Hedge fund strategies - a critical review

Table of Content

Table of Graphs

1 Introduction
1.1 Problem and objectives
1.2 Structure of the paper

2 Basics
2.1 History
2.2 General Characteristics
2.3 The hedge fund Universe

3 Style Analysis of different Hedge funds
3.1 Directional hedge fund styles
3.1.1 Equity long / short
3.1.2 Tactical Trading
3.2 Non-directional hedge fund styles
3.3 Hybrid hedge fund styles
3.4 Other hedge fund styles
3.5 Performance and Risk Measurement

4 Critical View on hedge funds
4.1 Hedge fund data
4.2 Hedge fund indices

5 Conclusion

References

Appendix

Table of Graphs

Graph 1: Estimated Global Hedge Funds Assets under Management

Graph 2: Hedge Fund Styles

1 Introduction

1.1 Problem and objectives

Historically, there have been two competing investment theories. On the one hand there is the traditional efficient markets theory, which states that share prices fully reflect market information and therefore only temporary mispricing occurs. The traditional investments to buy and hold equity and bonds, which benefit principally from market direction is based on this theory. On the other hand the second theory argues that greater inefficiencies occur, and therefore opportunities can arise that enable investors to exploit mispriced securities without facing excessive levels of risk. This is the principal argument behind hedge fund investing.^[1]

In the Oxford dictionary, the term “hedge” is described as a way of protecting yourself against a loss, especially money.^[2] To achieve this goal, hedge funds use a wide range of different investment strategies. These strategies are partly very complex and therefore sometimes very difficult to comprehend for the investor. This fact contributes mainly to the negative image of hedge funds in the general public. But the truth is that as hedge funds exploit chances of winning which result from market imperfections, they actually support and improve the stability of the financial systems.^[3]

The hedge fund industry experienced a very strong growth in the last two decades and represents a good alternative investment opportunity to traditional asset classes. Therefore this paper aims to provide an overview of the numerous hedge fund strategies which are applied by the increasing number of hedge funds. This knowledge is needed as some specialists already expect that traditional mutual funds may not be able to avoid adopting respectively integrating some sort of hedge fund strategies to remain competitive with hedge funds.^[4]

1.2 Structure of the paper

This paper starts with a brief outline of the development in the history of hedge funds. Then the main characteristics of hedge funds and the differences to mutual funds will be explained. Concluding the basics’ part a description of the continuously growing hedge fund universe will be provided. In the main part the various hedge fund strategies will be illustrated and a closer look at the performance and risk measurement will be taken. Thereafter hedge fund data and hedge fund indices will be critically reviewed. And finally an outlook concerning the future developments in the hedge fund industry will be part of the conclusion.

2 Basics

2.1 History

In 1949, Alfred Winslow Jones created the first hedge fund. He made use of short selling and leverage with the goal to generate positive absolute returns. As the fund was designed to benefit, independent of the broader market, the term “hedge fund” was applied. But it was in 1966 that the press first announced the success of Jones’ new investment style.^[5] Since then hedge funds have become more and more popular and different hedge fund strategies have been developed, most of which share the original objective - generating absolute returns. In 1968 there were 140 hedge funds in existence which suffered significant losses during the bear markets of 1969-1970 and 1973-1974. This resulted in a reduction of the number of hedge funds and the end of the first hedge fund boom. In 1986 numerous articles about the superior performance of Julia Robertson’s Tiger fund helped hedge funds back to their former popularity.^[6] Another negative highlight in the hedge fund history was the collapse of Long Term Capital Management (LTCM). This hedge fund was primarily invested in global fixed income arbitrage and equity index futures arbitrage. The main reason for LTCM’s collapse was its high leverage ratio of more than 25 (higher than the vast majority of hedge funds). Global interest rates anomalies were caused by the Russian debt crisis, which led to a loss of almost 90% of LTCM’s value. As a reaction to this negative incident, the constant growth in the hedge fund industry was temporarily stopped.^[7]

2.2 General Characteristics

There is no single definition for hedge funds but most investment professionals agree that a hedge fund can be described with the following characteristics and differentiation to mutual funds. Hedge funds are a pooled investment vehicle and invest in publicly traded securities. In contrast to mutual funds which only have long positions, hedge funds can make use of the full spectrum of financial instruments, such as futures, options and other derivatives. Furthermore, they can sell short or use leverage to improve the risk/reward profile of their bets. Mutual funds are highly regulated and restricted by the Securities Exchange Commission (SEC). In general, hedge funds are not registered with the SEC and therefore almost unregulated which contributed significantly to the mystery that surrounded hedge funds.^[8]

Hedge fund managers have the objective to generate an absolute positive return regardless of the performance of the economy.^[9] In contrast to that, mutual funds follow a relative return strategy, which means that they try to beat a market index, such as the S&P 500 or respectively another market benchmark. The performance of traditional funds is strongly related to the overall market development, whereas the source of good performances of hedge funds is primarily due to the skills of the manager.^[10] Hence the performance of mutual funds might be higher in bull markets, but hedge funds generate stable returns even in bear markets. Because of the importance of the manager’s skills for the hedge fund return and in order to create incentives for the manager, his compensation is set up differently. Traditional investment funds typically charge investors a percentage of assets under management, as hedge funds do too. In addition to this fix compensation, hedge fund managers may also receive a performance-related fee, under the condition that they realize a return which is superior to a predefined hurdle rate.^[11]

While hedge funds can offer attractive opportunities, investors might also face the following risks. First there is the liquidity risk for the investor. Hedge funds tend to be less liquid than traditional asset classes. Second, the overall risk profile might increase due to the use of financial instruments and high leverage ratios. Third, as hedge funds are mostly unregulated investment pools, they are typically not subject to detailed disclosure requirements. This leads to the fact that there is a lack of transparency in this industry. And finally, there is the manager risk. That means that in contrast to traditional funds where investors generally only worry about a market decline, investors in hedge funds have to cope with the risk that the manager himself may not perform in an adequate and expected way.^[12]

2.3 The hedge fund Universe

Traditional investment funds did not succeed to meet their goals in terms of performance and risk in the last few years. Hence the demand of investors for better ways of diversification and investment vehicles which are able to generate returns independent of the market conditions has grown. These circumstances have contributed to the remarkable growth in this industry.^[13] The hedge fund industry reported approximately US $ 970 billion in assets under management for 2004. This growth has been driven by the sheer number and diversity of individual hedge funds. The number of hedge funds increased dramatically from less than 2.000 hedge funds at the end of the 1980s to about 9.000 in 2005. The following graph shows the estimated hedge funds assets under management and demonstrates the rapid growth in this industry.

illustration not visible in this excerpt

Source: Anonymous (2005d): Size of the Hedge fund Universe,

<http://www.hedgefund.com/abouthfs/universe/universe.htm>, Call date: 25.09.2005.

3 Style Analysis of different Hedge funds

The term “hedge fund” refers to a universe of various investment strategies. These different investment styles vary considerably with respect to their objectives, expected returns and risk profiles among other factors. Therefore a framework for the various investment styles is needed to get a better understanding of hedge funds. But unfortunately, there is no accepted classification standard and hence a range of different frameworks are used in practice. For the sake of simplicity in this paper hedge fund styles are classified into directional, non-directional and hybrid hedge fund styles. The fourth group includes hedge funds styles which use more than one strategy and funds of hedge funds. This framework has been chosen because it is compatible with most existing classifications.^[14]

illustration not visible in this excerpt

Following: Lhabitant, François-Serge (2004) p. 6.

3.1 Directional hedge fund styles

Directional hedge fund styles, also referred to as market timing styles, strongly align their investments on the direction of the market. There are two sub groups, on the one hand Equity long / short and on the other hand tactical trading.

3.1.1 Equity long / short

The equity long / short hedge fund style belongs to the most applied strategies in the hedge fund industry today. It aims to benefit from investment opportunities via the possibility to use leverage, sell short, and hedge market risk.^[15] The hedge fund manager invests long and short in equities with the objective to reduce but not eliminate market exposure.^[16] This approach uses bottom-up research to take advantage of both over- and undervalued securities. The percentage of long and short positions in this strategy depends basically on the overall market conditions. That means that in bull markets the hedge funds generally have a net long exposure (more long gross exposure than short gross exposure) whereas in bear markets it can be favourable to have a net short exposure to avoid losses and generate returns from market downturns instead.^[17] The Strategy can be distinguished regarding the markets the fund managers invest in. The focus can lay on global or regional markets or special industry sectors. Furthermore, some hedge fund managers concentrate their investments on emerging markets. While most traditional investors prefer to avoid investment opportunities in emerging markets because of the low quality level of accounting standards and the political situation, hedge fund manager see the considerable potential for undervalued securities in these market conditions.^[18]

[...]

^[1] See: Fothergill, Martin/Coke, Carolyn (2000) p. 5.

^[2] Wehmeier, Sally (2000) p. 603.

^[3] See: Bundesverband deutscher Banken (Ed.) (2005) p. 3; Interview from 16.09.2005 with Patrick Lehnert, Deutsche Bank AG, see Appendix, p. 19.

^[4] See: Santini, Laura (2003) pp. 9-10; Interview from 16.09.2005 with Patrick Lehnert, Deutsche Bank AG, see Appendix, p. 19.

^[5] See: Lhabitant, François-Serge (2004) p. 5; Anonymous (2005a).

^[6] See: International Financial Services London (2004) p. 5.

^[7] See: Jaeger, Lars (2002) p. 5; International Financial Services London (2004) p. 7.

^[8] See: Harper, David (2005); Lhabitant, François-Serge (2004) p. 5.

^[9] See: Harper, David (2005).

^[10] See: Interview from 16.09.2005 with Patrick Lehnert, Deutsche Bank AG, see Appendix, p. 19.

^[11] See: Fung, William/Hsieh, David A. (1999) p. 6; Harper, David (2005).

^[12] See: Deutsche Bank Group (Ed.) (2003).

^[13] See: Amenc, Noël et al. (2004), p. 59.

^[14] See: Lhabitant, François-Serge (2004) pp. 5-6; Fung, William/Hsieh, David A. (1999) pp. 9-13.

^[15] See: Ineichen, Alexander M. (2002) p. 288.

^[16] See: Lhabitant, François-Serge (2004) p. 6.

^[17] See: Jaeger, Lars (2002) p. 162.

^[18] See: Lhabitant, François-Serge (2004) p. 7; Interview from 16.09.2005 with Patrick Lehnert, Deutsche Bank AG, see Appendix, p. 19; Vorobyova, Toni (2004).