posthuma, n and sluis van der, p.j. - unveiling hedge funds (200601)

7/29/2019 Posthuma, N and Sluis Van Der, P.J. - Unveiling Hedge Funds (200601)

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ABP Working Paper Series

Unveiling hedge funds

N. Posthuma and P.J. van der Sluis

January 2006-2006/06 ISSN 1871-2665

*Views expressed are those of the individual authors and do not necessarily reflect official positions of ABP


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What are hedge funds? The classic denition of a hedge fund is a

privately organized, pooled investment vehicle, investing primarily

in publicly traded securities and derivatives. Combinations of short

and long positions reduce exposures to general moves in markets,

while the focus is on proting from security selection. This denition

of a hedge fund does not span the various trading strategies applied

by hedge funds anymore. With the strong performance of stock and

bond markets globally in the late nineties, many hedge funds have

deviated from the classical denition by taking net positions that have

been more than 100% long or, in rarer cases, substantially short. Due

to the media attention of some large hedge fund blow-ups, it is often

perceived that hedge funds are very volatile, use a lot of leverage, and

take large speculative bets. We believe this is not true in general. Hedge

funds may use speculative instruments such as options and futures,

but they mainly do this in a very risk-controlled and conservative way.

Hedge fund strategies are often very subtle. The returns of nancial

assets break down in several risk premiums. If one of these component

risk premiums has a high return to risk ratio, a hedge fund can choose

to take up only this component risk and hedge out the others.

UNVEILING HEDGE FUNDS1

NOLKE POSTHUMA2 EN PIETER JELLE VAN DER SLUIS3

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The hedging out of the above component

risks is often a delicate issue. We will give some

examples below where we discuss the hedge

fund styles in detail. Due to the fact hedge

funds are largely unregulated they can gear

up any of the above component risk premiums.

Leverage is often needed to make the small risk

premiums economically signicant.

Nowadays a hedge fund is best dened by

its organizational structure and regulatory

status. We will discuss these issues below. Any

statement about a hedge fund is conditional

on the investment style of the fund. Therefore

we will classify hedge funds on basis of their

styles. We do not consider hedge funds to be

an asset class on their own. The investmentstyles are diverse and investing in hedge funds

is also a bet on active management. Seasoned

fund of funds managers understand that an

external managers track record of good past

returns is no guarantee for future good returns.

Instead they will focus on sustainability of the

return generating process of the manager

and do extensive due diligence on and daily

monitoring of the funds they invest in.

This paper is nothing more than an introduction

to hedge funds. It is not a compendium for

asset allocation decisions to hedge funds, nor a

digest for doing hedge fund manager selection.

The characteristics of hedge funds are such

that the latter two key issues are very tough.

We urge any potential hedge fund investor

to seek advice from experienced hedge fund

professionals.

1.1 Regulatory environment

Hedge funds are usually private partnerships

exempt from many regulatory controls

common to more traditional investment funds.

Hedge funds can be dened by their freedom

from regulatory controls as described by the

Investment Company Acts of 1933 and 1940.

These controls limit fund leverage, short selling,

holding shares of other investment companies,

and holding more than 10% of the shares

of any single company. Hedge funds do not

have to comply with the Fulcrum rule, which

forbids mutual fund managers to have dierent

fees for gains and losses. Marketing of hedge

funds is severely restricted by US law; they are

not allowed to advertise to the general public.

Word of mouth advertising and inclusion in

databases are the most important options left

to obtain funds. For regulatory purposes, before

1996, hedge funds had to limit the number of

investors to 99 to qualify for exclusion from

regulations governing public issuance of

securities, including restrictions on public

advertising and solicitation of investors. In 1996,the National Securities Markets Improvement

Act modied the Investment Company Act

by raising the ceiling on the number of U.S.

investors allowed in unregulated funds to 500.

In addition, recent rules by the SEC have further

broadened the ability of hedge funds to attract

individual and institutional money. Hedge funds

can accept money from qualied investors,

who have $5 million in capital to invest, and a

sophisticated understanding of the nancial

markets. In addition, they can accept money

from institutions such as pension funds that

have at least $25 million in capital. Recently

predominantly European governments have

released new laws that provide hedge funds

with more space for marketing activities.

Generally speaking, European regulations are

similar to those in the US. The extent to which

regulators can regulate is limited due to the

existence of many oshore fund structure

possibilities. Additional regulation tends to

drive hedge funds oshore where they are

further out of reach. Note that hedge funds

that invest in other hedge funds (fund of

funds) could comply with US rules even when

underlying funds are based oshore. Although

hedge funds are not strictly regulated, they are

regulated by the banks from which give them

credit. The banks themselves are regulated and

will not deal with anybody who cannot prove

to have adequate capital or provide adequate

margin.

1.2 Skill based and fee driven

Hedge funds are predominantly comprised of a

exible sta to swiftly take advantage of market

opportunities. Compared to traditional asset

managers, hedge funds charge aggressive fees.

Typical fee structures consist of 2% of assets

under management, and 20% of cumulative

prots on a yearly basis. The fast growth of the

hedge fund industry provokes a greater variety

in fee structures. Some performance fees are

calculated on basis of quarterly or even monthly

returns. It is noted that such performance fee is

equivalent to giving an in the money option

to the hedge fund manager each quarter or

month. The value of these options increases

with the volatility of the hedge fund, which is

controlled by the hedge fund manager. This

may give rise to a misalignment of interests

with the investor and the manager. The costs of

the organization could come in addition to the

fees. High watermarks are applied to give hedgefund managers incentives to control risk taking.

A high watermark determines that excess

return fees cannot be paid before earlier losses

have been compensated. The high watermark

is an incentive to avoid loss, but when losses

are made the coin turns, hedge fund managers

have the incentive to take on extra risk in order

to get above their watermarks, which delivers

them performance fees. Hedge funds often

require advance notice for redemptions of as

short as one month, and as long as three years.

Such notice or lockup periods are designed to

limit the impact of fund redemptions on the

investment strategy, which is often in illiquid

securities. Hedge fund managers often invest

a substantial amount of their own money in

their funds. This practice is hoped to have the

eect of aligning the interests of the managers

with those of the outside investors. However,

the emotional involvement of the manager

might also lead to human decits. The empirical

evidence is as follows. Liang (1999) nds

that average hedge fund returns are related

positively to incentive fees, size of fund assets,

and the lockup period. In particular, funds with

high watermarks outperform those without.

Note, in this research the author could only use

reported returns, poor performance might not

be reported by managers and could change

results.

2. Hedge fund industry growth

Hedge funds are commonly viewed as a

phenomenon starting in the late-1980s.

However, their history is actually considerably

longer than that. Unocial hedge funds have

been around for centuries. Take for example

Due to the media attention of

some large hedge fund blow-

ups, it is often perceived thathedge funds are very volatile,

use a lot of leverage, and take

large speculative bets

FIDUCIEE DECEMBER 2004 NUMMER 218


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rice futures traders in 18th century Japan. The

rst ocial hedge fund on record, the Jones

Hedge Fund, was established by Alfred Winslow

Jones in 1949. The fund invested in US stocks,

both long, and short in an attempt to reduce

market risk, and focus on stock selection.

Jones generated high returns while managing

to avoid signicant attention from the general

nancial community until 1966, when an article

in Fortune (Loomis) led to increased interest

in hedge funds. Two years later in 1968, the

Securities and Exchange Commission (SEC)

estimated that approximately 140 hedge funds

were in existence. During the equity market

downturn of 1969, assets under management

and the number of funds declined with severely

(70% for the largest registered funds) dueto losses, withdrawals and closures. Perhaps

(imitator) hedge funds could not resist the

temptation to be leveraged long during the

preceding bull market. As a consequence,

hedge funds lost their popularity. Proprietary

trading desks of banks were still trading

hedge fund strategies. Only in the early 1980s

did popularity rise again, with investments in

Julian Robertsons Tiger fund going up from

$8 million to $3 billion. Julian Robertson was

unable to run his equity long short strategies

anymore without a profound market impact.

Therefore, he decided to apply new investment

strategies. He began speculating on global

currencies based on macro economic views,

later a style called global macro. Since then,

growth has continued tremendously in terms

of number of funds, funds under management,

as well as the number of investment strategies.

Julian Robertsons Tiger fund closed down

in February 2000 after missing the tech

bubble. In retrospect his view on tech proved

to be correct with the dramatic decline of the

NASDAQ. Historically hedge fund investors were

wealthy individuals and families. The economic

expansion, combined with high compensation

packages in, for instance, the high-tech, and

nancial sector, and the success of many family-

owned and entrepreneurial business raised the

number of wealthy individuals substantially.

In the 1990s only a few institutional investors,

university endowment funds such as Harvard

and Yale, took the move to invest in these non-

institutional vehicles. The stellar performance of

major macro funds until 1998 and of leveraged

long equity funds during 1999 attracted

advantageous market attention. As in the

1960s, many imitator funds started in the 1990s,

and many funds closed down or liquidated

during the liquidity crisis of 1998 and the

equity market downturn in 2000. The liquidity

crisis, especially the collapse of Long Term

Capital Management (LTCM) attracted negative

attention. However, institutional interest

accelerated enormously with the slump in

global equity markets combined with the bleak

outlook. The perceived low correlation and

favorable Sharpe ratios of hedge funds, draw

many institutional investors into hedge funds.

Tremont TASS - one of the leading database

vendors - estimates the hedge fund industrys

asset base at $870 billion in August 20041. Many

me-too funds founded by former investment

bankers and the vast amount of capital drawnin, revitalized Julian Robertsons issue of market

impact and capacity. Since 2000, hedge funds

have produced lower returns. An extensive and

perhaps desperate search for new strategies is

conducted. Former investment bankers who

are now in hedge funds, have experience in

nancing and structuring deals. This could be

the reason why nancing catastrophe bonds,

mortgage and asset backed securities, credit

default swaps, complex derivative structures,

and arbitrage on capital structures has become

increasingly popular. These managers edge

against traditional investment banks is their

freedom to refrain from complying with several

banking regulations and the upcoming liquidity

restricting Basel II. Instead of competing with

hedge funds, investment banks collect hefty

fees for their services and even have their own

embedded hedge fund hotels.

3. Classications of hedge funds

Hedge funds use various trading strategies,

each of them having specic risk and return

characteristics, and exposures to traditional

asset classes (equity for example) that vary

strongly from negative to positive.

A level of aggregation makes it easier to probe

into hedge funds. Data-vendors, practitioners

and academics develop and use dierent

classications. Hedge funds can be classied

along several dimensions, such as investment

style, asset class and geographical focus,

leverage, and incentive structures. The most

general style labels are relative value, directional,

and event driven. Relative value encompasses

many trading strategies in equities and capital

structure arbitrage. Event driven strategies, are

also often relative value strategies. Relatively

new capital structure arbitrage strategies, such

as equity debt arbitrage, are booming with the

increase in instruments like equity debt swaps.

Known relative value opportunities may erode

as many managers apply the same trades.

Market capacities of directional strategiesdriven by geo-political circumstances are not

easily eroded. Governments and central banks

manipulate interest and exchange rates. This

causes short-run ineciencies in these markets,

that hedge funds exploit. Below we describe

some common style classications. Notice

that some for some strategies, multiple style

classications apply, and some classications

include many dierent strategies. Managers

choosing their own benchmark might be

tempted to choose the most favorable

benchmark.

Relative value

Relative Value styles try to eliminate

market risk and make use of market

ineciencies to obtain performance.

Managers who primarily exploit

mispricings between related

securities are also often labeled as

arbitrageurs.

Equity

Most managers classify their fund

as Long Short Equity. Long short

equity strategies include stock

selection, timing, sector rotation,

and alternative equity risk premium

strategies. Many investors for

instance perceive value, small stocks

to carry a specic risk premium,

which could be exploited. Most long

short strategies have an exposure to

the equity market between zero and

100% of capital. Dedicated Short

and Equity Market Neutral are other

equity trading styles, which

Note that hedge funds that

invest in other hedge funds(fund of funds) could comply

with US rules even when

underlying funds are based

oshore

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major dierences are the amount of

equity market exposure. A dedicated

short manager attempts to have a

negative exposure, while an equity

market neutral manager attempts

to eliminate exposure to the equity

market.

Emerging market

Investing in equity and xed income

securities in emerging markets

could result in returns diering from

investing in developed markets.

Market ineciencies are potentially

larger due to less coverage by

analysts, lower transparency, less

developed investors, dierentmarket structures, and government

inuence. Emerging Market is the

hedge fund style that applies to

managers who attempt to exploit

these opportunities. Geopolitical

risk is the risk for which these hedge

funds commonly seek rewards.

Fixed income strategies

Fixed income strategies include

bond selection, yield curve timing,

term structure arbitrage, and

exploiting liquidity and default

premiums. Especially carry trades,

i.e. buy long-term bonds, and sell

short-term bonds, are quite popular

amongst many hedge funds. Most

money invested in securities is

invested in xed income securities.

These vast markets are inuenced

by government and central bank

politics. The desire for status

quo (e.g. Keiretsu system Japan),

integration within a larger trading

block (e.g. EU), or the nancing of

budget decits (US) might inuence

monetary decisions, which could

deliver opportunities.

Event driven

The style classication Event Driven

is reserved for managers that

attempt to benet from events, such

as mergers, and changes in capital

structures. An example is Merger

Arbitrage, which managers often

sell the bidder and buy the takeover

target. The bidder oers a price for

the target above the market value.

If the merger succeeds a premium

is collected. This risk premium is

insurance for deal failure.

Another example of an event driven

strategy is the Distressed/High

yield style. A specic event is a rm

becoming nancially distressed.

Financial distress causes institutions

such as banks and regulators to

impose restrictions. Banks have

larger capital requirements for

non-investment grade compared

to investment grade loans. Basel II

requirements are likely to induce

even more limitations on banks tosupply capital to distressed rms.

The regulatory freedom of hedge

funds, places managers in a superior

position to benet from investing in

distressed rms.

Capital structure arbitrage

Capital structure arbitrage funds

exploit arbitrage opportunities in

securities of the same rm.

Convertible Arbitrage strategies were

popular during the 90s. Convertible

bonds can be decomposed in an

equity option and a bond. Firms

who issue convertibles are often

perceived as being more risky than

the average rm. Issuing straight

bonds would be too expensive, and

issuing equity could be unsuccessful

for these rms. The convertible is

a bond with a relatively low yield,

and equity is only diluted if the

rm is successful. Investors who

demand a risk premium for these

rms convertibles could make

convertibles cheap relative to the

two components. Hedge funds are

in an excellent position to prot

from these arbitrage opportunities,

as they have the skills to hedge

dynamically dierences in volatilities

of the bond and equity part. Hedge

funds of this convertible arbitrage

trading style make up 60-80% of the

convertible markets nowadays.

SEC Regulation D allows public rms

to sell shares privately to a limited

number of accredited investors

without formal registration. These

shares are usually sold at a discount.

The intention of the legislator is to

help distressed rms acquire capital

and become healthy again. There is

substantial freedom in structuring

private equity investments in

distressed rms, structures include

oating rate convertible preferred

stock, convertible resets, common

stock resets, or structured equity

lines.

Another example of capital structure

arbitrage is the Equity Debt Arbitrage

style. Managers of this style attempt

to exploit mispricings between therms debt and equity. High yield

and credit default swaps are xed

income investments with an equity

risk part. This equity risk part can

be hedged and if the xed income

market prices the risk dierent from

the equity market a premium can be

obtained.

Directional

Global Macro

The macro economic status and

politics of countries and regions

can have substantial impact on

xed income, foreign exchange and

commodity markets. Global Macro

managers attempt to exploit macro

economic mispricings. A famous

example of a global macro trader is

George Soros, who made a fortune

attacking the British pound, forcing

it to devaluate below the European

Monetary System exchange rate

bound. Global macro traders tend

to take leveraged directional bets.

This investment style includes

the popular Asian and gold carry

trades. Exposure to capital markets

typically exceeds the capital base,

which makes these funds quite

volatile. Global macro traders often

use forwards and futures. This style

exploits geopolitical risks.

Managed futures

Some managers predominantly

trade futures. Futures on major



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market indices, interest rate

products, and commodities are

highly liquid and easy to trade.

Next to fundamental (macro

economic) indicators, many traders

use indicators for market sentiment

and attempt to exploit patterns

in prices and volatilities, which is

called technical analysis. A trader

could further use a judgmental or a

systematic approach. Fundamental

traders often use judgment, while

technical traders (also called

Commodity Trading Advisors) use a

more rigid trading model. Managers

who apply mixtures of these trading

styles and select which markets totrade on are labeled discretionary.

Fund of funds and structured

products

Large institutional investors have

the resources to obtain knowledge

and operations necessary for direct

hedge fund investing and are able

to construct diversied portfolios

of hedge funds. Fund of Funds are

invented to deliver smaller investors

exposure to diversied portfolios of

hedge funds. For their expertise in

selecting managers fund of funds

charge fees in excess of the fees paid

to underlying hedge funds, resulting

in higher fees. Many investors are risk

averse and seek principal protection,

or their regulators demand them

to have some sort of principal

protection on their investments.

Several hedge funds capitalized on

this demand and oer structured

guaranteed products. We observe

this to be a trend in the retail sector

as well. Note that the structured

product adds another cost layer on

top of the fund of funds fees. This

is sometimes referred to as triple

dipping. Whether the increasing

costs are worth the risk reduction

depends on the preferences and

alternatives of the investor.

We conclude that hedge fund strategies and

their outlooks are diverse. Note that hedge

funds can apply multiple styles or strategies

simultaneously. Breuer (2000) gives an example

of how a hedge fund manager could layer ve

common hedge fund strategies on top of each

other and increase the leverage factor in the

process. It is quite possible that the strategies

and the pyramid of strategies are vulnerable

to the same factor, which is a liquidity crisis

in Breuers example. Style diversity does not

necessarily protect investors in market turmoil.

Due to the new money oating into hedge

funds and the limited capacity of the eld,

hedge fund managers seek new opportunities

in the more esoteric corners of nance. New

trends include energy and weather derivatives,

catastrophe bonds, car loan nancing, written-

o credit card debt and movie production

nancing.

4. Returns and risk

Section 4.1 explains the notions of absolute

returns, and asset based factors. In section

4.2 we review some of the risks in hedge fund

investing. We focus on the qualitative side of

risks. For a more extensive treatment of the risks

in hedge funds investing we refer to our own

study Posthuma and Van der Sluis (2005b) and

the references therein.

4.1 Absolute return and asset based factors

Some hedge fund returns have been quite

high. Due to incentives to create high returns

and the absence of traditional benchmarks,

the notion of an absolute return strategy has

been introduced. Absolute return is return not

related to benchmarks, but return delivered

by skill based investing. Several researchers

have tried to measure `absolute return or

excess return above certain benchmarks or

benchmark strategies. Because Sharpe ratios

are easily gamed, Kat and Amin (2003)

analyzed whether hedge funds returns have

ecient risk return proles. They found many

individual funds to be inecient, but that add

value on a portfolio level. Researchers found

exposures to (lagged) equity markets, volatility,

credit spreads, the term spread, and option

trading strategies. Agarwal and Naik (2003) for

instance used so-called location factors, which

are buy and hold investments in traditional

instruments such as equity, and bonds to

explain hedge fund returns. They added

strategy factors, which are returns of dynamic

trading strategies. It turns out that strategies

such as writing monthly out of the money put

options on the S&P 500 explain a large part of

the variation in hedge fund returns. Fung and

Hsieh (2001) explain returns of trend following

hedge funds with lookback straddles The non-

linear relationship with underlying markets and

the non-normality of returns has important

implications for performance attribution andrisk management, see Posthuma and Van der

Sluis (2005b). Co-skewness, co-kurtosis with

and between risk premium factors induces

phase locking crash events such as the liquidity

crisis in September 1998, see also Lo (2001).

The underlying fundamental factor of many

strategies is providing insurance and liquidity

for risks that other investors fear. We believe

that the excess return over investable asset

based factors is a measure that gives better

insight in the capabilities of hedge fund

managers than absolute returns.

Style drift and shift

The eyes of a predator could be the eyes

on the wings of a buttery. What you see

is not necessarily what you get. Managers

could change investment style or misclassify

themselves, which results in investors being

unaware about the risks that are taken.

Asset liability management and portfolio

construction based on wrongly perceived

risk-return patterns could lead to dangerous

sub-optimal portfolios. Posthuma and Van

der Sluis (2005a) show how style shifts can be

detected by means of a Kalman lter and asset

based factors.

Risks

Beside market and factor risks, there are several

other risks that are more dicult to measure.

Many specic risks arise from the typical

business of a hedge fund. To give an overview

we classify specic risks in four main types:

systematic, structure, trading/investment and

organizational risks. Some specic risks can be

placed under more than one main type of risk,

Tremont TASS estimates

the hedge fund industrys

asset base at $870 billion in

August 2004

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Systematic related risk

Systematic related risks are risks beared byevery fund of a group and are not specic for

one fund. The rst systematic risk is naturally

market risk. Common factor risk arises in

taking large positions in certain types of

securities, such as stocks in specic industries,

low-grade debt instruments or `deal stocks`.

An example of positions in `deal stocks are

merger arbitrage positions, consisting of a

short position in the acquiring rm and a long

position in the rm the targeted rm. Even

if hedge funds construct and apply a market

neutral strategy by osetting long and short

positions, systematic risk like the risk subject

to merger and acquisitions transactions as a

group remains. The third systematic related risk

arises from derivative investments. The use of

derivatives by hedge funds causes exposure to,

for example, interest rate and volatility changes.

These risks are often referred to as `Greeks risk`,

because the changes in the value of derivatives

due to changes in e.g. interest rate and volatility

are labeled with Greek letters.

Trading and investment related risks

The possibility to trade assets eciently is

often taken for granted in academic literature.

However, in the case of hedge funds trading and

investment related risks could be substantial.

An investment related risk is specic security

risk, the risk remaining after eects of common

risk factors have been removed. Even portfolios

with closely matched long and short positions

experience risk. Normally this risk is small, but

the use of leverage can enhance the specic

security risk substantially. Short positions

lead to borrow risk, the risk that the borrowed

security is called in by the lender. If replacement

borrow cannot be found, the short position

has to be closed out. And consequently theosetting hedge position has to be unwound.

Counterparty credit risk is also a risk that is

gained by making deals with other parties. If a

counterparty fails to close for instance an over

the counter option, the loss can be substantial.

Specic market opportunities are limited, which

leads to capacity risk. Greater capital inows will

diminish excess return possibilities, and can in

extreme circumstances disrupt markets, which

increase the risk of having to sell illiquid assets

below fair value (liquidity risk) to settle margin

calls. Related with the liquidity risk is the

stale pricing risk. Stale pricing is valuation of

positions without recent market trades, which

can lead to the use of accounting prices and a

misspecication of the volatility and correlation

characteristics of the investment. When the

same opportunities are exploited by multiple

managers at the same time, the resulting risk

is called herding risk, see Eichengreen and

Mathieson (2000). Brealey and Kaplanis (2001)

studied herding by examining correlations in

changes of fund exposures for individual funds.

They found evidence of correlated changes

in fund exposures, but this result can also be

explained by a large shift in the independent

variable. Another risk arising from big capital

inows is the risk that other market participants

nd out vulnerable positions of a manager and

take advantage of this knowledge by revisiting

their trading strategy (position risk). When

the large positions of hedge fund Long Term

Capital Management (LTCM) became known,

investment-banking rms began trading

against it, see Lowenstein (2000). One suddenly

worsening position can surprise a manager and

force him or her to close down other positions

in a sub optimal way. A short squeeze can be

especially painful since the theoretical loss isnow unlimited.

Structure related risk

The structure of hedge funds gives rise to

several risks. One risk stems from the freedom

to leverage, leading to credit crunch risk.

A tightening of credit facilities might force

aggressively leveraged funds to liquidate

positions at unfavorable times. The incentive

structure and the lockup period give rise to the

two other risks. The asymmetric feature of the

performance fees rewards managers for taking

risks, no cost for losses, higher fees of prots. A

high watermark has been invented to minimize

potential misuse of this fee structure. It states

that managers have to recoup losses before

they are entitled to performance fees. High

watermarks may result in increased risk-taking,

due to managers wanting to recoup losses fast.

A personal investment of the manager in his

own fund decreases this risk substantially. Liang

(1999) discovers a positive relation between

fund performance and the length of the lockup

period. A short lockup period and redrawings

can increase the risk of forced unwinding of a

protable long run trading strategy.

Organizational risk

A study by Capco (2003) on 100 hedge fund

failures showed that the most common reasons

for failure stem from misrepresentation of

fund investments, misappropriation of funds

and unauthorized trading. Only 38% of hedge

fund failures were due to investment risk

alone. Organizational risks including errors

in analyzing, trading, or recording positions

can be very damaging. If for instance the



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portfolio rebalancing of a market neutral fund

is incorrectly executed, market exposure results,

which could be exacerbated by higher degrees

of leverage. Most hedge fund managers have

specic knowledge about a few or only one

expertise area. This fact should lead them

to focus on their area of expertise, and limit

risks that are not in their eld of knowledge.

Due to diminishing specic opportunities for

excess return in his eld of expertise, a hedge

fund manager can decide to shift style. This is

potentially catastrophic; because it can cause

the manager to take leveraged bets in a game

he or she does not understand. Manager

manipulation of the voluntarily reported

gures to appear favorably to stakeholders and

potential clients is called managed prices. Feestructures and greed increase incentives for

fraud and front running. Fraud is a risk that has

occurred in new small funds as well as in large

established funds. Prices of small illiquid assets

can be moved by a relatively small fund. Greedy

managers might also be tempted to front run

their own fund. To minimize the impact of

catastrophe risk, such as a re that destroys

the oce or a virus that ruins the IT system,

managers should have proper backup systems.

People risk is the risk of losing key people with

essential knowledge and not being able to

replace them in time.

4.2 Caveats in historical hedge fund data

To explain hedge fund returns, it is necessary

to have reliable data. Knowledge about the

way the data is gathered gives insight in the

potential biases in the data and the limitations

of usage of the data. Voluntarily reporting and

data collection by data-vendors give rise to the

variety of biases that are potentially present

in hedge fund data. Fung and Hsieh (2000b)

distinguish between natural and spurious

biases. Natural biases arise from the birth,

growth and death processes of hedge funds,

while spurious biases arise from sampling

from an unobservable universe of hedge funds

and the way data vendors collect hedge fund

information. Natural biases are for example

self-selection and survivorship biases. Other

biases originate from the drive of hedge

fund managers to present good performance

combined with the opportunity to inuence

the return gures. The way research is carried

out can also cause biases. One can think, for

example, of regression analysis, which need

funds with a certain number of periods to

analyze, which will result in neglect of funds

with small return histories.

Survivorship bias

Survivorship bias occurs if only funds

existing at the end of the sample period are

considered. Non-surviving funds drop from the

database. Other reasons to stop reporting are

for instance closure for new investors, mergers,

bankruptcies, liquidations, and reporting

policy changes. The survivorship bias is usually

calculated by taking the performance dierence

between two portfolios: the surviving and the

observable portfolio. Liang (2000) shows that

poor performance is the main reason for a fundsdisappearance. The last returns of liquidating

funds are not always reported to database

providers, as a consequence additional return

activity can lead to a liquidation bias. Incentives

to report negative performance to database

providers are intuitively low or not present.

The amount of money returned to investors

can be monitored through the redemptions.

Ackermann, McEnally, and Ravenscraft (1999)

use information from the HFR database

providers. They nd that terminating funds

are returning the money to their investors

(redemptions), but can have additional return

histories. The redemption of the Net Asset Value

(NAV), i.e. the value that should be returned,

does not necessarily occur at the end of the

month. They nd that post-reporting returns

have a negligible impact on their results, and

the overall average loss in fund value beyond

the information contained in the database is

0.7%.

Backll and self-selection bias

Due to voluntary reporting, funds may

decide not to report or to stop reporting to

databases. This is called the self-selection bias.

The backll or instant history bias appears

when hedge funds with (good) track records

decide to report and data providers backll

their les to show this track record. Park (1995)

calls these records, instant histories. Good

track records in comparison to the hedge fund

universe lead to overestimating hedge fund

performance, while bad track records are not

backlled or the funds with bad track records

terminate and never report. Fung and Hsieh

(2000b) calculated the backll bias for the TASS

database. They eliminated the rst 12 months

of returns, because the hedge funds existed

on average 343 days before they reported

to the database. This is called the incubation

period, i.e. the period from inception till the rst

reporting date. The lasting mean performance

was 1.4% lower over the period 1994-1998.

Posthuma and Van der Sluis (2003) eliminated

the backll periods per individual fund in the

TASS database and found the backll bias

amount to 4% per annum over the period

1996-2002.

Limited history of hedge fund databases

Many hedge fund styles are exposed to tail risks

such as a market crash, a liquidity crisis, credit

crunch, and political crisis. By denition theseunpredictable events are rare, often a once-

in-a-generation event. Hedge funds databases

have reliable data as of the early 1990s. This

means that risk measures solely based on this

history will likely underestimate the risk. For

example, during the 1974 international banking

crisis, default spreads in the banking sector

surged dramatically. This event falls outside the

time span of the typical hedge fund database.

One way to gain some insight in these risks is

to use exposures of hedge funds to location

and trading strategy factors that have longer

histories. Scenario simulation and analysis is

key to get a grasp of what could happen.

4.3 Managing Risk

Measuring risk is one thing, managing risk

is another and of crucial importance. Large

sophisticated institutional investors are in the

position to enforce transparency, to do extensive

due diligence and manager searches. They have

best practice risk systems and have the scale

to daily monitor and audit their hedge fund

investments. Prudent institutional investors

are very keen on enforcing an alignment of

interest between the manager and the investor.

Furthermore, large institutional investors have

torn apart the major hedge fund databases.

They are fully aware of the potential

The eyes of a predator could

be the eyes on the wings of a

buttery. What you see is not

necessarily what you get.

23


9/9

biases that may result from using them. They

also know that an investment database is a

research tool, not a compendium of investment

opportunities. No investment should be taken

principally on the basis of information provided

by the database.

5. Conclusion

The growth in hedge fund assets, number

of funds, and investment styles has been

enormous. Fee hungry fund managers exploit

every alternative risk premium, besides the

ones on traditional bonds and stocks. Several

strategy elds have already been exhaustively

grazed by herds of managers. Capacity limits

have been met and new pastures are sought

after. Hedge fund managers continue todiscover and develop new alternative elds,

pushing the nancial frontier forwards. Even if

returns are not high, most investors will benet

from the diversication benets of hedge funds

on traditional portfolios.

The free and exible nature of the hedge fund

industry together with its lockup periods is

its key asset, and a challenge for traditional

institutional investors. Lack of transparency,

and freedom to apply virtually every imaginable

trading style, combined with organizational

risks, result in an overall risk-return prole that

is dicult to assess. Asset liability management

and portfolio construction becomes harder if

managers are able to switch style. Despite these

diculties, institutional investors commit vast

amounts of money to hedge fund managers.

We argue that worthwhile alternative risk

premiums next to equities and bonds exist,

and that regulatory freedom of hedge funds

places them in a unique position to obtain

these premiums. However, expectations of

hedge fund return-to-risk ratios should be

managed. Recent research taking into account

biases has shown that in the past returns are

overestimated and volatility is underestimated.

Not all hedge funds will be able to make up for

the hefty fees and the risks inherent in their

organizations. Therefore manager selection

and due diligence are key in the hedge fund

business.

Footnotes

1 The views expressed in this paper are those

of the authors and do not necessarily reect

those of our employer and colleagues

2 Drs. N. Posthuma, Researcher ABP

Investments

3 Corresponding author: Dr. P.J. van der Sluis,

Project Coordinator Research, ABP Investments

and Assistant Professor, Vrije Universiteit

Amsterdam, aliated to Post-graduate

Program for Financial and Investment Analysts

(VBA).

4 source: http://www.tassresearch.com/news_

ows_8_16_04.htm

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