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Home Articles Introduction to Hedge Funds - Part Two

Introduction to Hedge Funds - Part Two Research Team | Posted On Wednesday, April 15,2009, 01:31 PM

Introduction to Hedge Funds - Part Two




In part one; we had explained that hedge fund managers actively manage investment portfolios with a goal of absolute returns regardless of overall market or index movements. Hedge funds, however, conduct their trading strategies with more freedom than a mutual fund, normally avoiding registration. In this article, we qualify hedge funds' potential for higher returns, examine their volatility patterns, and take a look at funds of hedge funds, identifying their advantages and disadvantages.  

There are two basic reasons for investing in a hedge fund:

  1. To seek higher net returns (net of management and performance fees) and/or
  2. To seek diversification.    

Potential for Higher Returns, Especially in a Bear Market

Higher returns are hardly guaranteed in any investment. Many hedge funds invest in the same securities available to mutual funds and individual investors.  Therefore you can only reasonably expect higher returns if you select a superior manager or pick a timely strategy. Large numbers of experts argue that selecting a talented manager is the only thing that really matters. This helps to explain why hedge fund strategies are not scalable, meaning bigger is not better. With the help of mutual funds, an investment process can be replicated and taught to new managers, but many hedge funds are built around individual "stars", and genius is difficult to clone. For the same reason, some of the better funds are likely to be small.

A timely strategy is also significant. If your market outlook is bullish, you will need a specific reason to expect a hedge fund to beat the index. Conversely, if your outlook is bearish, hedge funds should be an attractive asset class compared to buy-and-hold or long-only mutual funds.

Diversification Benefits

Most of the institutions invest in hedge funds for the diversification benefits. If you have a portfolio of investments, adding uncorrelated that is positive-returning assets will reduce total portfolio risk. As hedge funds employ derivatives, short sales or non-equity investments they tend to be uncorrelated with broad stock market indices. But correlation varies by strategy. Historical correlation data remains consistent and here is a reasonable hierarchy:

Fat Tails Are the Problem

Hedge fund investors who are exposed to multiple risks and each approach have its own unique risks. For instance, long/short funds are exposed to the short-squeeze.

The conventional measure of risk is volatility or instability, that is, the annualized standard deviation of returns. Astonishingly, most academic studies demonstrate that hedge funds, on average, are less volatile or unstable than the market. For instance, over the bull market period we referred to earlier, volatility of the S&P 500 was just for about 14% while volatility of the aggregated hedge funds was only for about 10%. That is, about two-thirds of the time, we may have expected returns to be within 10% of the average return. In risk-adjusted conditions, as measured by the Sharpe ratio (unit of excess return per unit of risk), some approaches outperformed the S&P 500 index over the bull market period mentioned earlier.

The problem is that hedge fund returns do not follow the symmetrical return paths obscure by traditional volatility. Instead, hedge fund returns tend to be distorted. Particularly, they tend to be negatively distorted, which means they bear the dreaded "fat tails", which are mostly differentiated by positive returns but a few cases of extreme losses. That's why; measures of downside risk can be more useful than volatility or Sharpe ratio. Downside risk measures, such as value at risk (VaR), spotlight only on the left side of the return distribution curve where losses occur. They will answer questions such as, "What are the odds that I lose 15% of the principal in one year?"

Funds of Hedge Funds

For the reason that investing in a single hedge fund needs time-consuming due diligence and concentrates risk, funds of hedge funds have become popular. These are pooled funds that allocate their capital among several hedge funds, generally in the neighborhood of 15 to 25 diverse hedge funds. Nothing like the underlying hedge funds, these vehicles are often registered with the SEC and promoted to individual investors. Occasionally called a "retail" fund of funds, the net worth and income tests may be lower than usual. 

The compensations of funds of hedge funds include automatic diversification, monitoring efficiency and selection expertise. For the reason that these funds are invested in a minimum of around eight funds, the failure or underperformance of one hedge fund will not ruin the whole. Since the funds of funds are supposed to monitor and conduct due diligence on their holdings, their investors should in theory be exposed to reputable hedge funds only. As a final point, these funds of hedge funds are often good at sourcing talented or undiscovered managers who may be "under the radar" of the broader investment community. In reality, the business model of the fund of funds hinges on identifying talented managers and pruning the portfolio of underperforming managers.

The major disadvantage is cost, since these funds create a double-fee structure. Characteristically, you pay a management fee (and maybe even a performance fee) to the fund manager in addition to fees usually paid to the underlying hedge funds. Arrangements differ, but you may pay a 1% management fee to both the fund of funds and the underlying hedge funds. In regards to performance fees, the underlying hedge funds might charge up to 20% of their profits, and it is not unusual for the fund of funds to charge an additional 10%. Under this distinctive arrangement, you would pay 2% annually plus 30% of the gains. This makes cost a very serious issue, although the 2% management fee by itself is only about 50 basis points which is higher than the average small cap mutual fund (i.e. about 1.5%).

Another significant and underestimated risk is the potential for over-diversification. A fund of hedge funds requests to coordinate its holdings or it will not add value: if it is not cautious, it may inadvertently collect a group of hedge funds that duplicates its various holdings or - even worse - ends up constituting a representative sample of the entire market. Too many single hedge fund holdings (with the aim of diversification) are possibly to erode the benefits of active management, while incurring the double-fee structure in the intervening time. Various studies have been conducted, but the "sweet spot" seems to be around eight to 15 hedge funds.

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