hedge funds: challenges in assessing risk and...
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Hedge Funds: Challenges in Assessing Risk and Performance
Eduardo Schwartz
UCLA Anderson School
Hedge funds as legal entities
� Unregulated private investment vehicles for wealthy individuals and institutional investors (“accredited investors”)
� Structured in a way that exempts them from most of the laws and regulations that apply to other investment vehicles
Hedge funds are allowed to operate with lots of freedom and flexibility
� They can:
� trade any type of security or financial instrument
� operate in any market anywhere in the world
� make unlimited use of any kind of derivatives instrument
� engage in unrestricted short-selling
� employ unlimited amounts of leverage
Hedge funds are allowed to operate with lots of freedom and flexibility
� They can:
� hold concentrated positions in any security
� restrict the redemption of assets
� charge their investors whatever fees they want to
� compensate their managers in any way
� have only limited disclosure and reporting obligations to regulators, the public, or their own investors
Hedge funds as investment vehicles
� First hedge fund began in 1949 (long/short equity strategy)
� 1985: 40 hedge funds
� 1995: 1,000
� 2007: 9,000
� US hedge funds manage approx. $1.4 trillion in assets (1/8 of mutual funds)
� Europe - $325 billion
� Asia - $115 billion
Hedge fund performance
� Performance statistics suggest that hedge funds have generally been able to outperform traditional investment strategies by a wide margin� 1990–2006 period: many hedge fund strategies had higher average returns and higher Sharpe ratios than did the traditional benchmarks.
� “Long and short” hedge fund strategies generally had lower return volatilities.
� Several hedge fund strategies performed well during the three year bear stock market
Questions of concern regarding hedge funds performance
� Is hedge fund performance being measured correctly on a risk-adjusted basis?
� How can the persistence of high hedge fund returns be reconciled with the widely accepted view that financial markets are efficient?
Data on hedge funds returns
� Evaluating hedge funds performance is complicated by the lack of good data on returns
� Three important data biases have been identified in the literature� Survivorship bias
� Selection bias
� Backfilling bias
Data on hedge funds returns
� Survivorship bias
� May inflate historical returns if reported index do not include the returns of funds that have not survived
� The failure rate is very high: about 30% of new funds do not last more than three years
Data on hedge funds returns
� Selection bias � Voluntary nature of reporting. If only hedge funds with good performance choose to report to data vendors, this will result in an upward bias in reported average returns
� Backfilling bias� Arises because hedge funds are typically added to a database with an instant history
Reasons for disappearance from database
� 612 hedge funds disappear from the data set (1994-2000)� low past returns combined with a net money outflow increase the
likelihood that a fund will liquidate� 360 funds disappear due to liquidation, while 210 funds self-select
themselves out of the database.
Hedge fund study
� Funds that liquidate during the sample period have substantial lower average returns and net money flows than funds that self-select or survive
� Average quarterly returns� Liquidate: 0.50%� Self-select: 2.04% � Survive: 3.59%
� Average quarterly net money flows � Liquidate: 2.49%� Self-select: 7.47% � Survive: 9.07%
� Conclusion: average hedge funds returns may be overestimated by as much as 7.6%.
Why should hedge funds be able to earn excess returns?
� Substantially higher compensation (though asymmetric incentive fee structure) attracts ‘best’ managers
� Better-informed or more highly skilled managers may be able to outperform other managers
� Exodus of successful mutual fund managers� Several investment companies have had to launch their own hedge funds in an attempt to keep their best managers
Why should hedge funds be able to earn excess returns?
� Asset mispricings may persist because of a shortage of “arbitrage capital”
� Hedge funds employ investment strategies that mainstream investment institutions are unable to pursue due to regulatory constraints
Understanding return, risk and fees
� Worry that investors in hedge funds do not fully understand the true returns and the risks they bear (big failure rate)
� Fees are high. � The management fee to the general partner usually is 1-2 % of assets +20% of profits with ‘high water mark’
� The asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy
� The returns on many strategies are not normally distributed
� Average returns tend to be overstated (biases)
Concerns: systemic risk
� Systematic risks means the risk that failure of one counterparty to a transaction will trigger failure of other counterparties (Long Term Capital Management)
� Bank regulators now monitor the credit and counterparty exposure of financial institutions to hedge funds much more carefully
� Tougher oversight?
Risk management
� The dangers created by hedge funds need to be balanced against the many ways in which the funds actually reduce risk
� Because they can go short as well as long they can be less volatile than individual stocks or standard mutual funds
� Hedge funds help large investors to hold a diversified portfolio of investments
Risk management
� Hedge funds are willing and able to take risks that others wish to avoid (buy credit and currency derivatives)
� “Lock-up" rules prevent investors from withdrawing money on short notice; when crises strike, the funds have the freedom to be buyers
The biggest hedge-fund failure ever: Amaranth Advisors
� US-based hedge fund lost more than $6 b on investments in natural gas futures in September 2006.
� Amaranth's case reflects an incentive structure that can tempt some to assume heavy risk.
� Fee: 1.5% of assets + 20% of investment gains. � Star energy trader Brian Hunter won an estimated
$75 m bonus after his team produced a $1.26 b profit in 2005.
� Chief risk officer Robert Jones got a bonus of $5 m� Nicholas Maounis -- founder, majority owner, and
chief executive -- got an estimated $70 m plus some of Amaranth's $200 million-plus in performance fees.
The biggest hedge-fund failure ever
� Natural gas futures is a highly volatile market, where the price can move swiftly on changes in gas available in storage and on shifts in the weather
� Amaranth made a stunning $1.5 billion in six weeks last spring, mostly on energy trades
� But gains that big in a single market can portend swings just as fast the other way
The biggest hedge-fund failure ever
� In the last week of August, the value of the fund's assets reached $9.2 b, up about 27% since Jan. 1
� Weather-forecasting centers made two predictions: that the hurricane season would pass without major storms, and that the winter would be mild
� By the end of September, Amaranth was down more than $6 billion (65% of their assets) from its August value.
� Other market players profited handsomely from Amaranth’s debacle (Merrill Lynch, J.P. Morgan, Citadel) but there were no disruptions in the financial markets
Fortress Investment Group goes public
� Manages $30 billion, first private-equity and hedge fund manger to sell shares on U.S. markets
� Note that the shares are on the management company
� Private-equity funds averaged 39.7% annual returns since 1999
� Hedge funds have averaged 14% annual returns since 2002
� From $1.2 billion in 2001 to $30 billion last year—a 97% compound annual growth rate
Fortress Investment Group goes public
� Shares traded at roughly 40 times last year’s earnings
� About its IPO� Issued at $18.50 a share
� Opened for trading at $35
� Closed at $31—68% higher than its IPO price
� The five Wall Street veterans who built Fortress finished the day with holdings in the company worth about $10 billion
References
� Jenke ter Horst, 2006, Fund liquidation, self-selection and look-ahead bias in the hedge fund industry, WP.
� Ann Davis, Gregory Zuckerman, Henny Sender. Amid Amaranth’s Crisis, Other Players profited. The Wall Street Journal January 30, 2007.
� Gregory Zuckerman, Henny Sender, Scott Patterson. Hedge-Fund Crowd Sees More Green As Fortress Hits Jackpot With IPO, WSJ, Jan 2007.
� Sebastian Mallaby, 2007, Hands off hedge funds, Foreign Affairs.� Franklin Edwards and Stav Gaon, 2003, Hedge funds: what do
we know?, Journal of Applied Corporate Finance.
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