Financial Education

Since reported hedge fund performance is of doubtful significance and risk monitoring is difficult, due diligence takes on special significance when investments in hedge funds are being considered. Some of the things investors must determine include:

1. The structure of the fund
   • Legal entity
   • Identity of manager
   • Domicile
   • Regulatory regime
2. Strategy
   • Style
   • Instruments used
   • Benchmark
   • Niche
   • Current holdings
3. Performance data since inception for all funds under management
4. Risk management
   • What risks are measured
   • How are they measured
   • How are they controlled
   • How is leverage employed
5. Research
   • Has the firm’s research led to changes in strategy
   • Strength of research efforts
   • Research budget
   • Personnel
6. Administration
   • Lawsuits
   • Employee turnover
   • Disaster recovery plans
7. Legal and Regulatory
   • Fee structure
   • Lock-up period
   • Minimum and maximum subscription amounts
   • Drawback provisions
8. References
   • Professional
   • Other investors in the fund

Buyout funds represent a significantly larger market segment within private equity compared to venture capital. Mega-cap buyout funds typically will take public companies private through a leveraged buyout. Mid-market funds will purchase private companies or divisions of larger companies.

Buyout funds add value by restructuring operations, by buying opportunistically when companies are selling at less than their intrinsic value, or by capturing gains by adding to or restructuring existing debt. They can realize these gains through a later public offering, selling the company to another buyer or by recapitalizing (borrowing and using the proceeds to pay a special dividend).

Buyout funds differ from venture capital funds in a number of ways:

• They are usually highly leveraged
• Cash flows to investors are typically more stable and start sooner
• Returns are not as subject to measurement error

With the growth in the hedge fund industry has come a decline in the value added by hedge fund managers. Given the high fees typically charged by hedge funds, some have questioned whether passive approaches can be constructed that would provide returns similar to those of hedge funds while offering greater transparency and liquidity.

In the Winter 2007 Journal of Wealth Management Harry Kat discusses three general approaches to hedge fund replication:

• Factor Models
• Mechanical Trading Rules
• The author’s FundCreator product

In a factor model, linear regressions determine the market exposures experienced by a hedge fund or hedge fund index. Factors may include stock, bond, commodity and currency returns, or changes in credit spreads and market volatility. These exposures can then be taken via index products or derivative instruments.

In the case of funds that add value by timing short-term changes in market exposure, the investor’s trading behavior can be compared to mechanical trading rules.

The FundCreator product is a risk management tool that allows the investor to target the risk and correlation properties desired in order to maximize diversification potential.

There are a number of benchmarks available for hedge funds, distinguished primarily by the frequency of data reporting (monthly or daily), whether they are investable or not, and whether they list the actual funds from which they are comprised.

Principle differences among the indices include:

• Selection criteria - what kind of track record or level of assets must a fund attain in order to qualify for inclusion?
• Style classification
• Weighting scheme - usually either equal weights or based on assets under management
• How frequently the weights of the constituent funds are rebalanced
• Investability

Since hedge funds often promote themselves as absolute return vehicles (and thus do not have a direct benchmark) that absolute return nonetheless must be measured in terms of some benchmark. Important questions to consider are whether any alpha reported is sensitive to the benchmark in use and whether the alpha takes into account the true systematic risks faced by the portfolio.

There are also a number of limitations to most of the available hedge fund indices, including:

• Results are self-reported by the managers and may not be completely neutral or accurate
• Databases reflect survivorship bias as poorly performing managers exit leaving only the best included. This results in an upward bias to reported returns.
• The frequency of data reporting may lead to stale prices and distort correlation measures.
• Missing data can be filled at the manager’s convenience, leading to a backfill bias.

Studies to determine whether hedge fund returns can be mimicked using passive strategies have shown mixed results but do show that returns are influenced largely by the trading strategy employed. Market neutral strategies may offer better diversification to traditional asset classes.

Hedge fund returns have been shown to exhibit low skewness and high kurtosis, which are undesirable features. Mean-variance optimizations are sensitive to errors in the return estimates, and historical data (as discussed above) can be unreliable.

Formative stage companies and privately held companies often have limited access to capital. Start-ups often need capital to fund research or obtain office space before they have generated any revenue. Other companies may need capital in order to expand operations.

Venture capital can be supplied by Angel investors (accredited investors who supply small amounts of seed or early-stage capital), venture capitalists (who manage pooled capital and also offer companies financial and management support) or large companies who want to become strategic partners.

Financial needs for private companies typically go through several stages:

1. Early stage financing
   • Seed capital - small amounts of money used to form the company and prove the idea
   • Start-up - pre-revenue commercialization of a product
   • First stage - additional funds that may be needed, and which are typically supplied only when conditions warrant
2. Later-stage financing offers funds to promising companies that need to expand their operations
3. Exit stage
   • Acquisition by a larger company
   • Merger with another company
   • Initial public offering (IPO)

Longevity annuities exchange an up-front payment for a stream of payments that will begin some years after retirement. For example, the annuity may be purchased when the investor is 65, but only begin to pay benefits when the investor turns 80. Benefits will continue for the remainder of the investor’s life.

Investment annuity payouts per dollar invested are much higher than immediate annuity payments for several reasons:

• The lack of payouts in early years allows for greater compounding benefits on investment returns
• The shorter remaining expected life span after payouts begin allows for each payment to be larger
• Potential annuitants who die before reaching the target age subsidize returns for those who live longer

In the January/February 2008 Financial Analysts Journal, Scott argues that many investors will benefit from an allocation to longevity annuities, and that the optimal bundle depends upon the percentage of total assets the annuitant is willing to allocate to annuities. The greater the proportion annuitized, the earlier payments should start.

Like private equity funds, hedge funds are typically organized as either limited partnerships or limited liability corporations to protect investors from losses exceeding their initial investment and to avoid double taxation of corporate earnings.

Compensation for hedge fund managers typically is based on two components:

• A management fee of 1-2% of assets under management
• An incentive fee of 15-20% of the returns in excess of a pre-determined benchmark. Incentive fees are usually constrained by features such as high-water marks, claw-back provisions and other features.

The high fees earned by hedge fund managers has been widely criticized, particularly when the returns generated include some exposure to beta. Beta can be obtained very cheaply through passive investments such as index funds. However, to the extent that the hedge fund returns offer diversification the fees may simply represent a sort of insurance premium that investors are willing to pay  in exchange for risk reduction.

The investments made by hedge funds are often illiquid, and as such many funds require a lock-up period before investments can be withdrawn. In addition, most funds allow cash inflows and outflows only at specific times (usually quarterly.)

Private equity investments are investments made in companies that are not publicly traded. They can take a number of forms:

• Financing of private businesses by venture capitalists
• Leveraged buyouts of public companies
• Investments in distressed debt
• Financing public infrastructure projects

Characteristics of private investments include:

• Illiquidity (lack of a secondary market)
• Requirement of long term commitments
• Higher risk relative to public equities
• Need for a high internal rate of return (25-30%)
• Limited information availability, particularly for venture investments in novel technologies

The Sharpe ratio is often used for evaluating hedge fund performance. However, it has often been criticized for relying on the assumption that returns are normally distributed.

In the September 2007 Journal of Banking and Finance, Eling and Schuhmacher examine the Sharpe ratio and other performance measurement tools for evaluating hedge funds. By ranking hedge fund returns against 12 different performance measures, they find a high correlation between the different measures, suggesting that the choice of measure may not be a significant concern. The lowest correlations are between the Sharpe ratio, the Treynor ratio and Jensen’s alpha.

Given its practical advantages over other return measures, the Sharpe ratio’s popularity is now supported by empirical evidence. The authors find it to be an adequate measure of hedge fund performance.

In the May 2007 Review of Financial Studies, Duarte, Longstaff and Yu examine the risk/return characteristics of commonly used fixed-income arbitrage strategies. They find that the strategies that require high levels of modeling produce significant positive excess returns even after adjusting for risk, transaction costs and management fees.

Fixed income arbitrage strategies tend to exploit small differences between intrinsic value and market prices for securities. There has been some debate as to whether they are truly low risk arbitrage or whether the small positive returns most frequently earned are offset by infrequent but dramatic losses.

Of five strategies tested, the ones requiring the greatest intellectual capital - yield curve, mortgage and capital structure arbitrage - produced the highest excess returns after controlling for risk and costs. Swap spread arbitrage also produced positive risk adjusted returns.

Volatility arbitrage, or selling options on fixed income instruments and hedging the underlying asset exposure, produced positive excess returns but also had periods of significant losses.