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Hedge Fund Landscape

The first hedge fund emerged in 1949 when sociologist Alfred Winslow Jones and his four friends formed an investment partnership. The first reference to a hedge fund appeared in a 1966 Fortune article by Carol Loomis. Ms. Loomis wrote the story of Alfred Jones in The Jones Nobody Keeps Up With, little did she know that she was igniting a trend of investments that now accounts for $2.4 trillion of assets under management across the globe.

As of fiscal year 2012, the Yale Endowment’s strategic allocation to this category was 18.0%. Mr. David F. Swensen termed it “absolute return,” because hedge fund strategies aim to achieve a positive return on investments regardless of whether markets are rising or falling. On July 1st, 2013, the Endowment even increased this target allocation percentage from the 2012 level.

In the academic world, I call it “University Street” in one of my publications Where Would You Place Your Trust – Wall Street, Main Street, or University Street, there is a number of empirical studies that have demonstrated that incorporating hedge funds in a portfolio improves efficient frontier:

  • In 1999, R. McFall Lamm’s hedge fund research illustrated that hedge funds offer superior portfolio enhancing characteristics and should be a part of investors’ spectrum of investments.
  • In the Risk Management of Multi-Manager Portfolio’s Alternative Investment Strategies, Lars Jaeger’s portfolio study has shown that hedge funds dramatically improve the efficient frontier of the traditional portfolio.
  • In 2001, Schneeweis, Spurgin, and Karavas confirmed Dr. Jaeger’s findings and suggested a percentage of allocation to a portfolio of hedge funds that may be regarded as optimal.

A hedge fund is an investment pool that is relatively unconstrained in it does: it is an investment vehicles rather than an asset class. Hedge funds invest in a diverse range of markets, trade in liquid securities, use a wide variety of investment styles financial instruments, and exercise active management. Based on the investment styles, hedges fund can be broadly categorized as global macro, directional, relative value, and event-driven strategies.

Hedge Fund LandscapeThe recent sharp rise in bond yields and the widening high yield credit spreads have led hedge fund investors to prefer credit- and interest-rate-sensitive strategies, such as event-driven and relative value. These two strategies combined received over $25 billion in the first half of 2013. In terms of performance, the event-driven styles, featured by high-performing activist strategies and dynamic M&A activities, outperformed other main categories. The relative value strategy as a whole was the leading area of both performance and capital inflows in 2012.

Summary of Hedge Fund Performance by Strategy

Exhibit 5.1 Summary of Hedge Fund Performance by Strategy 12-31-2012Hedge funds offer unique terms such as subscriptions, redemptions and lock-ups so that each one may be quite different from another. Hedge funds do not have daily liquidity; some are with monthly subscriptions and redemptions, and some are quarterly. Each fund specifies the number of days required to redemption, with most ranging from 15 days to 180 days. There are also lock-up periods and most hedge funds typically require either one year or two year’ commitment. It could be hard lock or soft lock.Hedge funds use significant leverage; in most cases, leverage allows for the magnification of the return and risk. In hedge funds, when a relatively small amount of capital controls a large amount of assets, the losses can be small since they can be sustained from those assets before the manager’s capital becomes impaired. Therefore, the greater the leverage, the less price volatility a hedge fund manager will experience. In the past few years, the incentive structure leads managers to shoot for high returns while ignoring the potential consequence of being overleveraged, as a result, we have  seen some hedge funds using leverage with an aim to amplify the returns while having realized only a modest or even negative performance.

The hedge fund market is relatively unregulated because hedge funds were not created to sell to the public or most retail investors. Historically, hedge funds had been exempt from the regulations with regard to how hedge fund managers structure each fund and how they employ each strategy. Until recent years, regulations on hedge funds were enacted in the U.S. and Europe. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) signed into law, and it made regulation changes on some types of assets including hedge funds. The new rule requires that all hedge fund advisers with $100 million or more in assets under management (AUM) must register with the Securities and Exchange Commission (SEC). Second, a new regulatory regime for the derivatives markets is in place in which counterparties that trade over-the-counter (OTC) derivatives with hedge funds may be deemed a “swap dealer.” Therefore, derivatives instruments would be subject to registration with and regulation by the Commodity Futures Trading Commission (CFTC). Furthermore, the Financial Stability Oversight Council (FSOC) was created to monitor and address the stability of the U.S. financial system. In Europe, the Alternative Investment Fund Managers Directive entered into force on July 22nd, 2013; it was designed to regulate the EU fund managers that manage alternative investment funds including hedge funds.

Since inception, hedge fund managers have been charging high fees, with a structure of an annual management fee plus a performance fee. By the summer of 2013, according to HFR, the average hedge fund charged an annual management fee of 1.6 percent of assets, with a performance fee of anywhere between 10-20 percent of fund profits. Today, hedge fund managers in the industry are facing a challenging situation that is featured by a combination of limited alpha-generation, rising operational costs and compliance costs, and institutional investors’ request of customized services. Nevertheless, to compete with peers, some hedge funds managers are planning to lower fees on their funds while working on their approach for more cost-cutting opportunities.

As the hedge fund industry matures, competition is intensifying from both traditional and alternative investment managers. New entrants are accelerating industry convergence by blurring the lines in some cases between hedge funds, private equity funds, and mutual funds. Some private equity managers are working and exchanging ideas with hedge fund managers to seek more-convenient investment opportunities across sectors, and hedge fund managers, in turn, are pursuing new distribution channels involving private equities. Some mutual fund managers created and are actively promoting the benefits of liquid long/short equity, i.e., hedge mutual funds.

References:

  1. The Alternative Answer by Bob Rice 2013
  2. Hedge Fund Research (HFR) Database
  3. Risk Management of Multi-Manager Portfolio’s Alternative Investment Strategies by Lars Jaeger 2001
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