• HOME
• FINANCIAL PHYSICS

RRCM

• Coming Evolution of the Hedge Fund Industry
• Financial Times
• LI Business News
• Dow Jones Asset Man.
• Found.& Endowment Money Man.
• Global Investing

EXCEL

• Wall Street Transcript
• LI Business News
• Chicago Sun-Times
• Economic Times
• Laser Report
• Today's Investor
• Newsday
• Medical Laser Report
• Excel Tech. Annual Rept
• Inc. Magazine 1994
• Assn of Indians in America
• National 500 Technology
• Inc. Magazine 1995

• CONTACT

I. Background of Hedge Funds

Hedge funds first came into existence on January 1, 1949 when Alfred W. Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities to increase returns while reducing net market exposure and used leverage to further enhance the performance. Today the term hedge fund takes on a much broader context, as many of the hedge funds control risk by hedging one or more methods, but many do not. Hedge funds are broadly defined by⁽¹⁾ their structural characteristics, rather than their "hedged" nature. There are several characteristics common to most hedge funds.

First, hedge funds are primarily private investment vehicles and therefore exempt from some of the SEC’s regulatory requirements. The legal structure of the fund provides hedge fund managers with broad discretion over investment styles and asset classes. Hedge funds can take both long and short positions, make concentrated investments, use leverage, use derivatives and invest in many markets. This is in sharp contrast to mutual funds which are highly regulated and do not have the same breadth of investment instruments at their disposal. A hedge fund need not employ all of the tools all of the time, it merely has them at its disposal to meet the objective of achieving absolute maximum returns.

Second, hedge funds utilize a performance based fee (allocation) structure. Hedge fund managers are rewarded primarily in proportion to the profitability of the funds investments (typically 20% of profits). Many times a hurdle rate of return must be achieved or any previous losses recouped before the performance fee is paid. The reward system tends to encourage the hedge fund managers to achieve maximum returns. Most hedge funds also include a management fee based on a percentage of assets under management (typically 1-2%). This fee structure is again in sharp contrast to the mutual fund industry, where fees are based solely on assets under management.

Third, in addition to managing the fund as a general partner, the fund manager is generally an investor in the fund as a limited partner. The size of his investment can range anywhere from a 1% share up to a significant majority interest. Most hedge fund managers commit a large portion of their wealth to the funds in order to align their interest with that of other investors. Since managers tend to be significant investors in their own fund and keep a significant portion of their performance fees in the fund, they share in both the upside and downside of the fund returns. It appears that in hedge funds, the destination of managers and investors are the same and the nature of the relationship is one of true partnership.

There are many different investing styles and strategies of hedge funds, some of which are quite unique. A number of hedge fund industry groups, consultants and information providers attempt to aggregate hedge funds into specific styles. While each organization has its own categorization scheme, a review of several sources ⁽²⁾ yields the following list of styles most commonly included:

Exhibit 1
Investment Styles of Hedge Funds

Source: MAR/HEDGE

Investors decide to invest in hedge funds for a variety of reasons, but several studies reveal that the single most important reason for investing in hedge funds is to earn a superior return. Investors, both private and institutional, feel that hedge funds’ ability to pursue a variety of investing options (short, leverage, concentrated positions, etc.) provide greater possibility of outstanding returns. The ability of hedge funds to outperform mutual funds or the market is very much at the forefront of media attention. It is well documented that individual funds can indeed perform exceptionally well.

Various studies have been conducted to evaluate the performance of hedge funds⁽³⁾. Each of the different investment styles of hedge funds has its own risk and return profile. Generally speaking, the studies conclude that hedge funds as a group do provide higher and superior returns on average compared to the S&P 500 and mutual funds. However, there are some concerns regarding the validity of each study. A central question relates to the make-up of the sample, size of the funds, the survivorship effect, and the self-selection bias of the funds reporting results. Reporting of the data on hedge funds is voluntary and therefore, no one source is comprehensive. However, the differences between different studies also seem to get smaller over time which increases the significance of the results. Based on the studies available, the long-term average performance of hedge funds as a group can be estimated to be in the range of 17-20%, several percentage points higher than traditional equity returns ⁽⁴⁾ .

The volatility of hedge funds, as measured by standard deviation, varies greatly as a function of the strategy pursued. Some of the strategies, such as market neutral are designed to be low in volatility while others, such as short only or global macro funds, are highly volatile. However, the data indicates that a long-term standard deviation of a diversified pool of hedge funds as a group is very similar to the standard deviation of the stock market as measured by the S&P 500 index. The exhibit below compares the performance of hedge funds as a group against a variety of other instruments ⁽⁵⁾.

Exhibit 2
Risk & Reward Comparisons
Hedge Funds vs. Traditional Assets
(1986-1995)

Source: Cottier

Another motivation for private and institutional investors to include hedge funds as part of their investment portfolios is diversification benefit. In addition to their ability to generate higher returns, hedge funds show a low historic correlation to traditional investments. Because of their flexibility to use a full range of investment instruments and techniques, hedge fund returns are somewhat independent of the ups and downs of the market. The low correlation of hedge funds with traditional instruments has emerged as one of the key advantages for investors, especially institutional investors.

The correlation of hedge funds to the S&P 500 and Lehman bond indexes are shown in the Exhibit below. These results were obtained by Dr. Matthias Bekier and his group at the University of St. Gallen⁽⁴⁾. Again, there may be some reservation about the validity of these conclusions as only a limited set of data was used over a one year time horizon.

Exhibit 3
Correlation of Hedge Funds to Traditional Investments
(as measured by r²)

Source: Bekier

Correlation coefficients are usually measured in terms of r-squared. Bekier’s analysis shows that more than 70% of hedge funds have correlation coefficients with the S&P 500 and Lehman bond indexes below 0.3 which is considered to be a statistically insignificant correlation. An r-squared of 1.0 represents perfect correlation while a r-squared of 0.0 represents no correlation.

In summary, hedge funds as a group seem to offer higher returns with average volatility and have a low correlation with traditional investments. Based on Modern Portfolio Theory, it is possible for investors to boost returns while simultaneously lowering volatility by including hedge funds in their optimum portfolio versus a portfolio constructed exclusively with traditional instruments like stocks and bonds. It is our view that as investors become more and more sophisticated and become aware of these performance characteristics, they will allocate a larger portion of their investment assets to hedge funds.

While hedge funds are largely exempt from SEC regulation, there are some specific limits placed on the number and types of investors they may accept. Only "accredited" investors are eligible to invest in hedge funds. "Accredited" individuals must (1) be "sophisticated investors" capable of assessing the risks inherent in unregulated alternative investments and (2) have over $1 million in investable assets. For institutions to be considered "accredited" they must have over $5 million in investable assets. Furthermore, current hedge fund partnerships are limited to 99 partners (a new exemption to this rule allows partnerships of up to 499 investors). Of those 99 investors/partners, no more than 35 can be non-accredited investors.

Due to these restrictions, the universe of hedge fund investors is effectively limited to two specific groups: High Net Worth private individuals and institutional investors (including pension and benefit plans, endowments and foundations, insurance companies, banks and corporations) ^(4,5,6). The exhibit below illustrates the distribution of hedge fund assets by investor group.

Exhibit 4
Hedge Fund Assets by Investor Type

Source: KPMG Survey, Bekier, Cottier

By far the largest group of hedge fund investors is affluent private individuals. It is estimated that this group represents more than 80% of hedge fund assets. In fact, through the 1980s, investors in hedge funds were almost exclusively high net worth private investors. In the 1990s, this circle began to expand and institutional investors started to participate in hedge funds.

Private investors dominate hedge funds because they are more willing to pursue higher absolute returns and to bear the higher risk associated with those higher returns. This group consists primarily of high net worth individuals (defined as those with annual income in excess of $100,000 and net worth in excess of $1,000,000). Family offices and trust departments of private banks are also included in this grouping as their primary role is to manage the fortunes of wealthy individuals and families.

While this group may be a rather small slice of the overall population, they control over one third of the estimated $15 trillion in household financial assets in the United States ⁽⁷⁾. During the 1990’s, the high net worth market has grown at almost twice the rate of the general population. The primary sources of wealth creation have been initial public offerings (IPOs), creation and sales of businesses, merger and acquisition activity and the expansion of stock options as compensation. In the US, there are now nearly 2 million "accredited" household investors with investable assets over $1 million. This group controls about $5.3 trillion of financial assets. The Exhibit below shows the high-net worth market size and share of household financial assets by different wealth groups ⁽⁸⁾ .

Exhibit 5
The High Net Worth Market

Source: Sanford C. Bernstein

It is estimated that institutional investors represent less than 20% of hedge fund assets. Institutional investors include pension and benefit plans, insurance companies, non-profit organizations such as foundations and endowments and other organizations such as corporations and banks. The strict fiduciary responsibilities of many institutional investors and their sometimes bureaucratic investment decision making process has made them slower to adopt hedge funds. Media attention to specific instances of high returns and high variability of returns has created an impression of high risk.

Pension plans are subject to ERISA and the legal doctrine of the "prudent man" rule. The combination of the perceived riskiness of hedge funds and their fiduciary requirements has caused pension plans to be very cautious in their allocation to hedge fund investments. Insurance companies are regulated by state insurance authorities and generally are limited in their investment allocations to limited partnerships. Foundations and endowments on the other hand, have more investment autonomy and were one of the first institutional investor groups to embrace hedge funds.

Although the participation of institutional investors in hedge funds is small, they represent an important segment. Institutional investors as a group control almost twice the assets available for investment than high net worth investors. In the US, at the end of 1996, they had total investable assets of over $11.1 trillion ⁽⁹⁾ compared to the $5.3 trillion of "accredited" private investors. The largest group of institutional investors, by asset size, is pension and retirement plans. They are followed by insurance companies. Third place is occupied by non-profit organizations which include private foundations and endowments. Exhibit 6 below, shows the US institutional capital pool by major investor category along with their historical compounded annual growth rates ⁽⁹⁾ .

Exhibit 6
U.S. Institutional Balance Sheet
(dollars in billions)

Source: Putman, Lovell & Thornton

Although hedge funds are offered globally, the US market is the single most significant one measured by the assets contributed. US managers control almost three quarters of the global assets. We estimate that at the end of 1996, the global assets of hedge funds were approximately $170 billion. The table below estimates the total amount invested by various groups and the corresponding allocation rates for hedge funds for these segments of investors.

Exhibit 7
Breakout of Investments and Allocation Rates
Global Hedge Funds

Source: RRCM & KPMG