Financial Education

Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public.

Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:

• Poor performance, possibly including fund closure
• Very good performance has eliminated the need to attract capital

In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.

The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability – especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

A number of factors affect performance evaluation for hedge funds, particularly with respect to using the Sharpe ratio to measure risk-adjusted return.

Starting with return, typically monthly returns are compounded to an annualized rate of return. However, entry and exit opportunities may be permitted only quarterly or even less frequently. In addition, some measures of downside risk such as the maximum drawdown are not compounded. Measures comparing return (compounded) and drawdown (not compounded) may not fully reflect the risk/return profile.

The Sharpe ratio is defined as:

• Numerator is the difference between annualized return and the annualized risk-free rate
• Denominator is the annualized standard deviation of returns

The Sharpe ratio increases proportionately with the square root of time, and is not appropriate when returns are asymmetrical. In particular, the Sharpe ratio tends to be overestimated when returns are serially correlated or assets are illiquid. Furthermore, the correlations between the fund and an investor’s other portfolio assets are not considered.

There are a number of ways managers can “game” the Sharpe ratio, including:

• Lengthening the measurement interval
• Compounding monthly returns but calculating standard deviations without compounding
• Writing out of money put or call options to produce asymmetric returns
• Smoothing returns
• Using swaps to eliminate extreme outlying returns

In part because of these deficiencies, the Sharpe ratio has not been found to be a good predictor of hedge fund returns.

The growth in the hedge fund industry has increased the importance of measuring how hedge funds achieve their returns. Since many funds either explicitly or implicitly use leverage, a useful question is whether hedge funds merely represent an expensive way to use leverage.

In an article published in the Winter 2007 Journal of Wealth Management, Jean Brunel finds that simple leverage does not appear to be the primary determinant of market-neutral or long-short hedge fund returns. Instead, three broad themes emerge:

• Beta leverage is not a strong element of long-short or market neutral returns
• Hedge fund return replication requires dynamic management of leverage
• When hedge fund managers use leverage, they tend to lever their value added skills rather than generic risk exposures

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

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.

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