-at-risk in specific time periods. trading style. speed of entering and pulling out of positions. auditor. Risk management: Hedging methods. main investment decision process. minimum investment amount required. Verlag Paul Haupt. 3rd Edition. (Source: based on COTTIER. how are/were investors informed. trading experience. Performance data: Monthly return figures since inception. reasons for largest draw-downs and upturns. investment bias. Table 4. any changes in risk management during the course of the track record. round turn brokerage fees. success of strategy dependent on which market conditions. size of positions. structure of organisation. copies of audited performance tables and official tax statements. credit limits with brokers. consistency of strategy. reputation and life style. possibility of overriding these signals. This provides insight into the 42 . but importantly. marking-to-market of illiquid positions. 24 hour monitoring of positions and limits. Philipp. personal assets invested in then fund.) An investment analysis of a fund should not only take into consideration the likelihood of decline or loss of capital due to human and corporate aspects. frequency of communication with investors. Information on key principals and traders: Biographical background. legal actions against one of the principals of the fund in the past. 2000.
and although academic research can present good guidelines. and this in turn maximises the returns gained from money-making efforts. 43 . Proactive buy-side risk management can help minimise losses. This supplements previous parts by reviewing related factors other than fundamentals/performance centred aspects. In hedge fund investment its importance in amplified. MIT Sloan School of Management & AlphaSimplex Group. and associated issues of interest. Lang. June 2001. Part 5 examines hedge funds in a wider context. Gibson is a member of Global Association of Risk Professionals. and a thorough implementation can generate vastly improved risk/adjusted returns71. Working Paper.optimum level of diversification that can be achieved by including hedge funds. Clearly. 71 LO. it has an inherent limited ability to assist the investor in separate investment decisions. it remains a practical task. “Proactive Buy-Side Risk Management”. and should be rigorously employed. “Risk Management for Hedge Funds: Introduction and Overview”. Andrew. W. US. the paper was published on the Hedgeworld database. Yet. Monitoring is important for every investor. selection and risk management in the hedge fund investment processes is arguably closely linked to performance. continuous monitoring is crucial in hedge fund investing. These are interlinked factors in investment. 2001. The underlying flexible corporate structures and the dynamic investment strategies employed create an environment where important changes occur more frequently and quicker than in other investment funds. 70 GIBSON.. represents the second element required to evaluate if the current hedge fund boom has bubble theory characteristics. Mr. but has been re-introduced with more vigour by institutional investors in the hedge fund industry. To summarise. but the asset management industry is leaning towards employing more rigorous risk management processes because of a newfound respect for the value generating effect they yield70. The review of the evolution of the hedge fund industry.
5. attracting further growth in investments. presenting hedge funds in a wider perspective. Hedge Fund Research and Van Hedge Fund Advisors) 44 . Figure 5.5. and outlines future developments that will shape the industry and influence the role of hedge funds in asset management. This section examines the scale of the evolution in the hedge fund industry. significant developments have been taking place in the hedge fund industry. definitive data on the size of the market and number of hedge funds is not readily available. Since 1998. the main drivers and key developments. THE EVOLUTıON OF THE HEDGE FUND ıNDUSTRY The hedge fund industry has experienced a dramatic rise in capital under management in the 1990s.1 ASSET VOLUMES Because of the private nature of hedge funds and regulatory disclosure requirements. The European marketplace is of particular interest due to an arguably young and untapped hedge fund sector. and by comparing these.1 Growth of the Global Hedge Fund Universe 600 500 400 $ bn 300 200 100 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Mondohedge Hedge Fund Research Van Hedge Fund Advisors (Source: Mondohedge. identifying other factors that might influence an investment decision. This complements parts 3 and 4. Hedge fund databases provide estimates though. a reasonably accurate picture of the hedge fund industry can be presented.
April 10. Winter 2000. MondoHedge & Deutsche Bank. 75 TREMONT PARTNERS & TASS INVESTMENT RESEARCH. 74 RAMA. and TASS/Tremont estimates the total number of hedge funds to exceed 6000 in 200175. Hedge Fund Research presents an overview of the developments in the total number of hedge funds. there are other factors driving the increasing numbers of new hedge funds. “Hedge Funds: “An Industry Overview”. 1) There are few regulatory requirements and low start-up 72 73 www. One industry prediction expects these figures to grow to approximately 1.hedegworld. RR Capital Management and KPMG. Figure 5. 76 Tass/Tremont. 2002. Rao & SZILAGYI. Marhedge. capital currently under management by hedge funds is estimated to be between $ 600 and $ 700 billion72. Beyond investment demand though. 2000. 1998. New York. “The Coming Evolution of the Hedge Fund Industry: The Case for Growth and Restructuring”.In 2002. 45 . with about 2000 funds created in the year 2000 alone. their findings largely conform with other industry estimates76.7 trillion by 200573. The number of funds has increased proportionately. The growth in hedge fund capital has far surpassed the growth in equity markets and assets under investment management74. Erza. Journal of Alternative Investments. London & New York.com. Jerry G. ZASK. “The Case for Hedge Funds”.2 Total Number of Funds in the Industry 4500 4000 Number of Funds 3500 3000 2500 2000 1500 1000 500 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 (Source: Hedge Fund Research) An astounding number of funds have been created to meet the increased demand for hedge fund products in the asset management industry.
Carolyn. 77 46 .. “The Global Hedge Fund Industry: Moving into the New Millennium”. which clearly establishes the performance efficiency of hedge fund investment allocation in portfolios. there is certainly an untapped market. “Funds of Hedge Funds: An Introduction to Multi-manager Funds”. The European market is still negligible compared to the US market. published 2001 by Merrill Lynch Group International and Cap Gemini Ernst & Young International.2 THE EUROPEAN MARKETPLACE Since the financial crisis of the late 1990s. which has evolved more rapidly. 2nd Edition. 1999. Arthur Andersen. 78 CHANDLER. Martin & COKE. in: FOTHERGILL. 2002..costs. Prentice Hall London. 82 William Dombrowski. particularly in Europe. MarHedge. Martin & COKE. Sources vary83. there has been a significant expansion in the hedge fund industry. Earlier growth in the European market can largely be attributed to fund of funds. Institutions currently allocate less than 1% of assets into hedge funds80. a fund charging 1% of capital committed plus 20% of gross profits p. but currently the European market is estimated to constitute only around 5 % of the total hedge fund universe. the capital allocated to hedge funds still pales in comparison to the amounts of capital allocated to traditional strategies79. 2000. Carolyn. November 2001. 80 FOTHERGILL. Beverly. would earn more than 5 times the fees for traditional active equity products. 79 ARTHUR ANDERSEN. making barriers to entry trivial. Financial Markets Practice. Research has shown that the European hedge funds are at the leading edge of the industry’s growth82. is very attractive to competent managers78. London. benchmarks. Hedge Fund Research. In the latter half of the 1990s substantial Hedge fund management yields earnings that are vastly superior to traditional active fund management.a. BARRA Inc. The first fund of funds came from Europe in 1969. and high/ultra high net worth investors allocate approximately 4% of their capital into hedge funds81. “Funds of Hedge Funds: An Introduction to Multimanager Funds”. and guidelines. Deutsche Bank. “World Wealth Report 2001”. by Market Practices Group. “An Introduction to Hedge Funds”. Deutsche Bank. From: BARRA ROGERS CASEY. “Investing with the Hedge Fund Giants”. 5. 81 MERRILL LYNCH/CAP GEMINI ERNST & YOUNG. 2) Investment professionals are attracted by the financially rewarding compensation structure common to hedge funds77. 2001. London. When viewed in the light of the findings in parts 3 and 4. 83 Tass/Tremont. 3) The freedom to manage assets without constraints imposed by clients. Arthur Andersen. Nevertheless. 2000. assuming a 5% trading profit.
Figure 5.amounts of European capital was invested in single manager start-ups and existing funds84. Carolyn. 86 Ludgate Communications survey of 100 of the leading European Institutions that collectively control 60% of assets under management in Europe. 2000.3 Growth of the European Hedge Fund Market ($ billion) 35 30 25 20 15 10 5 0 1994 1995 1996 1997 1998 1999 2000 2001 (Source: Fothergill and Coke. 85 COTTIER. Bern. Philipp. This is further examined in Appendix B.300 billion. Different currencies and smaller individual asset management markets are further reasons behind the low levels of hedge fund investments85. Euro 5. “Funds of Hedge Funds: An Introduction to Multimanager Funds”. 47 . 2000) Growth in the European hedge fund market has been inhibited by the complex regulatory environment. Deutsche Bank. 2000. 84 FOTHERGILL. Institutional investors are expected to be the strongest driving force of growth in the European marketplace. 3rd Edition. Verlag Paul Haupt. London. Martin & COKE. “Hedge Funds and Managed Futures”. and capital under management is consequently expected to soar. This will be produce a considerable boost to the European hedge fund industry. The breakdown of corporate barriers in Europe and the introduction of the Euro. A recent survey revealed that 56% of European institutional investors are either currently investing in hedge funds or intend to do so in the future86. which varies between countries. are important elements in the increased growth prospects for hedge funds in European markets. 2000. Deutsche Bank.
5 European Asset Management Industry rating of the relative importance of hedge fund products to profitability now and in three years. Price Waterhouse Coopers. 2000) This considerable institutional interest in hedge funds is to due the increased realisation of the performance enhancing capabilities of hedge funds in a portfolio context. Low Low 10% Medium Not Relevant High Medium 40% (Source: From presentation by Bruce Weatherill. “Examining the findings of the 2000/2001 Private Banking Survey: Private Banking and its Changing Approach to Alternative Investments”. Institutional interest in hedge funds will not only increase the number of investors in hedge funds. but also raise levels of total assets committed. Figure 5.Figure 5.4 Percentage of European Institutions Currently Investing or Considering Investing in Hedge Funds 80 70 60 50 40 30 20 10 0 N et he rla nd s Sc an di na vi a Sw itz er la nd Ita ly G er m an y Fr an ce U K To t Not Relevant 14% High 36% % Currently Investing Considering Investing (Source: Ludgate Communications. 2nd Annual Euromoney European Hedge Funds Conference 2001) al 48 .
Institutional investors’ current reluctance to invest in hedge funds is peculiar. Since 1998 the hedge fund industry has greatly improved measures for transparency and risk control. The industry is however working towards accommodating the particular demands placed by institutional investors. Figure 5. Fund of funds assist in bypassing the stated problems. it remains an area of controversy. IMCA. La La ck of R eg ig D or ul 49 . and ultimately an increase in capital invested.6 Main Problems Cited by European Institutions Regarding Hedge Fund Investing 40 35 30 25 20 15 10 5 0 e es ity an dg ag tro io Fe at em qu Im on le ar Tr La ck of an sp en id cy d e n l is R k C % Li ow h Kn H Po of La ck of ck (Source: Ludgate Communications. An additional underlying factor that may contribute to the continued growth of the European hedge fund sector is the predicted dramatic rise of the European pensions and long-term savings market. Robert I.. Investment Management Consultants Association. 2000) Developments in these problem areas are key to an increased acceptance of hedge funds in the European market. and financial advisors commonly view them as the best way of investing in hedge funds87. September/October 2000. “Fund of Funds: The Right Choice for Your Clients’ Allocation to Hedge Funds”. and an examination of the underlying factors is necessary to understand the future evolution of the hedge fund sector. and although this has contributed to growth. This market controls a dominant 87 ROSENBAUM. which is in the interest of both parties.
and represents a very important market for the hedge fund industry. The investment technology hedge fund managers use has vastly improved and become more attainable. Not only have hedge funds developed in the last few years. other than the obvious performance argument. in a relatively untapped market. 5.3 KEY DEVELOPMENTS This section outlines the key developments in the hedge fund and investment management industries that have driven the increased interest and growth in hedge fund investments. Nicholas Vause. There are large growth prospects driven by solid underlying factors. attracting many new entrants. PWC. 88 PRICE WATERHOUSE COOPERS. including those from outside the traditional financial services industry.proportion of capital under management. 2000. London & New York. This also gives insight into whether hedge funds will have continued success irrespective of market conditions. The fundamental tools of successful hedge fund management have improved. and Travis Baker. An understanding of the evolutionary factors is important when evaluating the future role of hedge funds in portfolio management. and the playing field has consequently been levelled89. certain trends have shaped the evolution of the hedge fund industry. In summary. 2000. by John Hawksworth. A report by PWC predicts an increased annual inflow into EU savings of 200-300 billion euros88. “The European Pensions and Savings Revolution – Our Vision of the Future”. when before they were reserved for large corporate structures. 89 TREMONT PARTNERS & TASS INVESTMENT RESEARCH. “The Case for Hedge Funds”. It further argues that this will greatly affect the investment management sector. David Pettitt. Competitive trading advantage enjoyed by investment banks has therefore been channelled into hedge funds. 50 . the European hedge fund sector is at an early stage of development. Jenny Lee. Advanced computer systems and software are available at lower costs. However. but the asset management industry as a whole is also undergoing reform. Many of the factors are interlinked and it is difficult to distinguish their individual importance.
John Wiley & Sons. and the industry perception of hedge fund returns has been clarified. Increased transparency 90 TEMPLE. This also yields a risk management opportunity. The mythical perception of hedge funds. 51 . contrary to the popular view of hedge funds being very risky investments. but inevitably brought more attention to the transparency problem in hedge funds. This is arguably an important factor contributing to the attractive performance generated by hedge funds. 2001. Winter 1998. Hedge funds have increasingly attracted talent and expertise by recruiting the cream of asset managers and traders from the financial services sector. has only recently been removed92. 91 Performance of hedge funds is comprehensively outlined in Part 3. By displaying low correlation to traditional asset classes they are a valuable addition to investment portfolios. Misconceptions of hedge funds are still prevalent but there is an increased understanding of the risk and return opportunities hedge funds offer. Journal of Alternative Investments. “Dealing with the Myths of Hedge Fund Investments”. “Hedge Funds: the courtesans of capitalism”. Hedge fund managers have generated very attractive risk-adjusted returns for a long time91. Increased knowledge on hedge funds in the investment community has certainly been a contributor to growth. These individuals also bring more credibility to the industry. and channel their previous traditional clients into hedge funds90. 92 SCHNEEWIES. which induced the sector to facilitate for increasingly risk-concerned investors93. Thomas. Hedge funds are now viewed to be an increasingly important alternative source of returns. Academic research is considered to have been a great contribution to the asset management industry’s increased realisation of the performance characteristics of hedge funds. Chichester.The essential prime brokerage services are now well developed and offered by most investment banks. and clichés that have hindered the industry from expanding have been unravelled. Peter. which existed for over half a century. This only caused a temporary outflow of capital from hedge funds. The near collapse of LTCM was a defining moment for hedge funds.
John Wiley and Sons. The asset management industry is therefore leaning towards absolute return objectives to partly eliminate market risk95. 95 INEICHEN. UBS Warburg. Hedge funds partly replicate this progressive view of portfolio management by searching for alpha while managing risk. In conjunction with the increased interest in absolute return strategies. Nevertheless. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. causing portfolio management to mutate into risk management. New York. Philippe. and alpha is becoming more important to investors as market-based investment returns are decreasing96. assets and risk97. e. London. London. Ben.g. “Asset Management Industry: Changing Tides”. 2001. Although there have been developments in transparency. Current market conditions have made investors realise that the phenomenal returns seen in the last two decades cannot continue due to decreasing inflation94. Recent hedge fund start-ups are increasingly employing investment strategies that are more 93 JORION.not only makes for more efficient use of hedge funds in investment portfolios. and are proving increasingly popular. the hedge fund approach is also suited to these market conditions. with a lot of volatility in individual share prices. 2001. “Risk Management Lessons from Long-Term Capital Management”. “Searching for Alpha – The Quest for Exceptional Investment Performance”. 2000. Hedge funds are now perceived to be a more powerful tool in generating alpha. long held methodologies and investment styles are gradually being replaced by more scientific approaches and tools to manage money. Alexander M. Fund of funds can bypass some of the problems related to transparency. 94 FREEMAN & Co LLC. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. New York. 52 . Alexander M. the industry still has a long way to go. but is also an essential criterion for attracting more of the gigantic institutional investment market. 97 INEICHEN. the institutional investment management industry has arguably changed its perception of risk. European Financial Management Journal. 96 WARWICK. There has been a shift in focus from expected return to risk. and would therefore be a natural addition to any portfolio pursuing it. UBS Warburg. September 2000. 2001.
More precise forecasts. “The Global Hedge Fund Industry: Moving into the New Millennium”. Arthur Andersen. and should be able to accommodate for increased capital. but current profit margins for hedge funds are very 98 INEICHEN. 1999. London. although the current climate with investors racing to allocate capital into hedge funds suggests otherwise. other than that the industry will continue to grow. The hedge fund industry is very dynamic and changing constantly. Financial Markets Practice. and remains. UBS Warburg. Marketing of hedge funds has traditionally been. which in turn could influence investment decisions. the channelling and distribution process of hedge funds has become more straightforward. are difficult to make. The institutionalisation of hedge funds is another step in this process. Increasing competition within the sector is a certainty. i. whilst previously the investor had to actively search for hedge funds99. 2001.e. Larger institutions and financial advisors now offer hedge fund products to their clients.4 FUTURE EVOLUTıON OF HEDGE FUNDS There is widespread consent that the hedge fund industry will attract more capital in the future. traditional asset management firms are now buying up hedge funds and larger alternative investment/hedge fund groups are forming. Iain. Competition will be intensified when the industry grows and matures. Alexander M. London. will be substantial. But with an institutional investment industry partly in agreement that hedge funds make sense. by Market Practices Group. and the long-term outlook for hedge funds. AIMA. “Who’s Long? Market Neutral Versus Long/Short Equity”. 99 CULLIN. although the boutique structure is still the most prevalent100. moderately leveraged market neutral and equity long/short funds98. How dramatic this development will be is difficult to gauge. There are major trends that will have an impact on the industry though. complicated. 53 . This could lead to declining fees and profits. 5. especially from institutional investors. but predictions suggest that the inflow of capital. more conservative strategies embracing risk management. November 2001. “SPECIAL REPORT: Marketing Hedge Funds”.suited to this. 100 ARTHUR ANDERSEN.
54 . A growing hedge fund sector will also arguably find it difficult to maintain vastly superior returns. Declining returns may be a reality in the long term.g. 1998. but this is a rather unconvincing proposition. This could lead to an increased polarisation between niche specialists and multimanager structures. asset managers etc. Hedge fund consultants and intermediaries101 with expertise will play an increasingly important role in the distribution of hedge funds. but the implied risks should also decrease through improved risk management techniques. Large progressive asset management groups are establishing their own funds or offering fund of funds. and correlation to traditional assets classes will remain low. RAMA. New York. Industry consolidation will occur to some extent.3 is still in demand and is key to future development. 101 102 Financial advisors. A tougher competitive environment will evolve new investment strategies and increase product innovation. but are also cherished by the industry’s leading professionals103. a division of labour with specialists focusing on trading and fund funds focusing on selection and marketing. as emphasised in part 5. Jerry G. e. RR Capital Management and KPMG.generous. Increased transparency. but will fall short of evolving into a concentrated group of global providers. as is argued by some experts102. Institutional investors will require more customisation. and the hedge fund sector will continue to structure more sophisticated products. At some point transparency could endanger the proprietary nature of the investment strategies though. “The Coming Evolution of the Hedge Fund Industry: The Case for Growth and Restructuring”. where diseconomies of scale can be a greater concern. due to the increased capital exploiting the same niches of market inefficiency. The private “boutique” structures of hedge funds are not only favourable for proprietary investment strategies. As hedge funds grow and gain acceptance. through which they are capturing an increasing market share. regulation might be adapted to better facilitate for investments. but there is arguably a limit to economies of scale in the hedge fund industry. private banks. There are also concerns related to the industry’s ability to recruit enough talented managers to cater for increased capacity. Rao & SZILAGYI.
London. Odey Asset Management. 55 .This could lead to stricter supervision of hedge funds. 103 LATHAM. Euromoney 2nd Annual Hedge Fund Conference. In summary. the future evolution of the hedge fund industry should not hamper the industry’s ability to produce superior risk-adjusted returns to the extent that it should have a deterring influence on an investor’s decision to invest in hedge funds at the present time. The first step could be the establishment of a specific independent regulatory body to make disclosure practices less obscure. but it is ambiguous how welcome this development will be. and hence increased transparency. 2001. October. From presentation: “Established Firms Vs. Mark. Boutique Firms”. but currently this is a long way ahead. Investment Director.
but also refers to the notion of the hedge fund puzzle of abnormal risk-adjusted returns being genuine. but this does not discard the notion of abnormal returns. but rather the opposite. A bubble exists when investors reach a consensus view of increased expected returns and de-emphasise sound research. causing expectations to slowly diverge from fundamentals. The contrary hypothesis would be that the hedge fund boom is a bubble. The risk/return characteristics of hedge funds are unique. and the actual state of the hedge fund industry and the wider investment management industry. hedge funds produce abnormal returns. This paper has provided solid evidence in favour of the rationale of hedge fund investment. In contrast to the traditional view that active management does not yield better performance. This stipulates that theoretically hedge funds should be included in a portfolio of investments.CONCLUSıONS The hypothesis presented in this paper is that hedge funds do represent a new paradigm in asset management. 56 . A clarification of this hypothesis should be of credible assistance for the overwhelming number of investors currently considering investing in hedge funds. Capital allocation into hedge funds falls well short of what fundamentals suggest. and there is significant evidence of outperformance. The risk exposures faced by hedge funds are not comprehensively understood. the paper has examined the relationship between performance-oriented evidence. hence the hedge fund puzzle. and provide reassurance for investors who have capital allocated in hedge funds. The findings are that the current boom does not display the characteristics of a bubble. with the current boom reflecting economic rationale. A bubble will eventually burst when expectations converge with reality. and there are no alternatives that can offer similarly rewarding risk-adjusted returns. Hedge funds do add value. due diligence and logical economic reasoning. The apparent hedge fund boom has been under suspicion of being such an overvalued bubble. To evaluate whether such a bubble exists.
Evidence of the efficient levels of hedge fund investments lying between 10 and 20%. which eventually might have a deterring effect on hedge fund returns.a. they still control only a minute amount of the capital available. and partial capital allocation into hedge funds is a prudent investment approach. There is evidence that fund of funds is a highly efficient vehicle for capturing hedge fund performance. This raises the issue of capacity problems. The current boom is therefore not only a product of current market conditions. but hedge fund performance has been persistent throughout the dramatic expansion seen in the last decade. They can reduce risks to bond levels and while still maintaining steady returns of 10 to 15% p. 57 . Hedge fund consultants and fund funds are intermediaries that provide this service effectively. But there is also evidence that hedge funds were value-adding investments during the strong bull markets of the 1990s. Nevertheless. Although there has been a dramatic inflow of capital into hedge funds. hedge funds do significantly out-perform traditional investments. It is questionable whether this could even occur in the longer term. but represents a newly understood paradigm in investment management. they have such strong performance characteristics that it is certain that their ability to provide value-added will not fade away in the short term. Fund selection and risk management are of great importance. contrasts with institutional investors currently allocating less than 1 %. At this point in time. and could become even more valuable in the event of the predicted further market slowdown occurring. Moreover.Significant non-correlation to traditional investments further enhances their value in a portfolio context. These performance characteristics are especially valuable in current market conditions. This issue remains ambiguous. and the risks associated with holding just one or two funds can be extreme. Hedge fund investments should be considered in the context of a broadly diversified portfolio of funds. The growth prospects are enormous. investors should therefore disregard bubble theory and follow fundamentals.
Working Paper. May 2001. CORNEZ. No. “Deconstructing Structures Products”. “Hedge Funds and Managed Futures”. Contemporary Books. Valentin & LARQUE Rudolphe. 2000b. Sinopia Asset Management. “An Introduction to Hedge Funds”. Bern. Style and Performance Persistence of Hedge Funds”. New York. Gaurav S & KAT. COTTIER. “Investing with the Hedge Fund Giants”. “Hedge Fund Returns and their Drivers”. Arthur Andersen. NYN Stern School of Business and Yale School of Management. Richard A & MYERS. CAGLAYAN. Franklin R. 2002. Rian. Narayan Y. City University of New York & Colombia University. University of Reading.. CAGLAYAN. AGERWAL. August 2000. London. Harry M. 1998. Financial Markets Practice. BARRA Inc. Working Paper. Vikas & NAIK. BREALEY. BOUSSEMA. BROWN Stephen J & GOETZMANN. COLE. Ecole des HCE. 3. Journal of Alternative Investments. 58 . “On taking the Alternative Route: Risk. 2001. Alain & SEQUIER. by Market Practices Group. Reward. Cole Partners LLC. “The Offshore Money Book”. Vol. 2001. “Hedge Fund and commodity Fund Investment Styles in Bull and Bear Markets”. November 2001. Beverly. “Hedge Fund Performance and Manager Skill”. Pierre. “Hedge Fund Performance 1990-2000: Do the Money Machines Really Add Value?”. Master Thesis. 2000. Narayan Y. “Performance Evaluation of Hedge Funds with Option-based and Buy-and Hold Strategies”. Working Paper. Prentice Hall London. AGERWAL. University of Lausanne 2001. Richard G. Vikas & NAIK. William N & IBBOTSON. CHANDLER. “Principles of Corporate Finance”. Stewart C. “The Global Hedge Fund Industry: Moving into the New Millennium”. 2000a. Arnold L. 2. “Offshore Hedge Funds: Survival & Performance 1989-1995”. 2000. AMIN. Working Paper. “Hedge fund Survey Overview”. Vol. “Multi Period Performance Persistence of Hedge Funds”. Working Paper. JPMorgan Chase Securities & Colombia University. 2000. Paris. Journal of Financial and Quantitative Analysis. No. BARRA ROGERS CASEY. 2000. Mustafa O & EDWARDS. Franklin R. 6th Edition. 2nd Edition. 35. BURKI.BıBLıOGRAPHY AGERWAL. Narayan Y. 2001. 4. 3rd Edition. Vikas & NAIK. 2000. Mustafa O & EDWARDS. McGraw Hill. Philipp. 2000. “Transaction Costs and Trading Strategies: An Empirical Analysis on Global Equity Markets”. ARTHUR ANDERSEN. Verlag Paul Haupt. Brad & AKEY. CAPITAL MARKETS RISK ADVISORS Inc. Merian & BUENO.
UBS Warburg. “Proactive Buy-Side Risk Management”. AIMA. The Review of Financial Studies. David A.. Switzerland. JEAGER. FUNG. “Absolute Return Fund Strategies: The Young Ones”. UBS Warburg. VECTOR ASSET MANAGEMENT. 2000. London. No. Robert G. Deutsche Bank. Working Paper. Lang. William & HSIEH. Hedge Funds Review “What do you want from a prime broker?”.. William & HSIEH. FUNG. FUNG. Vol. “Funds of Hedge Funds: An Introduction to Multi-manager Funds”. FUNG. 2000. David A. 2001. Lars. 1999. “Performance Characteristics of Hedge Fund and CTA Funds: Natural Versus Spurious Biases”. William & HSIEH. “Empirical Characteristics of Dynamic Trading Strategies. Alexander M. “Combining Performance and Market Volatility in Portfolio Allocation”. David A. “The significance of Transparency and Liquidity for Multi-Manager Portfolios of alternative investment strategies”. 2001. Financial Stability Forum. New York. London. “Benchmarks of Hedge Fund performance: Information Content & Measurement Biases”. Duke University. INEICHEN. 2001. 59 . Duke University. London. 2. GREEN. Working Paper. “Who’s Long? Market Neutral Versus Long/Short Equity”. Cover Story. 2001. 2001. No. London. Martin & COKE. SAIS Group AG.. 1999. 2000. “Fund of Funds and Absolute Returns”. 3. IAFE.CROSSBOARDER CAPITAL. Gibson is a member of Global Association of Risk Professionals. Fuqua School of Business. “Asset Management Industry: Changing Tides”. “Background Note on the Hedge Fund Industry”. “The Warren Buffet Portfolio: mastering the power of the focus investment strategy”. 2000. 2000. CULLIN. FOTHERGILL. John Wiley & Sons. “Asset based Hedge Fund Styles and Portfolio Diversification”. New York. William & HSIEH. Jacobson Fund Management. INVESTOR RISK COMMITTE. FREEMAN & Co LLC. Journal of Financial and Quantitative Analysis. IMF. “SPECIAL REPORT: Marketing Hedge Funds”. “Hedge Funds: Bubble or New Paradigm? The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management”. Mr. AIMA newsletter 2001. Alexander. Carolyn. 10. “Hedge Fund Disclosure for Institutional Investors”. David A. 10. Fuqua School of Business. London.. London. INEICHEN. 2001. the paper was published on the Hedgeworld database. January 2001. 1997a. 2001. Iain. 2000. The Case for Hedge Funds”. Henry G. DA COSTA. HAGSTROM. GIBSON. Alexander M. Vol.
Mark & PULVINO. HOWELL.. U. “The Truth about Hedge Funds”. Working Paper. No. MERRILL LYNCH/CAP GEMINI ERNST & YOUNG. Francois-Serge. PFPC – Global Fund Services. LOFTHOUSE. Harvard University and Northwestern University. 2001. John Wiley and Sons. SAIS Group AG. Todd & STAFFORD. “The Benefits of alternative investment strategies in the Institutional portfolio”. 2001. “The Young Ones”. Lehman Brothers Inc. Philippe. Forthcoming Journal of Finance April 2002. Michael. Crossborder Capital Ltd. HARMSTONE. Bill. 2001. “Limited Arbitrage in Equity Markets”. LIANG. W. (Managing Director. Joseph G. “Why Hedge Funds Make Sense”. AIMA newsletter. Bing. FAME. University of Massachusetts. 2nd Edition. “Risk Management Lessons from Long-Term Capital Management”. Bloomberg Press. Financial Analysts Journal. “Navigate the Maze of Opportunities”.) KESTIN. MARTIN. 2001. 60 . 2000. “Investment Management”. “Growth in the Global Hedge Fund Industry and Due Diligence of Offshore Hedge Funds”. “Corporate Finance and Investment: Decisions and Strategies”. 1999. “Market Neutral Investing: long/short hedge fund strategies”. LO. George. “Risk Management for Hedge Funds: Introduction and Overview”. 4. “Assessing market risk for hedge funds and hedge fund portfolios”. European Financial Management Journal. “World Wealth Report 2001”. Erik. Princeton. Forthcoming Journal of Financial and Quantitative Analysis. 2000. PIKE. London. 1999. Cayman Islands Monetary Authority. Stephen. US. Current Version 2000. Richard & NEALE. Mark-Anthony. “Hedge Funds: The Living and the Dead”. London. OSTERBERG. 1993. UNION BANCAIRE PRIVEE & THUNDERBIRD. Prentice Hall. 1999. “Alpha transfer: Optimising the Benefit of Active Management”. New York. June 2001. LIANG. Weatherhead School of Management. 2001. Forthcoming in Derivatives Strategies. 2000. Bing. Cleveland. MORGAN STANLEY DEAN WITTER. Federal Reserve Bank of Cleveland. “On the Performance of Hedge Funds”. Andrew. James B. Chichester. McKENZIE.S & Ireland. Switzerland. Ross & JEAGER Lars.JORION. Vol. NICHOLAS. June 2001. 55. “Making Sense of Hedge Fund Returns: What matters and what doesn’t”. Working Paper. 2000. MITCHELL. Research paper 24. MIT Sloan School of Management & AlphaSimplex Group. published 2001 by Merrill Lynch Group International and Cap Gemini Ernst & Young International. September 2000. Weatherhead School of Management. William P & THOMSON. LHABITANT. Andrew R.
PRICE WATERHOUSE COOPERS. Erza. Jenny Lee. SCHNEEWIES. Winter 2000. London & New York. 1993. RUTTERFORD. Clark University. London. 1998. “The Case for Hedge Funds”. TREMONT PARTNERS & TASS INVESTMENT RESEARCH. 2nd Edition. Franklin & HENRY. “Fund of Funds: The Right Choice for Your Clients’ Allocation to Hedge Funds”. SCHNEEWIES. New York. “Hedge Funds: Portfolio Diversifiers. Finance and Development. SCHIENIER. 1996. WATSON WYATT / INDOCAM. “Dealing with the Myths of Hedge Fund Investments”. Richard. ROSS. RAMA. “Hedge Funds: “An Industry Overview”. 2001. Rao & SZILAGYI. John W & Co. AIMA Newsletter. SPURGIN. Whose got the Alpha?”. Nicholas Vause. RZENPCEYNSKI. Chichester. John Wiley and Sons. ZASK. Thomas. London. 2001. Burkhead & LEE. “Searching for Alpha – The Quest for Exceptional Investment Performance”. Journal of Alternative Investments. Isenberg School of Management & University of Massachusetts. RR Capital Management and KPMG. Robert I. Mark S & NENBAUER. Garry G & DREES. 2000. New York. London. 1999. Jerry G. London. by John Hawksworth. 61 . 1999. 2000. and Travis Baker. SCHNEEWIES. September/October 2000. Alpha. McGraw Hill. 2001. Dec. “Alpha. Winter 1998. Thomas & SPURGIN Richard. IMCA. “Introduction to Stock Exchange Investment”. 2000. David Pettitt. Jeanette. Working Paper. Journal of Alternative Investments. WATSON WYATT / INDOCAM. “Corporate Finance”. Randolph W & JAFFE. John Wiley & Sons. ROSENBAUM. Working Paper. Return Enhancers or Both?. Isenberg School of Management & University of Massachusetts. Thomas. “Adding hedge funds to a traditional asset portfolio: what can we learn?”. Working Paper. Peter. 2001. Ben. “Managing Global Finance and Risk”. WARWICK. 4th Edition. “The Coming Evolution of the Hedge Fund Industry: The Case for Growth and Restructuring”.. 2000. 2000. Stephen A & WESTERFIELD. “The European Pensions and Savings Revolution – Our Vision of the Future”. TEMPLE. Investment Management Consultants Association. William. PWC. “Hedge Funds: the courtesans of capitalism”. “Alternative investment review relating to the continental European marketplace”. Jeffrey F. “How to Game Your Sharpe Ratio”. “Alternative investment review relating to the United Kingdom marketplace”. Macmillan.
org http://www.com http://www.hedgefund411.turnkeyhedgefunds.com http://www.com http://www.ıNTERNET RESOURCES http://altinvest.iijai.com http://www.com http://www.com http://www.aima.irr.albourne.hedgefunddynamics.org http://www.com http://www.hfr.hedgefundcity.net http://www.tassman.magnum.hedgefundnews.com http://www.com http://www.parkplace.com 62 .com http://www.planethedgefund.vanhedge.com http://www.com http://www.hedgefundcenter.com http://www.com http://www.hedgeinfo.com http://www.org http://www.com http://www.hedgeworld.e-hedge.plusfunds.village.mondohedge.com http://www.
Included are guides from recognised hedge fund advisories. and portrays the complexity and sophistication of the hedge fund universe. Aggressive growth Distressed securities Emerging markets Funds of funds Income Macro Market neutral .Mortgage backed securities .Distressed securities . an overview with examples of different hedge fund classifications is presented here.Equity index arbitrage . investment companies and academics.Fixed income hedge Market independent .Capital structure arbitrage .Derivatives arbitrage .Fixed income arbitrage .APPENDıX A – STRATEGY CLASSıFıCATıON To illustrate the diversity in hedge fund strategy classification.Index Enhancement RR Capital/KPMG Long/short equity Convertible arbitrage Event driven Equity market neutral Equity trading Global macro Fixed income arbitrage Dedicated short bias Emerging markets Managed futures Fund of funds TASS/Tremont Market neutral Convertible arbitrage Global macro Growth Value Sector Distressed securities Emerging markets Opportunistic Leveraged Bonds Short Only Van Hedge Fund Advisors Inc. but the overview serves to further build an understanding of investment approaches hedge fund managers can employ. There is a confusing array of strategies.Systems trading Market hedged .Merger arbitrage Market neutral .Equity hedge .securities hedging Market timing Opportunistic Several strategies Short selling Special situations Value 63 .Discretionary trading .Convertible bond arbitrage .1 Classification by Industry Professionals Financial Risk Management Ltd. Table A. Market speculating .Long/short equity .arbitrage .
It is questionable if there will ever be one considering. 2) Managers ability to change and drift between strategies.Convertible hedge .Bond hedge Event . Hsien Convertible arbitrage Distressed securities Emerging markets Equity hedge Equity market neutral Equity non-hedge Event driven Fixed income Macro Market timing Merger arbitrage Relative value arbitrage Sector Short Selling Statistical Arbitrage Directional Strategies Macro Long Hedge (long bias) Short A universal classification of hedge fund strategies is far from existing.2 Classification by Academics Phillip Cottier Leveraged long equity Short-only equity Long/short US equity Long/short European equity Long/short global equity Leveraged bond and fixed income arbitrage Mortgage-backed securities arbitrage Convertible bond Distressed securities Emerging markets Macro Currency Multi-strategy Multi-manager Thomas Schneeweis & Richard Spurgin Relative value .Multi-strategy Equity hedge . 4) The lack of a leading hedge fund index. Naik Non-directional Strategies Fixed income arbitrage Event driven Equity hedge Restructuring Event arbitrage Capital structure arbitrage William Fung & David A. 1) The complexity of the strategies.Systematic .Hedged equity . but such is the nature of the industry.Global / international Global .Short Vikas Agerval & Narayan Y. 3) The lack of transparency.Domestic long .Discretionary .Table A. These factors combine to make academic work and performance monitoring difficult.Merger arbitrage . 64 .Bankruptcy .Equity market neutral .
and other countries are represented in this short description of the regulatory environment in important markets.S. but limited Yes. Isle of Man U. a detailed description of the legal and marketing aspects for the selected countries is beyond the scope of this paper. but limited Yes If registered as a mutual fund or as a participation company Yes No (except public futures funds) Yes Not more than 99 sophisticated investors of which 65% must be accredited Unlimited for professional investor funds - Ireland High Yes.1 Degree of regulation of hedge funds in selected countries General flexibility of regulation EC Austria.K Low Medium No Very limited No Authorised unit trusts only Switzerland Medium Yes Luxembourg Channel Islands. Table B. including offshore funds Yes if local management and sufficient disclosure Bermuda High Professional investor funds only - 65 . Germany Japan Very low Very low Hedge fund incorporation Public offering of non-traditional funds No No Private offering of domestic and offshore nontraditional funds Not specified Existing clients only. up to 30 in Germany If registered to qualified institutional investors or up to 50 private investors To existing clients By authorised persons to professionals and existing clients Yes. Presented here is an overview of the degrees of regulation in selected countries. However.APPENDıX B – REGULATORY ıSSUES The European hedge fund industry has been limited in development due to complicated and inflexible regulation. The regulatory environment for the hedge fund industry is very complex and varies greatly from country to country. Medium Medium High Yes. if not on a commercial basis No No Low No No France U. This is very much an international business though.
Verlag Paul Haupt. Bern. Philipp.) 66 . “Hedge Funds and Managed Futures”. Netherlands Antilles British Virgin Islands Very High Yes if very high investment - - Very High No restrictions - - (Source: The overview is based on findings in: COTTIER.Cayman Islands. Bahamas. 3rd Edition. 2000.