Introduction to Hedge Funds

Neil A. Chriss, December 1998

Banking and Finance G63.2751

Summary of Lecture

This lecture will define what hedge funds are, discuss some of the key strategies that hedge fund managers employ and will introduce some of the important vocabulary and quantitative tools used by hedge fund managers. The accompanying reading for this lecture is Hedge Funds Demystified: Their Potential Role in Institutional Portfolios. I thank the Pension and Endowment Forum of Goldman Sachs & Co. for kindly granting permission for me to reproduce this document for use by the class. A portion of this lecture is drawn from this document.

Types of Investment Funds

There are many types of investment funds besides hedge funds, and to place hedge funds more precisely in the broader context of different funds, it is a good idea to define several other sorts of funds. In this section we will talk about:

Mutual Funds

Mutual funds are actually investment companies, that is, they are firms that collect investments from investors and professionally invest money on behalf of investors. Investment companies collect fees from investors, usually drawn directly out of the investment, as a fee for the service of investment. There are primarily three types of fees an investment company will charge:

Mutual funds come in two varieties: closed end and open end. Open end mutual funds are investment companies that continually offer new shares of the fund to the public for investment and stand ready to redeem outstanding shares at the net-asset value (NAV) of the fund. In this sense, the company is the unique market maker of shares in the company. They will sell or buy the shares every day. Mutual funds sell their shares at the fund net-asset value per share, which may be regarded as the value of the investment in the fund. It is calculated by taking the value of all investments in the fund less any liabilities (such as fees) divided by the total number of outstanding shares.

Mutual funds are regulated investment companies. In particular, they are regulated by the Investment Company Acts of 1940 and 1970. The 1940 Act regulates certain aspect of a fund's operations including financial statements, investment goals, personnel, debt, and managers. The 1970 Act regulates sales charges (i.e., sales load and in particular the maximum sales load) and fees of mutual funds. The main point that concerns us in this lecture is that mutual funds are tightly regulated entities, a fact which is not the case for hedge funds.

Note that open end mutual funds cannot be traded in a secondary market. Their values are determined by the investment company (mutual fund company) and the company is required (by the Act) to buy and sell the shares of the company at the NAV. Two key pieces of terminology concerning all funds are:

Closed-end mutual funds unlike open end funds are traded in a secondary market. Such funds are distinct from open end funds and work as follows. The fund issues a limited number of shares and does not redeem the shares. Rather, the company publishes information about its NAV and the shares are traded on a secondary market or through an over-the-counter market. In this sense, investors purchases shares of closed end funds much in the same way they purchase shares of stock and for similar reasons. An important feature of closed end funds is that their market values and net-asset values may differ. This is because the net-asset value, determined by the value of the investments in the fund, may be different than the value (per share) that investors are willing to pay for the fund. A closed-end fund whose market value is less than its NAV is said to be trading at a discount.

Pension Funds

A pension fund is an investment company that manages the assets of employees of a company and disburses the assets to employees upon retirement. Contributions to the fund by both employer and employee finance the pension fund assets. There are two main types of pension funds:

I bring up pension funds in this lecture for two reasons. First, they are a type of investment fund and therefore knowledge of them helps to reduce confusion about what and what not a pension fund is, and second, pension funds are large investors in hedge funds. Moreover, the pension industry has been growing world wide for some time; as a result has an impact on capital markets, as expressed in the following quote:

Another point concerning the relationship between hedge funds and pension fund investment is the need for financial innovation, as Davis points out:

Pension funds are often referred to as pension plans, and the organizations that establish pension plans (such as private or public companies) are referred to as "plan sponsors". US Pension funds are regulated by the important ERISA Act of 1974 (Employee Retirement Income Security Act), and this has implications on how the monies coming from a pension fund can be invested, how they are to be disbursed, as well as the financial and fiduciary standards of many of the participants in the pension plan world. We can only briefly discuss ERISA here, but the full text of the act can be found on the internet at http://www.benefitslink.com/erisa.

The act begins with the following statement:

Summarizing the US governments reasons for regulating the pension plan industry, we see:

The second point is important for investment funds: ERISA money, that is, monies invested by pension plans, receives different tax treatment vis-a-vis capital gains. Moreover, pension plans have three alternatives with regard to how they manage their assets:

Two important points when comparing pension funds as investors in hedge funds versus individuals as investors in hedge funds are 1) fees and 2) tax treatment. Pension funds typically pay fees for assets under management that are well below standard hedge fund fees. For example, Frank Fabozzi in Investment Management (Prentice Hall, 1995) reports that a study in 1991 found that public pension funds pay an average of .31% (31 bps) to have their external assets managed (that is, they pay .31% of total assets under management as management fee) and private pension funds pay .41% (41 bps).

As such, pension funds have different investment goals relative to individual investors. As many hedge funds draw from pension plans for investment capital, understanding the investment goals and rules of pension plans is an important aspect of hedge fund marketing.

More on Tax Treatment of Pension Funds

The following brief discussion on tax treatment of pension funds is taken from Pension Funds, E. P. Davis, Oxford 1997. Broadly speaking there are three different ways a pension fund can be taxed, depending on which part of the pension monies are taxed. From this point of view, pension money is divided into three pieces: contributions (the money going into the fund) and income (the increase in the funds value due to asset appreciation), and benefits (the money coming out of the fund to pay employees upon retirement, or withdrawal from the plan). Each piece may either be exempt (E) or taxed (T).

A contribution to a pension plan is said to be tax free if the income to the individual or employer that goes to the pension fund is not taxed. For example, suppose a US employee makes $50,000 per year and contributes $2,000 to his or her pension fund in a given tax year. If this contribution is tax free, then the employee's taxable income that year is $48,000.

The US follows what is basically an EET taxation plan for pension funds, though there are limits on the level of tax-free contributions for DC plans. Such contributions are limited to $30,000 per annum. For DB plans, the amount of benefits that may be paid to an individual is limited to an "indexed ceiling", that is, the maximum level increases with a pre-defined index level.

Most countries globally follow an EET-like plan. The following table may be of interest:

Country Form of Taxation
USA EET: contributions and asset returns tax free. Benefits taxed.
UK EET
Germany TET: Employers' contributions taxed as wages; employees' contributions and asset returns tax free. Benefits taxed at a low rate.
Japan ETT: Contributions tax free. Tax on asset returns, except for tax-free lump sum.
Canada EET:
Netherlands EET
Sweden ETT
Denmark ETT: Contributions tax free. Tax on real asset returns. Benefits taxed, including including 40$ of lump-sum payments.
Switzerland EET
Australia TTT: Contributions, asset return, and benefits taxed.
France E(E)T
Italy EET

Source: Pension Funds, E. P. Davis, Oxford 1997

Investment Implications

Depending on the particular taxation rules applied to a hedge fund, the plan sponsor will view various investment styles differently. For example, if a government taxes realized income on capital gains (i.e., Australia) then a high turnover investment strategy (i.e., lots of capital gains) would be tax-disadvantageous to a pension fund. In the US, due to the EET approach to taxation, capital gains are not taxed, and plan sponsors do not have to look for "tax efficient" investment strategies.

Hedge Funds

The first thing to know about hedge funds is that the term hedge fund is not a legal term, but rather an industry term. What a hedge fund is, therefore, is subject to some amount of interpretation. Consider a few definitions. From Wall Street Words Houghton & Miflin 1997:

From the VAN Hedge Fund Advisors International web page:

From the Hennessee Group LLC Web page:

A hedge fund is a "pool" of capital for accredited investors only and organized using the limited partnership legal structure... the general partner is usually the money manager and is likely to have a very high percentage of his/her own net worth invested in the fund.

As you can see, the definitions above focus on several aspects of investment companies known as hedge funds:

All three components are important in understanding hedge funds. To go further let's discuss first what hedge funds are and what some of their salient features are:

Who invests in hedge funds?

And the rule contains the following points for an organization, corporation or other such entity:

One important item that none of the definitions covered was hedge fund fee structures, which is, in my opinion, a key distinguishing feature of hedge funds versus in particular mutual funds. Hedge funds almost always have a fee structure that includes both a fixed fee and a management fee. The fixed fee usually ranges between 1 and 2% of assets under management and the management fee ranges between 20 and 25% of upside performance. As hedge funds are unregulated, these ranges are often exceeded, and can be as high as 5% fixed fee and 25% management fee. Hedge fund fees are often quoted in language such as "2 and 20" meaning 2% fixed fee and 20% management fee. There are two additional important points about hedge fund fees:

The performance fee is sometimes calculated net of a benchmark. That is, the returns that fees are paid on are sometimes only those returns in excess of some benchmark. Sometimes the benchmark is a risk-free interest rate such as LIBOR (often called the cash benchmark, meaning performance fees are paid on the profit that would be made in excess of an investment in cash) and other times it is a market index such as the MSCI World Index or the S&P 500 index.

Example: Suppose at the beginning of year 1 a hedge fund has a net asset value of 100, and throughout the year the fund realizes a 25% return, raising the net asset value to 125. Then if an investor entered the fund with a $1,000,000 investment at the beginning of year 1 then his or her "shares" would be worth $1,250,000 gross of fees. If the benchmark was cash, say 5%, then the fees would be paid on the $200,000 upside in excess of cash. That is, the first 5% of the return would not have to have fees paid on it. If the fees were 2 and 20, then the investor would pay $20,000 in fixed fee (2%) and 20% of the upside above cash, that is, an additional $40,000 for a total of $60,000 in fees. This would make the investment value, gross of fees, equal to $1,190,000.

The high water mark is an important concept: investors in hedge funds enter the fund at a certain net asset value, which we'll call the entering NAV. If the fund loses money in a given year and then makes back that money in a subsequent year, the investor is usually not required to pay a management fee on any portion of the upside in the subsequent year that was below the entering NAV.

Example: Suppose an investor enters a hedge fund with a $1,000,000 at the beginning of year 1, and in that year the fund is down 20%, that is, the value of the investment drops to $800,000 gross of fees. The investor still pays the management fee (that is why it is called a fixed fee), but the investor pays no management fee. Now suppose that after year two the investment value is up to $1,200,000, representing over a 30% gain in year two for the fund. The investor, nevertheless, only pays a management fee on $200,000, that is, he or she only pays a fee on the amount in excess of the entering NAV. The entering NAV in this case is called the high water mark. In subsequent years if there is a drop in NAV, the new high water mark will be the entering NAV of the previous year, or the previous high water mark, whichever is greater.

Liquidity

Hedge funds, unlike mutual funds, are not able to stand ready to buy and sell shares on any given date. Rather they have two forms of liquidity constraints that they impose on investors:

Liquidity dates refer to pre-specified times of the year when an investor is allowed to redeem shares. Hedge funds typically have quarterly liquidity dates, but yearly liquidity dates are not unheard of. Moreover, it is often required that investors give advanced notice of the desired to redeem: these redemption notices are often required 30 days in advance of actual redemption. Here is a quote from the November 16, 1998 issue of Pension & Investments, commenting on hedge fund redemptions:

Lockup refers to the initial amount of time an investor is required to keep his or her money in the fund before redeem shares. Lockup therefore represents a commitment to keep initial investment in a fund for a period of time. Once the lockup period is over, the investor is free to redeem shares on any liquidity date. The length of the lockup period represents a cushion to the hedge fund manager, especially a new one. If the hedge fund is unlucky enough to experience a drawdown (a sharp reduction in net asset value) after the launching of his or her fund, then the lockup period will force investors to stay in the fund rather than bail out. The ability for a hedge fund to demand a long lockup period and still raise a significant amount of money depends a great deal on the quality and reputation of the hedge fund as well as the market savvy of the marketers of the fund. For example, Long Term Capital Management was able to require a three year lockup from investors. The Wall Street Journal in How Salesmanship and Brainpower Failed to Save Long-Term Capital November 16, 1998 reports that John Meriwether, manager of Long Term Capital

Then there were the sky-high fees: an annual management charge of 2% of assets, plus 25% of profits, compared with 1% and 20% respectively, for most of the industry.

Legal Structure

U.S. hedge funds are structured as limited partnerships. A limited partnership is characterized by the fact that it has two types of partners:

Limited partners have limited liability with respect to the creditors of the partnership. In other words, the extent of the liability of a limited partner is the partner's investment. In the context of hedge funds, limited partners buy shares in the "corporation" (the hedge fund) and the value of the shares, gross of fees, are tied to the net asset value of the fund. In practical terms, the general partners run the hedge fund. They are often referred to as the hedge fund manager. The limited partners are the investors.

The Hedge Fund Industry

It is important to understand the magnitude of the hedge fund industry and the sizes of some of the key players in the industry. "Hedge Funds Demystified" estimates that the size of the whole industry is approximately $400bn, and that the investor pool is dominated by wealthy individuals (accredited investors), with pension fund interest increasing. "Hedge Funds Demystified" also notes that it is difficult to accurately assess the size of the industry, so this number should be read as mainly an indication of the order of magnitude. To get a sense of where this stands, consider the pension fund industry by contrast. Davis, in Pension Funds, reports that as of year end 1991, the US pension fund industry's assets were at least $2.9 trillion. In other countries, the number was less for two reasons: the pension fund industry contributes less assets as a percentage of GDP than the US (except Germany and Switzerland) and the US GDP is much larger than other countries. Nevertheless, the global pension fund industry (as of year end 1991) was estimated at approximately $4.2 trillion. The numbers since then have surely grown, but I currently do not have more up-to-date numbers.

Types of Hedge Funds

Hedge funds are generally classified according to the type of investment strategy they run. Below we review the major types of strategies, but refer members of the class to "Hedge Funds Demystified" for greater detail.

Market Neutral (or Relative Value) Funds

Market neutral funds attempt to produce return series that have no or low correlation with traditional markets such as the US equity or fixed income markets. Market neutral strategies are characterized less by what they invest in than by the nature of the returns. They often are highly quantitative in their portfolio construction process, and market themselves as an investment that can improve the overall risk/return structure of a portfolio of investments. Market neutral funds should not be confused with Long/Short investment strategies (see below). The key feature of market neutral funds are the low correlation between their returns and the traditional asset's.

Event Driven Funds

Event driven funds seek to make profitable investments by investing in a timely manner in securities that are presently affected by particular events. Such events include distressed debt investing, merger arbitrage (sometimes called risk arbitrage) and corporate spin-offs and restructuring.

Long/Short Funds

Funds employing long/short strategies generally invest in equity and fixed income securities taking directional bets on either an individual security, sector or country level. For example, a fund might do pairs trading, and buy stocks that they think will move up and sell stocks they think will move down. Or go long sectors they think will go up and short countries they think will go down. Long/Short strategies are not automatically market neutral. That is, a long/short strategy can have significant correlation with traditional markets, and surprisingly have seen large down turns in exactly the same times as major market downturns. For example, Pension & Investments reported on November 30, 1998:

Many long-short managers, which aim to profit from going long on stellar stocks and selling short equity albatrosses, typically use traditional stock valuation factors such as price-to-earnings and price-to-bok value ratios in their mathematical models to cull the winners from the losers. Unfortunately for them, when the market ran into turbulence in late July and August, investors sought safe haven in some of the largest-but expensive-stocks that these models had rejected as overpriced.

Then, after the Federal Reserve Bank began easing interest rates in late September, investors rushed to buy small-capitalization, high-octane stocks that had been neglected in favor of large cap stocks for most of the year. ... As a result, some market long-short managers got hit with a double-whammy.

Tactical Trading

Quoting from "Hedge Funds Demystified":

The Hedge Fund Industry and Quantitative Methods

Quantitative methods have been successfully applied in the hedge fund industry to improve returns, and control risk. That said, there have been striking failures of seemingly quantitatively driven funds (such as Long-Term Capital). Some of the most quantitatively driven strategies occur in the Market Neutral/Relative Value Sector of the Hedge Fund World, so we will exam this sector in more detail by discussing some of the specific types of strategies they employ. The following is a list of important and quantitatively driven market neutral/relative value strategies. I refer you to "Hedge Funds Demystified" for a detailed description of each:

Hedge Fund Returns

As hedge funds are often viewed as providing returns that are "cheap" relative to risk, their performance is usually evaluated on a risk-adjusted return basis. The common number that is quoted is the Sharpe Ratio which is the ratio of annualized excess returns to the annualized standard deviation of returns. The following repeats the data in Table 7 of "Hedge Funds Demystified" and gives an idea of the relative performance of hedge funds compared with some standard indexes over the period January 1993 - December 1997. The table represents returns on each Hedge Fund Sector, that is, the returns and standard deviations in each column represents the returns that were realized on an equal weighted investment portfolio of all the hedge funds in a given sector.

Market Neutral Funds (38 Funds) Event Driven Funds (49 Funds) Equity Long/Short (89 Funds) Tactical Trading (101 Funds) S&P 500 FT/S&P Actuaries World (USD Perspective) Lehman Aggregate Bond Index
Compound Return 13.37% 17.25% 19.29% 19.48% 20.25% 15.18% 7.48%
Standard Deviation 1.86% 3.12% 7.20% 9.97% 10.66% 10.88% 4.14%
Sharpe Ratio 4.69 4.05 2.07 1.54 1.52 1.03 .7

Leverage

The final point of this lecture is the notion of leverage in hedge funds. Leverage has many different precise definitions, but all of them attempt to measure the amount of assets being funded by each investment dollar. Leverage, especially in the days following the Long-Term Capital bailout, has been in the press a lot. There are two fundamentally different ways of measuring leverage:

Consider two fictitious funds with the following investments

FUND A

FUND B

Long Short Long Short
$100 $0 $100 $100

Suppose each fund has $10 of investment capital. First of all, fund A is leverage 10 to 1 in either definition of leverage, while fund B is leveraged 10 to 1 in the first definition, but 20 to 1 in the second. What are the risks in holding each fund?

First, let's examine the risks we can enumerate:

Thus, from one point of view, the position of Fund B might be regarded as more risky than the position of Fund A. Why? Because Fund B has essentially $200 of potential market movements available, while Fund A only has $100. But, suppose the short position in fund B is actually a hedge against the movement of the long position. That is, suppose the short position is highly correlated with the long position so that the short position is risk-reducing relative to the long position. In this case, the risk of fund B may be regarded as less than the risk of fund A. An immediate conclusion of this example is that it is difficult to assess from leverage alone the level of risk inherent in a fund. To form a more accurate understanding of risk requires an understanding of the distribution of future returns of a fund.

Put another way, the information we provide here cannot in itself adequately express the risk of the fund. So, then, why don't people look at the risk of funds (e.g., Value at Risk or some other risk measure) and forget about leverage altogether? Why do investors and the press worry about leverage so much these days? The answer is that risk is deceptively difficult to measure. Consider for example a highly leveraged fund that is long and short securities that are highly correlated. Moreover, assume that this correlation is measured using historical data, and that the fund is regarded as only moderately risky due to the presumed stability of return correlations. If the fund is highly leveraged and it turns out that the correlation assumptions are incorrect, then the damage of the incorrect analysis will be severe precisely due to the miscalculation in the correlations. Put another way, the damage of a mis-estimate of risk is itself leveraged when the fund is leveraged.