Hedge funds’ rise and fall—and rise?

In his finance textbook, David Stowell notes that between 1990 and 2007, assets under management by hedge funds increased from $39 billion to $1.9 trillion. He investigates why “most hedge funds, in fact, are not hedged.”

	Title:	An Introduction to Investment Banks, Hedge Funds and Private Equity: The New Paradigm
	Author:	David P. Stowell
	Pages:	578pages
	Publisher:	Academic Press
	Price:	$65

The term “hedge fund” was hatched in 1949 when Alfred W. Jones “created a fund that utilized short selling of assets to hedge other assets that were purchased to create an investment portfolio,” writes Professor Stowell.  The goal was to neutralize the effect of changes in the market through buying assets that would increase in value and selling short assets that would fall.  The desired outcome was to remove overall market risk.

Hedge funds have continued to be viewed as investments offering returns that are “uncorrelated” with market returns—an attractive characteristic for investors who want to lower the risk from traditional stocks and bonds or who want to increase returns without increasing risk.

Several academic studies have showed that the “beta” for broad hedge funds—or correlation of their returns with returns from the S&P 500, in this case—wasn’t as low as many people may have thought.  A 2001 study in the Journal of Portfolio Management found a beta of .84, with a score of 1.0 being perfect correlation.  Then a 2009 study in Portfolio Risk Analysis found a beta of .44, still a somewhat positive correlation.

What, then, are hedge funds?  Even the U.S. Securities and Exchange Commission has affirmed that the term hedge fund “has no precise legal or universally accepted definition.”  Most market practitioners, however, consider a hedge fund to have six characteristics.

Characteristics of Hedge Funds
1.    Almost complete flexibility in investments, including long and short positions
2.    Ability to borrow money, and increase leverage through derivatives, to enhance returns
3.    Minimal regulation, based on serving only sophisticated investors and high-net-worth individuals
4.    Some illiquidity, since investments are often put in “lock-up” for the first one or two years of a hedge fund’s life, and quarterly disbursements may then be subject to “gates,” as well
5.    Investors include only wealthy individuals and institutions, except through “fund of funds” investments—also included in the term hedge funds—which are available more broadly
6.    Annual fees that reward fund managers for performance—typically “2 and 20”—2% of net asset value and 20% of the increase in the fund’s net asset value.  These fees are much higher than for typical mutual fund and money managers, but private equity managers enjoy similarly high fees.

The list of securities regulations from which hedge funds are exempt is hefty:

•    Leverage
•    The use of derivatives
•    Short selling
•    Fees
•    Reporting
•    Investor liquidity

Mutual funds, by contrast, are subject to all of these regulations.  

Perhaps one of the chief characteristics of hedge funds is the use of leverage, or borrowing, to increase returns.  This borrowing results in hedge funds’ losses and gains being magnified.  There are four major categories of leverage.

Margin Loans
Professor Stowell offers an example of a margin loan;  if a typical hedge fund receives, say, $100 million from investors, then it might create a “margin loan” through borrowing $300 million from a bank, and then using the investment money and loan to buy $400 million of stock, with the stock held as collateral against the bank loan.  In this case, if the $400 million portfolio fell in value by 25% to $300 million, then that would result in a total loss of the investor’s capital, if the hedge fund closed down.  Alternatively, if the portfolio increased in value by 25% to $500 million, then the investor’s capital would have doubled in value—before subtracting management fees and operating costs.  

Repurchase Agreements
This is where a “hedge fund agrees to sell a security to another party for a predetermined price and then buy the security back at a higher price on a specified date in the future.”  Not to be confused with the “repo man” who takes back your car if you fall behind on payments.

Selling Securities Short
In this case, hedge funds use the proceeds from selling short to buy other securities.

Derivatives
Buying derivatives contracts allows hedge funds to “create exposure to an asset” and to its potential change in value, “without using as much capital as would be required by buying the asset directly.”  Got that?

How Leveraged Are They?
Professor Stowell explains that at the end of 2007, hedge funds had over $1.9 trillion in investor capital.  Adding the debt and derivative positions on top of that resulted in a total of $6.5 trillion in investable assets—a leverage ratio of a massive 3.4 times! This amount was equal to almost one-third of the total investments controlled by the kings of investable assets—the insurance industry.  And it was just over one-fourth of the investments held by the giant pension fund industry.  

Then came the credit crisis.  By the first quarter of 2009, the leverage ratio had dropped to 2.0 times investor capital, and total investable assets decreased by 64%, to $2.4 trillion.

Performance
An examination of the results of hedge fund investments, from academic research, is instructive, and perhaps a little surprising.

In aggregate, hedge funds have only slightly outperformed the public equities market.  From 1996 to 2006, average annual hedge fund returns, after the “2 and 20” fees are deducted, was 10.6%, according to Hedge Fund Research’s Fund Weighted Composite Index, compared to 8.1% for the MSCI-World Equity Index.  

When the market turned down, though, during 2007 and 2008, the HFR index dropped by 5%, while the MSCI index dropped by 20%. The top-quartile hedge funds, however, have significantly outperformed equities.  From 2002 to 2008, for example, median returns of the top tenth of hedge funds outperformed the HFR Fund Weighted Composite Index by a whopping 45.8%.   

Conclusion:  “the average hedge fund slightly outperforms the broad equity market in a normal market environment (and with lower risk), but it substantially outperforms during unstable markets.”  In addition, investors with money in the top-performing hedge funds have enjoyed overall returns that are significantly higher than average hedge fund returns.

Will the hedge fund industry rise again with an improving world economy?  Stay tuned—or take one of Professor Stowell’s classes.

In the third and last installment, we’ll look at private equity.


Published in September 2011.  by Christine Arrington (E-mail:  Christine.Arrington@casium.fr)