Hedge fund
A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments.[1] In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.
Hedge funds are considered
Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the
A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and a performance fee (typically, 20% of the increase in the fund's net asset value during a year).[1] Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the asset management industry,[6] with assets totaling around $3.8 trillion as of 2021.[7] Hedge fund managers can have several billion dollars of assets under management (AUM).
Etymology
The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk.
History
During the US
The sociologist
In the 1970s, hedge funds specialized in a single strategy with most fund managers following the long/short equity model. Many hedge funds closed during the recession of 1969–1970 and the 1973–1974 stock market crash due to heavy losses. They received renewed attention in the late 1980s.[15]
During the 1990s, the number of hedge funds increased significantly with the
During the first decade of the 21st century, hedge funds gained popularity worldwide, and, by 2008, the worldwide hedge fund industry held an estimated US$1.93 trillion in
In June 2011, the hedge fund management firms with the greatest AUM were
In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets under management rising to a record $3.1 trillion.[34]
Notable hedge fund managers
- John Meriwether of Long-Term Capital Management, most successful returns from 27% to 59% through 1993 to 1998 until its collapse and liquidation.
- George Soros of Quantum Group of Funds
- Ray Dalio of Bridgewater Associates, the world's largest hedge fund firm with US$160 billion in assets under management as of 2017[35][36]
- Steve Cohen of Point72 Asset Management, formerly known as founder of SAC Capital Advisors[37][38][39]
- John Paulson of Paulson & Co., whose hedge funds as of December 2015 had $19 billion assets under management[40]
- David Tepper of Appaloosa Management
- Paul Tudor Jones of Tudor Investment Corporation
- Israel Englander of Millennium Management, LLC
- Leon Cooperman of Omega Advisors[45]
- Michael Platt of BlueCrest Capital Management (UK), Europe's third-largest hedge-fund firm[46]
- James Dinan of York Capital Management[47]
- Stephen Mandel of Lone Pine Capital with $26.7 billion under management at end June 2015[48]
- Larry Robbins of Glenview Capital Management with $9.2 billion of assets under management as of July 2014[49]
- Glenn Dubin of Highbridge Capital Management[50][51][52]
- CQS with $14.4 billion of assets under management as of June 2015[58]
- David Einhorn of Greenlight Capital[59][60] as the top 20 billionaire hedge fund managers.[61]
- Bill Ackman of Pershing Square Capital Management LP
- Kenneth Griffin of Citadel with over $62 billion in assets under management as of December 2022.[62][63]
Strategies
Hedge fund strategies are generally classified among four major categories:
The elements contributing to a hedge fund strategy include the hedge fund's approach to the market, the particular instrument use, the
Sometimes hedge fund strategies are described as "absolute return" and are classified as either "market neutral" or "directional". Market neutral funds have less correlation to overall market performance by "neutralizing" the effect of market swings whereas directional funds utilize trends and inconsistencies in the market and have greater exposure to the market's fluctuations.[65][68]
Global macro
Hedge funds using a global macro investing strategy take large
Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments, whereas systematic trading is based on mathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following market trend (long or short-term) or attempts to anticipate and profit from reversals in trends.[67]
Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or sector specialists such as "systematic currency", in which the fund trades in
Directional
Directional investment strategies use market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.[65][68] Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options.
Within directional strategies, there are a number of sub-strategies. "
Event-driven
Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event.
Corporate transactional events generally fit into three categories:
Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share buy backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.[79]
Other event-driven strategies include credit arbitrage strategies, which focus on corporate
Relative value
Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the
- Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
- in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
- Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the corresponding stocks.
- Asset-backed securities (fixed-income asset-backed): fixed income arbitrage strategy using asset-backed securities.
- Credit long/short: the same as long/short equity, but in credit marketsinstead of equity markets.
- Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical modelling techniques
- Volatility arbitrage: exploit the change in volatility, instead of the change in price.
- Yield alternatives: non-fixed income arbitrage strategies based on the yield, instead of the price.
- Regulatory arbitrage: exploit regulatory differences between two or more markets.
- Risk arbitrage: exploit market discrepancies between acquisition price and stock price.
- Value investing: buying securities that appear underpriced by some form of fundamental analysis.
Miscellaneous
In addition to those strategies within the four main categories, there are several strategies that do not entirely fit into these categories.
- Fund of hedge funds(multi-manager): a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
- Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
- Multi-strategy: a hedge fund using a combination of different strategies.
- 130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of 100%.
- Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging.
- AI-driven: using sophisticated machine learning models and sometimes big data.
Risk
For an investor who already holds large quantities of equities and bonds, investment in hedge funds may provide diversification and reduce the overall portfolio risk.[82] Managers of hedge funds often aim to produce returns that are relatively uncorrelated with market indices and are consistent with investors' desired level of risk.[83][84] While hedging can reduce some risks of an investment it usually increases others, such as operational risk and model risk, so overall risk is reduced but cannot be eliminated. According to a report by the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010.[85]
Risk management
Investors in hedge funds are, in most countries, required to be qualified investors who are assumed to be aware of the
In addition to assessing the market-related risks that may arise from an investment, investors commonly employ operational due diligence to assess the risk that error or fraud at a hedge fund might result in a loss to the investor. Considerations will include the organization and management of operations at the hedge fund manager, whether the investment strategy is likely to be sustainable, and the fund's ability to develop as a company.[89]
Transparency, and regulatory considerations
Since hedge funds are private entities and have few public disclosure requirements, this is sometimes perceived as a lack of transparency.[90] Another common perception of hedge funds is that their managers are not subject to as much regulatory oversight and/or registration requirements as other financial investment managers, and more prone to manager-specific idiosyncratic risks such as style drifts, faulty operations, or fraud.[91] New regulations introduced in the US and the EU as of 2010 required hedge fund managers to report more information, leading to greater transparency.[92] In addition, investors, particularly institutional investors, are encouraging further developments in hedge fund risk management, both through internal practices and external regulatory requirements.[83] The increasing influence of institutional investors has led to greater transparency: hedge funds increasingly provide information to investors including valuation methodology, positions, and leverage exposure.[93]
Hedge funds share many of the same types of risk as other investment classes, including liquidity risk and manager risk.[91] Liquidity refers to the degree to which an asset can be bought and sold or converted to cash; similar to private-equity funds, hedge funds employ a lock-up period during which an investor cannot remove money.[68][94] Manager risk refers to those risks which arise from the management of funds. As well as specific risks such as style drift, which refers to a fund manager "drifting" away from an area of specific expertise, manager risk factors include valuation risk, capacity risk, concentration risk, and leverage risk.[90] Valuation risk refers to the concern that the net asset value (NAV) of investments may be inaccurate;[95] capacity risk can arise from placing too much money into one particular strategy, which may lead to fund performance deterioration;[96] and concentration risk may arise if a fund has too much exposure to a particular investment, sector, trading strategy, or group of correlated funds.[97] These risks may be managed through defined controls over conflict of interest,[95] restrictions on allocation of funds,[96] and set exposure limits for strategies.[97]
Many investment funds use
Some types of funds, including hedge funds, are perceived as having a greater
Fees and remuneration
Fees paid to hedge funds
Hedge fund management firms typically charge their funds both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund's net asset value and typically range from 1% to 4% per annum, with 2% being standard.[99][100][101] They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS, for being too high.[102]
The performance fee is typically 20% of the fund's profits during any year, though performance fees range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.[103][104] Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.[105]
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e., profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempt to recover the losses over a number of years without a performance fee.[106]
Some performance fees include a "
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year), or when withdrawals exceed a predetermined percentage of the original investment.[110] The purpose of the fee is to discourage short-term investing, reduce turnover, and deter withdrawals after periods of poor performance. Unlike management fees and performance fees, redemption fees are usually kept by the fund and redistributed to all investors.
Remuneration of portfolio managers
Hedge fund management firms are often owned by their portfolio managers, who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits. Funds do not tend to report compensation, and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their funds and the capital they are thought to have invested in them.[111] Many managers have accumulated large stakes in their own funds and so top hedge fund managers can earn extraordinary amounts of money, perhaps up to $4 billion in a good year.[112][113]
Earnings at the very top are higher than in any other sector of the financial industry,[114] and collectively the top 25 hedge fund managers regularly earn more than all 500 of the chief executives in the S&P 500.[115] Most hedge fund managers are remunerated much less, however, and if performance fees are not earned then small managers at least are unlikely to be paid significant amounts.[114]
In 2011, the top manager earned $3 billion, the tenth earned $210 million, and the 30th earned $80 million.[116] In 2011, the average earnings for the 25 highest-compensated hedge fund managers in the United States was $576 million[117] while the mean total compensation for all hedge fund investment professionals was $690,786 and the median was $312,329. The same figures for hedge fund CEOs were $1,037,151 and $600,000, and for chief investment officers were $1,039,974 and $300,000, respectively.[118]
Of the 1,226 people on the Forbes World's Billionaires List for 2012,[119] 36 of the financiers listed "derived significant chunks" of their wealth from hedge fund management.[120] Among the richest 1,000 people in the United Kingdom, 54 were hedge fund managers, according to the Sunday Times Rich List for 2012.[121]
A portfolio manager risks losing his past compensation if he engages in insider trading. In Morgan Stanley v. Skowron, 989 F. Supp. 2d 356 (S.D.N.Y. 2013), applying New York's faithless servant doctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in violation of his company's code of conduct, which also required him to report his misconduct, must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness.[122][123][124][125] The court called the insider trading the "ultimate abuse of a portfolio manager's position".[123] The judge also wrote: "In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron's behavior damaged the firm's reputation, a valuable corporate asset."[123]
Structure
A hedge fund is an
Prime broker
Administrator
Calculation of the net asset value ("NAV") by the administrator, including the pricing of securities at current market value and calculation of the fund's income and expense accruals, is a core administrator task, because it is the price at which investors buy and sell shares in the fund.[136] The accurate and timely calculation of NAV by the administrator is vital.[136][137] The case of Anwar v. Fairfield Greenwich (SDNY 2015) is the major case relating to fund administrator liability for failure to handle its NAV-related obligations properly.[138][139] There, the hedge fund administrator and other defendants settled in 2016 by paying the Anwar investor plaintiffs $235 million.[138][139]
Administrator back office support allows fund managers to concentrate on trades.[140] Administrators also process subscriptions and redemptions and perform various shareholder services.[141][142] Hedge funds in the United States are not required to appoint an administrator and all of these functions can be performed by an investment manager.[143] A number of conflict of interest situations may arise in this arrangement, particularly in the calculation of a fund's net asset value.[144] Most funds employ external auditors, thereby arguably offering a greater degree of transparency.[143]
Auditor
An auditor is an independent
Distributor
A distributor is an
Domicile and taxation
The legal structure of a specific hedge fund, in particular its
US tax-exempt investors (such as pension plans and endowments) invest primarily in offshore hedge funds to preserve their tax exempt status and avoid unrelated business taxable income.[155] The investment manager, usually based in a major financial center, pays tax on its management fees per the tax laws of the state and country where it is located.[157] In 2011, half of the existing hedge funds were registered offshore and half onshore. The Cayman Islands was the leading location for offshore funds, accounting for 34% of the total number of global hedge funds. The US had 24%, Luxembourg 10%, Ireland 7%, the British Virgin Islands 6%, and Bermuda had 3%.[158]
Hedge funds take advantage of a tax loopole called carried interest to get around paying too much in taxes by fancy legalistic maneouvres on their part.[159]
Basket options
Deutsche Bank and Barclays created special options accounts for hedge fund clients in the banks' names and claimed to own the assets, when in fact the hedge fund clients had full control of the assets and reaped the profits. The hedge funds would then execute trades – many of them a few seconds in duration – but wait until just after a year had passed to exercise the options, allowing them to report the profits at a lower long-term capital gains tax rate.
— Alexandra Stevenson. July 8, 2015. The New York Times
The US
These banks and hedge funds involved in this case used dubious structured financial products in a giant game of 'let's pretend,' costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation.
— Carl Levin. 2015. Senate Permanent Subcommittee on Investigations
A dozen other hedge funds along with Renaissance Technologies used Deutsche Bank's and Barclays' basket options.[161] Renaissance argued that basket options were "extremely important because they gave the hedge fund the ability to increase its returns by borrowing more and to protect against model and programming failures".[161] In July 2015, the United States Internal Revenue claimed hedge funds used basket options "to bypass taxes on short-term trades". These basket options will now be labeled as listed transactions that must be declared on tax returns, and a failure to do would result in a penalty.[161]
Investment manager locations
In contrast to the funds themselves, investment managers are primarily located
London was Europe's leading center for hedge fund managers, but since the Brexit referendum some formerly London-based hedge funds have relocated to other European financial centers such as Frankfurt, Luxembourg, Paris, and Dublin, while some other hedge funds have moved their European head offices back to New York City.[165][166][167][168][169][170][171] Before Brexit, according to EuroHedge data, around 800 funds located in the UK had managed 85% of European-based hedge fund assets in 2011.[158] Interest in hedge funds in Asia has increased significantly since 2003, especially in Japan, Hong Kong, and Singapore.[172] After Brexit, Europe and the US remain the leading locations for the management of Asian hedge fund assets.[158]
Legal entity
Hedge fund legal structures vary depending on location and the investor(s). US hedge funds aimed at US-based, taxable investors are generally structured as
By contrast,
The investment manager who organizes the hedge fund may retain an interest in the fund, either as the general partner of a limited partnership or as the holder of "founder shares" in a corporate fund.[178] For offshore funds structured as corporate entities, the fund may appoint a board of directors. The board's primary role is to provide a layer of oversight while representing the interests of the shareholders.[179] However, in practice board members may lack sufficient expertise to be effective in performing those duties. The board may include both affiliated directors who are employees of the fund and independent directors whose relationship to the fund is limited.[179]
Types of funds
- Open-ended hedge funds continue to issue shares to new investors and allow periodic withdrawals at the net asset value ("NAV") for each share.
- Closed-ended hedge funds issue a limited number of tradeable shares at inception.[180][181]
- Shares of Irish Stock Exchange, and may be purchased by non-accredited investors.[182]
Side pockets
A side pocket is a mechanism whereby a fund compartmentalizes assets that are relatively
Side pockets were widely used by hedge funds during the
Regulation
Hedge funds must abide by the national, federal, and state regulatory laws in their respective locations. The U.S. regulations and restrictions that apply to hedge funds differ from those that apply to its mutual funds.
In 2007, in an effort to engage in
United States
Hedge funds within the US are subject to regulatory, reporting, and record-keeping requirements.[195] Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission, and are subject to rules and provisions of the 1922 Commodity Exchange Act, which prohibits fraud and manipulation.[196] The Securities Act of 1933 required companies to file a registration statement with the SEC to comply with its private placement rules before offering their securities to the public,[197] and most traditional hedge funds in the United States are offered effectively as private placement offerings.[198] The Securities Exchange Act of 1934 required a fund with more than 499 investors to register with the SEC.[199][200][201] The Investment Advisers Act of 1940 contained anti-fraud provisions that regulated hedge fund managers and advisers, created limits for the number and types of investors, and prohibited public offerings. The Act also exempted hedge funds from mandatory registration with the SEC[68][202][203] when selling to accredited investors with a minimum of US$5 million in investment assets. Companies and institutional investors with at least US$25 million in investment assets also qualified.[204]
In December 2004, the SEC began requiring hedge fund advisers, managing more than US$25 million and with more than 14 investors, to register with the SEC under the Investment Advisers Act.
The U.S.'s Dodd-Frank Wall Street Reform Act was passed in July 2010[4][92] and requires SEC registration of advisers who manage private funds with more than US$150 million in assets.[210][211] Registered managers must file Form ADV with the SEC, as well as information regarding their assets under management and trading positions.[212] Previously, advisers with fewer than 15 clients were exempt, although many hedge fund advisers voluntarily registered with the SEC to satisfy institutional investors.[213] Under Dodd-Frank, investment advisers with less than US$100 million in assets under management became subject to state regulation.[210] This increased the number of hedge funds under state supervision.[214] Overseas advisers who managed more than US$25 million were also required to register with the SEC.[215] The Act requires hedge funds to provide information about their trades and portfolios to regulators including the newly created Financial Stability Oversight Council.[214] In this regard, most hedge funds and other private funds, including private-equity funds, must file Form PF with the SEC, which is an extensive reporting form with substantial data on the funds' activities and positions.[1] Under the "Volcker Rule", regulators are also required to implement regulations for banks, their affiliates, and holding companies to limit their relationships with hedge funds and to prohibit these organizations from proprietary trading, and to limit their investment in, and sponsorship of, hedge funds.[214][216][217]
Europe
Within the European Union (EU), hedge funds are primarily regulated through their managers.[68] In the United Kingdom, where 80% of Europe's hedge funds are based,[218] hedge fund managers are required to be authorised and regulated by the Financial Conduct Authority (FCA).[191] Each country has its own specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France.[68]
In the EU, managers are subject to the
Offshore
Some hedge funds are established in
South Africa
In South Africa, investment fund managers must be approved by, and register with, the Financial Services Board (FSB).[224]
Performance
Measurement
Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository, and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals[225][226] and databases.[227]
One estimate is that the average hedge fund returned 11.4% per year,[228] representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.[68] Another estimate is that between January 2000 and December 2009 hedge funds outperformed other investments and were substantially less volatile, with stocks falling an average of 2.62% per year over the decade and hedge funds rising an average of 6.54% per year; this was an unusually volatile period with both the 2001-2002 dot-com bubble and a recession beginning mid 2007.[229] However, more recent data show that hedge fund performance declined and underperformed the market from about 2009 to 2016.[230]
Hedge funds performance is measured by comparing their returns to an estimate of their risk.[231] Common measures are the Sharpe ratio,[232] Treynor measure and Jensen's alpha.[233] These measures work best when returns follow normal distributions without autocorrelation, and these assumptions are often not met in practice.[234]
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios;[234][235] the Omega ratio introduced by Keating and Shadwick in 2002;[236] Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;[237] and Kappa developed by Kaplan and Knowles in 2004.[238]
Sector-size effect
There is a debate over whether alpha (the manager's skill element in performance) has been diluted by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry.[239][240]
Hedge fund indices
Indices play a central and unambiguous role in traditional asset markets, where they are widely accepted as representative of their underlying portfolios. Equity and debt index fund products provide investable access to most developed markets in these asset classes.
Hedge fund indices are more problematic. The typical hedge fund is not traded on exchange, will accept investments only at the discretion of the manager, and does not have an obligation to publish returns. Despite these challenges, Non-investable, Investable, and Clone indices have been developed.
Non-investable indices
Non-investable indices are indicative in nature and aim to represent the performance of some database of hedge funds using some measure such as mean, median, or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.
Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases. Funds' participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.
The short lifetimes of many hedge funds mean that there are many new entrants and many departures each year, which raises the problem of
When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias" or "backfill bias".
Investable indices
Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds, making an investable index similar in some ways to a fund of hedge funds portfolio.
To make the index investable, hedge funds must agree to accept investments on the terms given by the constructor. To make the index liquid, these terms must include provisions for redemptions that some managers may consider too onerous to be acceptable. This means that investable indices do not represent the total universe of hedge funds. Most seriously, they under-represent more successful managers, who typically refuse to accept such investment protocols.
Hedge fund replication
The most recent addition to the field approaches the problem in a different manner. Instead of reflecting the performance of actual hedge funds, they take a statistical approach to the analysis of historic hedge fund returns and use this to construct a model of how hedge fund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle, they can be as representative as the hedge fund database from which they were constructed. However, these clone indices rely on a statistical modelling process. Such indices have too short a history to state whether this approach will be considered successful.
Closures
In March 2017, HFR – a hedge fund research data and service provider – reported that there were more hedge-fund closures in 2016 than during the 2009 recession. According to the report, several large public pension funds pulled their investments in hedge funds, because the funds' subpar performance as a group did not merit the high fees they charged.
Despite the hedge fund industry topping $3 trillion for the first time ever in 2016, the number of new hedge funds launched fell short of levels before the
Debates and controversies
Systemic risk
had to be mounted by a number of financial institutions.)However, these claims are widely disputed by the financial industry,
This does leave the possibility that hedge funds collectively might contribute to systemic risk if they exhibit herd or self-coordinating behavior,[250] perhaps because many hedge funds make losses in similar trades. This coupled with the extensive use of leverage could lead to forced liquidations in a crisis.
Hedge funds are also closely connected to their prime brokers, typically investment banks, which could contribute to their instability in a crisis, though this works both ways and failing counterparty banks can freeze hedge funds assets, as Lehman brothers did in 2008.[251]
An August 2012 survey by the Financial Services Authority concluded that risks were limited and had reduced as a result, inter alia, of larger margins being required by counterparty banks, but might change rapidly according to market conditions. In stressed market conditions, investors might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly leveraged fund.[252]
Transparency
Hedge funds are structured to avoid most direct regulation (although their managers may be regulated), and are not required to publicly disclose their investment activities, except to the extent that investors generally are subject to disclosure requirements. This is in contrast to a regulated mutual fund or exchange-traded fund, which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment adviser of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.[253]
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified.[254] A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g., returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different.[255] With these limitations, investors have to do their own research, which may cost on the scale of US$50,000 for a fund that is not well-established.[256]
A lack of verification of financial documents by investors or by independent auditors has, in some cases, assisted in
The process of matching hedge funds to investors has traditionally been fairly opaque, with investments often driven by personal connections or recommendations of portfolio managers.[267] Many funds disclose their holdings, strategy, and historic performance relative to market indices, giving investors some idea of how their money is being allocated, although individual holdings are often not disclosed.[268] Investors are often drawn to hedge funds by the possibility of realizing significant returns, or hedging against volatility in the market. The complexity and fees associated with hedge funds are causing some to exit the market – CalPERS, the largest pension fund in the US, announced plans to completely divest from hedge funds in 2014.[269] Some services are attempting to improve matching between hedge funds and investors: HedgeZ is designed to allow investors to easily search and sort through funds;[270] iMatchative aims to match investors to funds through algorithms that factor in an investor's goals and behavioral profile, in hopes of helping funds and investors understand the how their perceptions and motivations drive investment decisions.[271]
Links with analysts
In June 2006, prompted by a letter from
The systemic practice of hedge funds submitting periodic electronic questionnaires to stock analysts as a part of market research was reported by The New York Times in July 2012. According to the report, one motivation for the questionnaires was to obtain subjective information not available to the public and possible early notice of trading recommendations that could produce short-term market movements.[276]
Value in a mean/variance efficient portfolio
According to modern portfolio theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios that offer the highest level of return per unit of risk). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.[107]
However, there are at least three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
- Hedge funds are highly individual, making it hard to estimate the likely returns or risks.
- Hedge funds' correlation with other assets tends to rise during stressful market events, making them much less useful for diversification in bad times than they may appear in good times.
- Hedge fund returns are reduced considerably by the high fees that are typically charged.
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds.[277][278] The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds took no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
Hedge funds tend to perform poorly during equity
See also
- Activist shareholder
- Alternative investment
- Naked Capitalism
- Corporate governance
- Fund governance
- Investment banking
- List of hedge funds
- Vulture fund
Notes
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Further reading
- Thomas P. Lemke, Gerald T. Lins, Kathryn L. Hoenig & Patricia S. Rube, Hedge Funds and Other Private Funds: Regulation and Compliance (Thomson West 2014 ed.).
- Thomas P. Lemke & Gerald T. Lins, Regulation of Investment Advisers (Thomson West 2014 ed.).
- Thomas P. Lemke, Gerald T. Lins & A. Thomas Smith III, Regulation of Investment Companies (Matthew Bender 2014 ed.).
- SSRN 931254.
- Marcel Kahan & Edward B. Rock, 'Hedge Funds in Corporate Governance and Corporate Control' (2007) 155 University of Pennsylvania Law Review 1021
- Makrem Boumlouka, 'Regulation and Transparency in US OTC Derivative Markets', Original Thoughts Series #1, August 2010, Hedge Fund Society Hedge Fund Society
- Boyson, Nicole M.; Stahel, Christof W.; Stulz, Rene M. (2010). "Hedge Fund Contagion and Liquidity Shocks". The Journal of Finance. 65 (5): 1789–1816. S2CID 17421154.
- Stowell, David (2010). An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm. Academic Press.
- Strachman, Daniel A. (2014). The Fundamentals of Hedge Fund Management: How to Successfully Launch and Operate a Hedge Fund, Second Edition. Wiley.