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1
Hedge Funds:
Inside the Buyer’s Head
Robert A. Jaeger, Ph.D.March 21, 2005
2
Motives for Investing
Potential for
Attractive absolute return
LIBOR plus 3% to 8%, depending on risk tolerance
Volatility lower than standard equity benchmarks
Low correlation with standard markets, especially in down markets
3
Issues
Sources of return and risk
Leverage, short selling, and taxation
Performance fees
Transparency
Capacity: is there a hedge fund bubble?
4
Major Hedge Fund CategoriesM
ore
Ris
k
L
ess
Ris
k Relative value: long vs. short positions, minimal net market exposure.
Event-driven: net long bias, emphasizing specific corporate transactions (mergers, acquisitions, reorganizations, etc.) likely to produce definable changes in value within a definable period (typically 3-12 months).
Equity hedge funds: “micro” investors focused on stock selection and company analysis, enhanced with ability to use leverage and sell short.
Global asset allocators: “macro” investors who can be long, short or neutral with respect to multiple markets (interest rates, currencies, equity indexes, commodities).
Short sellers: net short, usually focused on US equities, designed as hedge against down markets.
5
Convertible Hedge
Global/International
Mkt Neutral Equity
Bond Hedge
RV/Multi-Strategy
T-Bills International Equity
International Bonds
US Bonds
US Equity
Short Selling
SystematicDiscretionary
Domestic Opportunistic
Domestic Long Biased
ED/Multi-Strategy
Distressed Debt
Deal Arbitrage
0
2
4
6
8
10
12
14
16
0 5 10 15 20 25
Annualized Standard Deviation (%)
Ann
uali
zed
Rat
e of
Ret
urn
(%)
Historical Risk/Return Characteristics
1995 – 2004:October
Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) See www.eacm.com for more information regarding the EACM100® Index.
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Conv Hedge
Global/International
Mkt Neut Eq
Bond Hedge
RV/Multi-Strategy
T-Bills
InternationalEquity
Inter'lBondsUS Bonds
US Equity
Short Selling
Systematic
Discretionary
Dom Oppo
Domestic Long Biased
ED/Multi-Strat Distressed
Deal Arbitrage
-4
-3
-2
-1
0
1
2
3
4
5
6
0102030405060708090100
Gain Frequency (%)
Ave
rage
Ret
urn
(%)
Performance in S&P 500 Negative Months
1995 – 2004:October
Analysis based on statistical measures calculated from monthly total returns. Source: Standard & Poor’s 500, MSCI EAFE $, Lehman Bros Govt/Credit Index, Citigroup World Govt Bond ex US Index ($), Merrill Lynch 90 Day T-Bills and EACM100® Index. Performance results for the various hedge fund strategies are derived from strategy components returns for the EACM100® Index Onshore Funds (January 1990 – December 2003) and EACM100® Index – Offshore Funds (January 2004 – October 2004.) See www.eacm.com for more information regarding the EACM100® Index.
US Equity (S&P 500 Composite) was down 38% of the months, with an average monthly loss of 4.0%.
7
Two Kinds of Strategies
Many hedge fund strategies employ “enhanced active management”: traditional active management enhanced with short selling, leverage, and other techniques. For example:
Market neutral equity Fixed income arbitrage Equity hedge funds Global macro investing
Some hedge fund strategies are genuinely distinctive, not based on traditional techniques. These strategies are important sources of liquidity for financial markets.
Convertible hedging Risk arbitrage Distressed debt
8
How Do Hedge Funds Make Money?
Hedge funds make money the old-fashioned way: they take risk.
Beware of common stories that underestimate risk:
“They exploit market inefficiencies” – not enough to go around
“They supply liquidity to markets” – some do, some don’t
“They take advantage of manager skill” – hedge funds have no monopoly on manager skill
9
Risk Factors
General risks Leverage Concentration Illiquidity
Market-related risks Directional market risk Non-directional systematic risks, e.g.,
Equity: long value vs. short growth, long small cap vs. short large cap
Fixed income: carry trades: long higher risk vs. short lower risk
Exposure to volatility and “trendiness” Organizational risks
Small shops, smaller asset bases, shorter records Blow-up risk, headline risk
10
Leverage, Short Selling, and Taxation
Short selling is sometimes designed to reduce risk, sometimes designed to enhance return, sometimes both.
Leverage definitely increases risk, may or may not increase return.
Leverage can create Unrelated Business Taxable Income (UBTI) for tax-exempt investors. The use of offshore funds generally avoids UBTI.
11
Performance Fees
Most hedge funds charge a combination of asset-based and performance-based fees, often 1% plus 20%, or more.
Performance fees grant the hedge fund manager a “free call option” on the fund’s performance, may create an incentive to take incremental risk.
12
Hedge funds generally offer much less transparency than traditional separately managed accounts.
Many institutional investors are overly obsessed with transparency, failing to distinguish between
Daily position and transaction reports
and
Useful portfolio information
Transparency
13
Some common estimates:
7,000 – 10,000 hedge funds
1,000 fund of funds
Total assets $800 billion - $1 trillion
Steady growth in recent years, driven by weaknesses in traditional markets, concerns about rising interest rates
Is there too much money chasing too few opportunities? Important to separate homogeneous strategies from heterogeneous strategies.
Homogeneous: Managers tend to “herd” around similar positions, e.g., convertible hedging, risk arbitrage, distressed debt.
Heterogeneous: Wide divergence among manager positions, e.g. equity hedge funds, global asset allocators.
Capacity issues are more pronounced in homogeneous strategies.
Capacity and Bubbles
14
2004 Performance
2004 Annual Return
EACM 100® Index 4.7%
MSCI Hedge Fund Composite 6.6%
CSFB/Tremont Investable Index 5.2%
S&P Hedge Fund Index 3.9%
HFRI Fund of Funds Composite Index 6.4%
CISDM Hedge Fund Index – Fund of Funds (Median) 9.2%
Most funds of funds target a net return of LIBOR plus 3%-8%. Returns in 2004 were at the low end of the range.
Some returns are based on preliminary results and subject to change.
15
Performance by Strategy
EACM 100® Index – Offshore Funds
Relative ValueMarket Neutral EquityConvertible HedgeBond HedgeMulti-Strategy
Event-DrivenDeal ArbitrageBankruptcy/DistressedMulti-Strategy
Equity Hedge FundsDomestic Long BiasedDomestic OpportunisticGlobal/International
Global Asset AllocatorsDiscretionarySystematic
Short Selling
S&P 500 Composite
4.7
2.3-0.2
0.65.2
4.4
11.24.4
13.715.3
6.96.5
5.38.9
4.15.8
2.2
-10.8
10.9
-15 -10 -5 0 5 10 15 20
2004 Annual Return %
Source: EACM Advisors LLC
16
Low Volatility Equity market volatility has been very low, both at the
index level and the individual stock level. This applies both to implied and realized volatility.
Low volatility is particularly hard on convertible hedging, but also hurts other strategies that depend on price movements for trading profits.
Source: Citigroup/Smith Barney and Chicago Board Options Exchange
Implied Index and Stock Volatility
Historical Index and Stock Volatility
17
Low Dispersion of Returns
Hedge funds need stocks to display differences in return, but dispersion is at historically low levels.
Source: Citigroup/Smith Barney and Chicago Board Options Exchange
Historical Cross-Sectional Stock Volatility
18
Did Hedge Funds Cause these Problems?
Hedge funds are clearly not the cause of low short term interest rates.
Do hedge funds cause low volatility and low dispersion? No – they would do this only if hedge funds, in aggregate, pursue contrarian trading strategies that act as a negative feedback loop in the markets. In fact, many hedge funds are more momentum-oriented, acting as a positive feedback loop.
Several years ago, hedge funds were blamed for adding to market volatility. You can’t have it both ways.
19
Heterogeneous Strategies
Many hedge fund strategies are extremely heterogeneous, especially: Equity hedge funds Global asset allocators
Diversity holds at two levels: Setting up the position Managing gains and losses
Most hedge funds tend to cut losses quickly Some hedge fund managers like to add to winning
positions, others are quicker to take profits.
20
Heterogeneity in Action
Short Position
Builder
Trimmer
Long Position
Builder
Trimmer
Buy
Sell
Sell
Sell
Buy
Buy
Sell
Buy
Stock downStock up
Beware of glib generalizations about “what the hedge funds are doing.”
21
Two Final Thoughts
Many people think that hedge funds make money by identifying inefficiencies and anomalies. On this view, the growth of the business means that the inefficiencies will get “arbed away.” But most hedge funds do not make money by seeking inefficiencies.
Be careful about database returns and index returns. Our basic suspicion is that hedge funds, in aggregate, do not make money. Manager selection and strategy diversification are the keys to success. Hedge fund investing is like venture capital investing: the performance of the median fund is not compelling, but a well-managed portfolio can provide excellent risk/return properties.