Hedge Funds


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Hedge Funds

  1. 1. The Case For Hedge Funds Tremont Partners, Inc. & TASS Investment Research Ltd.
  2. 2. Contents Page Number Executive Summary 2 Introduction 4 Size of the Industry 7 7 Assets & Number of Funds 8 Location of Hedge Funds and their mangers Primary Investment Categories of 8 Hedge Funds 8 Long/Short Equity 9 Convertible Arbitrage 9 Event Driven 11 Equity Market Neutral 11 Equity Trading 11 Global Macro 12 Fixed Income Arbitrage 12 Dedicated Short Bias 13 Emerging Markets 13 Managed Futures 14 Fund of Funds Hedge Funds: Why They Make Money 15 15 The Outsourcing of Proprietary Trading 15 The Inherent Return in Proprietary Trading 17 Positive Selection of Alpha 18 Summary The Numbers: What They 19 Demonstrate Fees 23 Capacity 25 Transparency 26 Summary 27 Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 1 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  3. 3. Executive Summary Since 1949 when Alfred Jones established the first hedge fund, the hedge fund industry continues to be one of the most misrepresented and misunderstood areas of finance. The often trumpeted spectacular successes of the likes of George Soros and Julian Robertson over the past 2 decades, contrasted with the dramatic losses of Long Term Capital Management and others in 1998, have done little to advance understanding of an industry frequently shrouded in mystery. Indeed these examples have only fueled wild speculation and misconceptions, much of it press driven, that hedge funds represent the ultimate roulette table for a chosen few. This perception, however, is inconsistent with the reality that hedge funds have remained one of the fastest growing financial sectors, experiencing unprecedented growth throughout the 1990s. This report examines some of the reasons why. The report will show that hedge funds can produce superior risk adjusted returns. Although the authors recognize that statistical results are routinely discounted by the cynics, who attribute these results to convenient curve fitting or optimization, the report contends that the results are not a statistical aberration, but rather the result of the inherent source of return in the asset class. The inherent return of hedge funds is the excess profit that can be earned from consistently dealing in the world’s capital and derivative markets on superior terms. These terms are augmented by the positive selection of alpha intrinsic in the structure of all hedge funds. Hedge funds are paid, and have the incentive, to trade when others cannot, will not, or need to be on the other side. Further, the report offers a summary of the current size of the industry, explanations of the eleven primary categories of hedge funds and analysis of key industry issues including fees, transparency and capacity. Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 2 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  4. 4. Tremont Partners, Inc. & TASS Investment Research Ltd. Tremont is a diversified financial services company specializing in hedge funds. The business is focused in three areas – consulting, information and research, and investment products. Tremont was established in 1984 and, since then, has been providing hedge fund consulting services to financial intermediaries, institutions, pension funds, foundations, and wealthy families. Tremont currently manages in excess of US $6 billion in third party hedge funds on behalf of its clients. The company has a 40 person consulting team specializing in hedge fund research and unique portfolio solutions. TASS Investment Research is the information and research subsidiary of Tremont. Founded in London in 1990, TASS is one of leading providers of data, information and market intelligence to the hedge fund industry. Tremont’s head office is in Rye, New York. TASS and Tremont Europe are based in London. Copies of this report are available for US$50/£30 please see contact details on page 28. NOTICE This document is for information purposes only. Any information contained within it is the opinion of the authors and nothing in this document should, under any circumstances, be considered as investment advice. Certain statements in the document constitute “forward looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward looking statements. The Company assumes no obligation to update these forward looking statements to reflect actual results, changes in assumptions or changes in other factors affecting such forward looking statements. This document is the copyright of Tremont Partners, Inc. and TASS Investment Research Ltd. and may not be copied without prior written permission. Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 3 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  5. 5. Jones's model was devised from the Introduction premise that performance depends more on stock selection than market Hedge funds comprise one of the direction. He believed that during a fastest growing sectors of investment rising market, good stock selection will management. With rare exception, identify stocks that rise more than the their distinguishing characteristics market, while good short stock today are: an absolute return selection will identify stocks that rise investment objective; the ability to be less than the market. However, in a long and/or short with the freedom to declining market, good long selections use the widest possible range of will fall less than the market, and good financial instruments needed to short stock selection will fall more implement the investment strategy; and than the market, yielding a net profit in performance related compensation. all markets. Typically, Tremont and TASS do not classify long only funds as hedge Jones's model performed better than funds. However, we recognize certain the market. He set up a general exceptions in niche markets and where partnership in 1949, and converted it to it is difficult to implement a short a limited partnership in 1952. While position - for example, specialist his fund used leverage and short distressed securities and high yield selling, it also employed performance- managers. based fee compensation. Each of the above characteristics was not unique in In 1949, Alfred Jones established the itself. What was unique, however, was first hedge fund in the US. At its that Jones operated in complete beginning, the defining characteristic secrecy for seventeen years. By the of a hedge fund was that it hedged time his secret was revealed, it had against the likelihood of a declining already become the model for the market. Hedging was employed by hedge fund industry. businesses as far back as the 17th Century. Hedges were mainly Jones kept all of his own money in the employed in the commodity industries fund, realizing early that he could not for producers and merchants to hedge expect his investors to take risks with against adverse price changes. In his their money that he would not be original hedge fund model, Jones willing to assume with his own capital. merged two speculative tools - short Curiously, Jones became sales and leverage - into a conservative uncomfortable with his own ability to form of investing. At the time of the pick stocks and, as a result, employed fund's inception, leverage was used to stock pickers to supplement his own obtain higher profits by assuming more stock-picking ability. In 1954, Jones risk. Short selling was employed to hired another stock picker to run a take advantage of opportunities. Jones portion of the fund. Soon, he had as used leverage to obtain profits, but many as eight stock pickers, employed short selling through baskets autonomously managing portions of of stocks to control risk. the fund. By 1984, at the age of 82, he Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 4 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  6. 6. had created the first fund of funds1 by at 40% levels. Not only were they amending his partnership agreement to outperforming in bull markets, but in reflect a formal fund of funds structure. bear market environments as well. For example, in 1990 Quantum was up While mutual funds were the darlings 30% and Jaguar was up 20% while the of Wall Street in the 1960's, Jones's S&P 500 was down 3% and the MSCI hedge fund was outperforming the best $ World index was down 16%. The mutual funds - even after the 20% press began to write articles and incentive fee deduction. The news of profiles drawing attention to these Jones' performance created excitement; remarkable funds and their and by 1968, approximately 200 hedge extraordinary managers. funds were in existence, most notably those managed by George Soros and During the 1980s most of the hedge Michael Steinhardt. fund managers in the United States were not registered with the SEC. During the 60s bull market, many of Because of this, they were prohibited the new hedge fund managers found from advertising, relying on word of that selling short impaired absolute mouth references to grow their assets. performance, while leveraging the long The majority of funds were organized positions created exceptional returns. as limited partnerships, allowing only The so-called hedgers were, in fact, 99 investors; the hedge fund managers, long, leveraged and totally exposed as therefore, required high minimum they went into the bear market of the investments. European investors were early 1970s. And, during this time, quick to see the advantages of this new many of the new hedge fund managers breed of manager, which fueled the were put out of business. As Jones development of the more tax efficient pointed out, few managers have the offshore funds. In the U.S. and ability to short the market, since most Europe, the hedge fund industry of the equity managers have a long only '80s was an exclusive club of wealthy mentality. individuals and their private bankers. During the next decade, only a modest Hedge Funds currently represent one number of hedge funds were of the fastest growing segments of the established. In 1984, when Tremont investment management community. began tracking hedge fund managers, it Over the past 10 years the number of was able to identify a mere 68 funds. funds has increased at an average rate (Today, TASS, the investment research of 25.74% per year, showing a total growth of 648%3. The reason for the subsidiary of Tremont, tracks 2,600 funds and managers).2 Most of these unprecedented growth is simple. funds had raised assets to manage on a Money follows talent. Having attained word of mouth basis from wealthy significant personal wealth as fund individuals. Julian Robertson's Jaguar managers or proprietary traders, the Fund, Soros' Quantum Fund and talented managers are leaving large Steinhardt Partners were compounding companies to manage their own money. They are establishing simple, 1 See page 14 2 3 This figure includes CTAs These figures include fund of funds Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 5 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  7. 7. corporate structures with limited investment levels ($50 million) and set employees and forming funds with up long lock-up periods (five years). absolute and risk adjusted return objectives. These funds typically Lack of access to certain established charge performance fees, usually 20% funds created a large fund of fund of profits. By limiting the size of business. A fund of funds offers a assets under management, these wide array of managers for a lower companies can react quickly to events minimum investment, while providing in the financial community, trading oversight and monitoring of the without impacting share prices. With investment. As in the mutual fund fees earned as a percentage of profits, a industry, where there are more funds company can earn as much money on a than stocks on the New York Stock $100-million asset base as a traditional Exchange, one day there may be more money manager earns on $1-billion. funds of funds than individual hedge funds. While many of the original and During the 1990s, the flight of money truly great hedge fund managers are no managers from large institutions longer available, the market is well accelerated, with a resulting surge in supplied with newcomers. the number of hedge funds (see chart). Their fledgling operations were funded, increasingly, by the new wealth that had been created by the unprecedented bull run in the equity markets. The managers’ objective was not purely financial; many established their own businesses for lifestyle and control reasons. Almost all invest a substantial portion of their net worth in the fund alongside their investors. The 1990s saw another interesting phenomena; a number of the established money managers stopped accepting new money to manage. Some even returned money to their investors. Limiting assets in many investment styles is one of the most basic tenets of hedge fund investing if the performance expectations are going to continue to be met. This reflects the fact that managers make much more money from performance fees and investment income than they do from management fees. Due to increasing investor demand in the 1990s, many funds established higher minimum Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 6 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  8. 8. most hedge funds either carry short Size of the Industry positions, or operate in unlisted securities. In either case, general Assets & Number of Funds knowledge by the marketplace of a hedge fund manager’s position There is much confusion within the carries consequences. industry about the total number of hedge funds. Having recently 2. In the United States hedge funds completed the internal merger of the are almost always structured as Tremont and TASS databases, we private limited partnerships. So are estimate that there are 5,000 funds in many other forms of non-public the whole industry. However, in investment designed for the excess of 90% of the US $325 billion sophisticated investor. It is not under management in the industry is unusual for private, non-SEC managed by some 2,600 funds.4 registered funds to be included, accidentally or otherwise, in the overall hedge fund count. Growth in Hedge Funds Including Fund of Funds 3. Opinions differ regarding the 2500 definition of the words “hedge 2000 fund”. The most commonly 1500 accepted definition is that a hedge 1000 fund must: 500 ♦ Have an absolute 0 return -DQ -DQ -DQ -DQ -DQ -DQ -DQ -DQ -DQ -DQ performance objective. ♦ Allow the manager to be active Figure A on both the long and short sides of the markets. It is often observed that the overall size of the industry differs depending upon ♦ Compensate the manager with one’s source of information. There are performance related fees. a number of reasons for this: ♦ Allow the manager tremendous 1. The hedge fund industry has flexibility in investment style evolved in a culture of secrecy. and approach. This secrecy was mandated in the US for statutory reasons and hedge However, some analysts include all funds are neither allowed to absolute return funds within the advertise nor to hold themselves hedge fund definition, even if these out as investment opportunities to funds do not typically go short. the public. Further, the culture of secrecy stemmed from the fact that 4 Figure A entitled Growth in Hedge Funds Including Fund of Funds does not include CTAs. Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 7 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  9. 9. Primary Investment Categories of Hedge Location of Hedge Funds and their Managers Funds Figure B Hedge funds are not homogeneous. While 72% of the total assets under Domicile of Funds management in the industry are 1 invested in the equity markets, the 2 investment disciplines used are diverse 3 and distinct. As defined by Tremont 4 and TASS there are 11 primary 5 investment categories in the hedge 6 fund industry. These are: Long/short Key Equity; Equity Market Neutral; Equity 1. USA (33.9%) 2. Cayman Islands (18.9%) Trading; Event Driven; Convertible 3. British Virgin Islands (16.5%) Arbitrage; Fixed Income Relative 4. Bermuda (11%) Value/Arbitrage; Global Macro; Short 5. Bahamas (7.2%) Sellers; Emerging Markets; Managed Other (12.5%)5 6. Futures; Funds of Funds. Long/Short Equity Domicile of Fund Managers This directional strategy involves 2 equity orientated investing, on both the 9% long and short side of the market. The 1 91% objective is not to be market neutral. The manager has the ability to shift from value to growth, and from small, Figure C medium to large capitalization stocks, Key: 1 Fund managers domiciled in and from a net long position to a net The USA short position. The strategy may hedge 2 Fund managers domiciled with options and futures. The focus outside the USA may be regional, such as long/short US equity; long/short European equity; or sector specific such as long and short technology stocks, long and short financial stocks, long and short healthcare stocks. Long/short equity funds tend to construct and hold 5 The makeup of the domiciles in ‘Other’ is as portfolios that are significantly more follows: Australia 0.2%, Austria 0.2%, British West concentrated than traditional fund Indies 0.07%, Canada 0.2%, Channel Islands 2%, France 1.6%, Ireland 2.1%, Isle of Man 0.2%, managers. Luxembourg 2.53%, Mauritius 0.2%. Mexico 0.07%, Netherlands Antilles 1.0%, Netherlands 0.2%, Nevis 0.07%, Sweden 0.8%, Switzerland 0.3%, United Kingdom 1.2% Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 8 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  10. 10. Long/Short Equity represents 30.6% of all funds and 29.8% of all assets under management. Event Driven This strategy is categorized by equity Convertible Arbitrage orientated investing designed to capture price movement generated by Hedged investing in the convertible an anticipated corporate event. The securities of a company identifies this Event Driven category primarily strategy. A typical investment position includes: risk (or merger) arbitrage, is long the convertible and shorts the and distressed securities investing. It common stock of the company issuing also includes Regulation D (Reg D) the convertible. Positions are designed investing and High Yield investing. to generate profits from the bond and the short sale, while protecting Risk Arbitrage principal from directional market moves. Hedge funds may limit their Risk arbitrage specialists invest activities to a single market (e.g. the simultaneously in long and short US), or they may invest globally. positions in both companies involved in a merger or acquisition. Risk There are two components to the arbitrageurs are typically long the overall return from a convertible stock of the company being acquired arbitrage position. Static Return and and short the stock of the acquiring Volatility Return. company. The risk to the arbitrageur is that the deal fails. Risk arbitrageurs The Static Return is comprised of the seek to capture the price differential following: between the stock of the target and the stock of the acquirer. Profits result as coupon from the convertible bond plus the price of the target stock converges the interest rebate on the cash from the with the stock price of the acquirer. short sale minus the dividend on the Risk arbitrage positions are considered underlying short stock. to be uncorrelated to overall market direction with the principal risk being The Volatility Return is comprised of “deal risk” i.e. that the deal fails to go profits generated by short-term through. position adjustments of the short stock position. Adjustments are necessary to Distressed Securities account for the changing ratio of stock needed to hedge the underlying Distressed securities funds invest in the convertible bonds as prices fluctuate. debt, equity or trade claims of companies that are in financial distress, Leverage may be employed to augment typically in bankruptcy. In this both the static and volatility return. context, distressed means companies in need of legal action or restructuring to Convertible Arbitrage represents 3.5% revive them, not companies in need of of all funds and 4.4% of all assets FDA approved medication. These under management. Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 9 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  11. 11. securities generally trade at substantial derivatives. Investments usually take discounts to par value. Hedge fund the form of receiving a convertible managers can invest in a range of bond or convertible preferred issue in instruments from secured debt (at the return for an injection of capital. What low end of the risk scale) to common is unique about these securities is that, stock (at the high end of the risk scale). unlike, standard convertible bonds or The strategy exploits the fact that preferreds, the exercise price either many investors are unable to hold floats or is subject to a look back below investment grade securities. provision. This has the effect of Further, few analysts cover the insulating the investor from a decline distressed market, ensuring that, for the in the price of the underlying stock. knowledgeable hedge fund managers Typically the investor will be long the prepared to do their homework, many convertible, short a percentage of unresearched and inexpensive common stock and also hold warrants. opportunities can exist. On the effective dates of the transaction the manager can exercise, Distressed managers can follow either if he chooses to, and convert into an active or passive approach. Active common stock at a better market price. managers get onto the creditor committees and assist the recovery or reorganization process. Passive High Yield managers buy the distressed securities and either hold them until they The politically correct phrase for “junk appreciate to the desired level, or trade bonds”, high yield investing involves them. Distressed managers can benefit applying a buy/hold, or a trading substantially from the creativity of strategy to high yield securities. financial engineers. The growing Managers may buy the high yield debt complexity of debt instruments can of a company that they think will get a provide extensive opportunities for the credit upgrade or that might be in a credit analyst and distressed manager. position to redeem the outstanding Distressed debt investing often results high coupon issue. Other areas of in a manager holding “cheap” equity in opportunity include buying the a newly reorganized company. discounted bonds of companies that are potential take over targets. Some managers combine these strategies This is one of the few areas where long only with levered pools of bank debt. can be included in the Tremont/TASS universe Portfolio securities are generally sold of hedge funds. when they reach upside or downside price targets, or if the issuer of the Regulation D securities, or industry fundamentals change materially. This strategy, usually called Reg D, involves investing in micro and small Until recently high yield was primarily capitalization public companies which a US focused strategy. However, are raising money in the private capital today it can be global. Some managers markets. The manager can invest via include emerging market bonds, others the stock, via convertibles or other Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 10 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  12. 12. limit themselves to investment grade kept buying as long as sales and countries only. earnings were meeting growth targets; the managers were not concerned with This is one of the few areas where long only valuations. Today, some equity traders can be included in the Tremont/TASS universe use purely technical signals like of hedge funds. relative strength and price momentum. While others have more eclectic Event Driven represents 11.9% of all approaches. funds and 16.6% of all assets under management. Managers specializing in this area have more than doubled in the past 12 months, with a particular concentration Equity Market Neutral in funds that specialize in day trading. The investment strategy is designed to Equity Trading represents 1.1% of all exploit equity market inefficiencies funds and 2.4% of all assets under and usually involves being management. simultaneously long and short matched equity portfolios of the same size within a country. Market neutral Global Macro portfolios are designed to be either beta or currency neutral (equal Global macro managers carry long and currency - long and short) or both. short positions in any of the world’s Well-designed portfolios typically major capital or derivative markets. control for industry, sector, market These positions reflect their view on capitalization and other exposures. overall market direction as influenced Leverage is often used to enhance by major economic trends and /or returns. Statistical arbitrage is events. theoretically designed to be an equity market neutral strategy. To date, The portfolios of these funds can liquidity concerns have limited the include stocks, bonds, currencies, activity primarily to the US, Japanese and/or commodities in cash or and UK equity markets. derivative format. The funds may use highly opportunistic investment Equity Market Neutral represents 3.8% strategies investing on both the long of all funds and 3.9% of all assets and short side of the markets. The under management. portfolios can be highly leveraged. Most of these macro hedge funds invest globally, in both developed and Equity Trading emerging markets. Equity trading, sometimes called There are two schools of global macro momentum investing, also includes managers: Those who come from a mutual fund timers, is one of the long/short equity background and fastest growing categories of the those who come from a derivative industry. Originally managers used to trading background. Macro funds run buy small growth companies that they by companies like Tiger Investment Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 11 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  13. 13. Management and Soros Fund typically aim to deliver steady returns Management were originally invested with low volatility, due to the fact that primarily in US equities. The success the directional risk is mitigated by of these managers at stock picking hedging against interest rate resulted over time in substantial movements, or by the use of spread increases in assets under management. trades. Fixed income arbitrage can As the funds increased in size, it include interest rate swap arbitrage, US became increasingly difficult to take and non-US government bond meaningful positions in smaller- arbitrage, forward yield curve capitalization stocks (the stocks often arbitrage, and Mortgage Backed preferred by the equity hedge fund Securities Arbitrage. managers because they are generally under-researched by the brokerage Mortgage Backed Securities community). Consequently, the funds Arbitrage started gravitating towards more liquid securities and markets in which bigger The mortgage-backed securities bets could be placed. strategy specializes in arbitraging mortgage backed securities and their Funds run by Moore Capital, Caxton, derivatives. This strategy takes place and Tudor Investment Corp developed primarily in the United States. The from a futures trading discipline market is over the counter and which, by its very nature, was both extremely complex. The two greatest global and macro economic in scope. risks are prepayment and valuation; all The freeing up of the global currency securities are marked to market, but the markets and the development of non- pricing and valuation models used by US financial futures markets in the the different participants may vary, and 1980s provided an increasing number overall market liquidity has a huge of investment and trading opportunities impact. not previously available to investment managers. Fixed Income Arbitrage represents 5.1% of all funds and 7.7% of all Global Macro represents 4.0% of all assets under management. funds and 14.9% of all assets under management. Dedicated Short Bias Fixed Income Arbitrage As recently as three years ago there was a robust category of hedge funds The fixed income arbitrageur attempts known as “dedicated short sellers”. to profit from price anomalies between However, the ravages of the current related interest rate instruments. The bull run have reduced their ranks to all majority of managers trade globally, but a handful of funds. Recently there although a few just focus on the US has emerged a category of funds market. In order to generate returns committed to maintaining net short as sufficient to exceed the transaction opposed to pure short exposure costs, leverage may range from 10 times up to 150 times NAV employed. Genuine fixed income arbitrageurs Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 12 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  14. 14. The short biased managers invest Emerging Markets mostly in short positions in equities and equity derivative products. To be This strategy involves equity or fixed classified as a short biased manager, income investing focusing on the short bias of the manager’s emerging markets around the world. portfolio must be constantly greater Certain commentators regard emerging than zero. To effect the short sale, the market hedge funds as a contradiction manager borrows the stock from a in terms. Many of the emerging counter party (often its prime broker) markets do not allow short selling, nor and sells it in the market. The broker do they offer viable futures or other as collateral keeps the proceeds from derivative products with which to the sale. An additional margin of hedge. typically 5% to 50% must be deposited in the form of liquid securities. The This is one of the few areas where long only margin is adjusted daily. Leverage is can be included in the Tremont/TASS universe of hedge funds. created because margin is below 100%. Short selling can be time Emerging Markets represents 5.6% of consuming and expensive. The all funds and 3.5% of all assets under manager needs very efficient stock management. borrowing and lending facilities. Because of this, short positions are sometimes implemented by selling Managed Futures forward; selling stock index futures or buying put options and put warrants on single stocks or stock indices. The managed futures traders, otherwise called commodity trading advisers It is generally accepted that the short (CTAs), trade in the listed financial side of the market can be much less and commodity futures markets around efficient than the long side of the the world. They may also trade in the market. Restrictions on short selling global currency markets. Most traders vary from jurisdiction to jurisdiction. apply their individual disciplines to the For example, the United States has its markets using a systematic approach; “uptick” rule (namely you cannot while a small percentage use a initiate a new short sell position when discretionary approach. The systematic the price of the stock is going down); approach tends to use price and market Europe does not have an uptick rule; specific information in determining the and in many emerging markets short investment decisions. The selling is simply not possible. discretionary approach tends to use Derivatives can be used to get around price, market information as well as some of these issues, particularly in the broader economic and political US. fundamentals in determining the investment decisions. Most CTAs Dedicated short bias represents 0.5% trade a very diversified range of of all funds and 0.4% of all assets markets and contracts and seek to under management. identify trends in each market/contract. Differences include: time horizons, asset allocation, contract selection, Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 13 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  15. 15. contract weighting, the treatment of short term market “noise”, and use of leverage. Most CTAs are regulated by the CFTC as opposed to the SEC in the United States. Managed Futures represents 18.6% of all funds and 15.9% of all assets under management. Funds of Funds The hedge fund industry’s closest equivalent to a mutual fund, the majority of funds of funds invest in multiple hedge funds (5 to 100) with different investment styles. The objective is to smooth out the potential inconsistency of the returns from having all of the assets invested in a single hedge fund. Funds of funds can offer an effective way for an investor to gain exposure to a range of hedge funds and strategies without having to commit substantial assets or resources to the specific asset allocation, portfolio construction and individual hedge fund selection. A growing number of style or category specific funds of funds have been launched during the past few years. For example, funds of funds which invest only in Event Driven managers; or funds of funds which invest only in Equity Market Neutral style managers. Fund of Funds represent 14.1% of all funds.6 6 As Fund of Funds invest in other funds the percentage of all Hedge Fund assets under management has not been given to avoid double counting. Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 14 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  16. 16. drawing top-flight talent off the trading Hedge Funds: Why desks at an accelerating pace. Further, They Make Money in this era of shareholder value, financial institutions’ appetite for risk The Outsourcing of Proprietary and the, sometimes, uneven return stream of proprietary trading has Trading diminished, causing cutbacks and decreased trading lines. In broad Previous studies have focused on the terms, the risk capital funding the statistical robustness of returns that market making and speculative hedge funds offer investors. While the activities of the largest proprietary preponderance of evidence suggests traders is increasingly coming from hedge funds over time offer equity like private sources in the form of hedge returns with lower risk profiles, few funds. studies consider the sources of the returns. The Inherent Return in To understand the inherent robustness Proprietary Trading of the hedge fund structure, one must grasp the significance of the changes For decades financial institutions have hedge funds have wrought among been granted “unfair” trading traditional financial institutions. While advantages (or “edges”, in industry the hedge fund structure is relatively parlance) in return for providing new, the investment activities liquidity to the vast array of conducted within them are not. These international capital and derivative investment activities typically center markets, and for taking speculative risk on market making and proprietary positions when hedgers needed to trading. contract with a speculator to manage risk, cash flow and lock in future Historically, large financial institutions prices. These trading advantages were the only organizations with the include superior information (first call capital, infrastructure and access to on breaking news), reduced transaction conduct the trading and investment costs (either in the form of lower activity now common to hedge funds. commissions or tighter quotes from the Senior positions on proprietary trading market makers), superior market desks represented the top of the career access as well as other structural and ladder for professional traders. With statutory benefits. These edges exist or the advent of hedge funds, there was were granted because the markets need added another rung to this ladder. these liquidity and speculative Traders who could establish a history functions to be performed to ensure of profitability and proven expertise their smooth operation. They represent could now ply their craft with investor the first component of the inherent assets, potentially earning both higher return in hedge funds. incomes and the opportunity to control their professional destinies. A second level of inherent return is created by virtue of the fact that most Over the last decade, two trends have of the specialized activities, conducted developed. The hedge fund structure is within hedge funds, require a Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 15 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  17. 17. substantial research infrastructure. It While alpha usually determines the is, in most cases, uneconomic for degree to which any given hedge fund traditional mutual funds to build the prospers, virtually all successful hedge appropriate research capability given funds exploit some type of trading the substantially lower fees they charge advantage. These advantages include relative to hedge funds. Risk arbitrage, superior information, lower transaction for example, requires specialized costs, better market access, size expertise from analysts and lawyers. advantages and structural inequities in Given the fact that there are a limited the markets in which they operate. number of deals at any point in time, and limited liquidity, it does not make One of the more common advantages economic sense for a fund charging 60 is superior information, which often basis points to hire the individuals manifests itself in situations where the necessary to conduct the activity. hedge fund manager is dealing in a limited universe of securities and Virtually all hedge funds take financial instruments. Typically these advantage of some type of investment managers will surface in an area where edge. Many enjoy multiple only a relatively small group of experts advantages. To take a basic example, a closely follows the instruments, though specialist on the floor of a stock a larger group may follow the sector exchange is granted market privileges generally. In these situations a that average investors do not receive. mismatch of both expertise and Most notably, they are allowed to see objectives can be exploited to the the build up of orders above and below benefits of the hedge fund manager. the current price of the stocks they are assigned. Further, they are allowed to For example, managers specializing in take the opposite side of customer distressed securities develop transactions in their own trading tremendous expertise pertaining to a accounts as well as receiving other relatively small universe of companies. statutory advantages from the A given manager has the opportunity exchanges. Finally, they execute their to learn more about a particular trades with the lowest possible company than all, but a handful, of transaction costs. Those factors are individuals. Further, activity in the trading advantages and the securities of distressed companies combination of those trading (typically companies in Chapter 11) advantages means that even a specialist usually precludes involvement from with a modest level of skill can ply his large public investment funds. The craft profitably. fact that these large funds may invest in the securities at a later date once the But not all specialists are equally company returns to health adds profitable. Even specialists who cover potential return to the hedge fund’s companies with tremendous similarity holdings. can vary greatly in profitability. That difference is considered to be a Relative size, either large or small, can function of the trader’s skill, or alpha. be an edge. For instance, short term or day trading equity firms typically benefit from the fact that their small Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 16 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  18. 18. size (relative to large mutual funds) position at some discount or premium allows them to capture smaller market to fair market value. In essence, the movements. hedger is paying what amounts to an Size advantages can generate other insurance premium to the speculator advantages. For example, managers who assumes the risk. Hedgers usually dealing in below-investment grade operate in derivative markets for non- debt in a particular emerging market economic reasons. Their motive is to country or region can find themselves operate their underlying businesses among the largest investors in that profitably rather that look to profit narrow universe of securities. As some from their derivative market dealings. of the largest players, the market views them as buyers or sellers of last resort. Another advantage lies in the broad As a result, these managers tend to get investment mandates that are typical of the first call on breaking news leading most hedge funds. Managers are not to advantage in superior information. restricted to the long side only, or to listed securities only. Hedge funds That same size advantage compounds typically can employ a wider range of into superior market access as market strategies to capture an investment idea makers will typically make deeper and than most traditional managers. Put tighter quotes to the active investor simply, hedge funds function as over the occasional participant. vehicles to capture manager skill, or alpha. Virtually any financial activity Large size usually translates into lower can be packaged within the structure. transaction costs. For example, most statistical arbitrage programs generate The additional profitability of a trading large volumes of equity trading, as enterprise directly related to these every long position is matched against trading advantages is the inherent a short position. Furthermore, return of hedge funds. Put another positions are usually turned over way, hedge funds collect the money quickly. This makes them very that is left on the table, either by design desirable clients to their prime brokers, or neglect, to encourage certain market who offer them low commission rates participants to trade when others can’t, in addition to the benefits of superior choose not to, or must be on the other market access and first call on side of the transaction. As investment information. banks and other financial institutions retreat from the business of providing Other types of managers will benefit liquidity and speculative capital, that from structural inequities in the inherent return is being offered to marketplace. Derivative markets, for investors in the form of hedge funds example, exist for the purpose of risk and other alternative investment transference. They typically facilitate vehicles. transactions in which one party, saddled with an unwanted market risk, Positive Selection of Alpha contracts with another to lock in a future price, a discipline known as The inherent returns of the activities hedging. In that transaction, the are amplified by a key attribute of the speculator usually assumes the risk Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 17 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  19. 19. hedge fund structure; incentive based aligned. The firm and its employees compensation. do only as well as the investors. Among the best managers, the internal Performance based compensation investment can grow to such creates positive manager selection. proportions that the company’s Only managers with established investment income exceeds its fee industry pedigrees have the credibility income. It is not uncommon for to raise initial assets. Only managers successful hedge funds to close to new who continue to deliver compelling net investment or even return capital to returns to investors keep and grow investors. This occurs because large their assets. hedge funds often earn more from incentive fees than management fees. The hedge fund structure is attractive These factors coalesce to create an to top tier talent as it affords greater attitude where annual profitability is financial rewards to managers who can paramount. deliver net performance on large pools of investor capital. Further, for Summary successful managers, it allows them to build their companies in their own The inherent return in hedge funds is a image, working where and when they function of the trading advantages that want exist, either by design or neglect, to encourage investors to trade when The incentive-based compensation others can’t, won’t or need to be on the structure amplifies the positive other side. These advantages can selection process. Unlike mutual include cheaper costs, better market funds, most hedge funds have limited access, superior information as well as capacity to invest assets. As a result, other structural and statutory benefits. they depend on incentive fees and must These advantages are not new. In fact generate profits consistently in order to they have existed for decades, but prior maintain their financial viability. This to the emergence of hedge funds, they typically influences the mindset of were in the exclusive domain of large hedge fund managers away from the financial institutions that traditionally complacency that can occur among supplied liquidity and speculative traditional managers who dwell in a capital to the market place. The benchmarked universe. A manager provision of these services is essential who must pay the bills every quarter to the smooth operation of the world’s draws little satisfaction from being capital and derivative markets. down less that the S+P 500 if it means a dramatic loss of income to the Starting with the inherent return as a company. foundation, the potential benefits of this return are amplified through the This mindset is further augmented by positive selection of alpha. This the fact that most managers invest their positive selection occurs because of the personal capital in the funds they performance-based compensation manage. Many managers will require intrinsic to all hedge funds. Incentive key employees to invest as well, based compensation creates a ensuring that everyone’s interests are Darwinian model in which only most Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 18 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  20. 20. talented managers can far exceed the earning potential available within the financial institutions from which they emerged. The Numbers: What They Demonstrate7 P e ns io n Fund Ind ic e s L o ng / ho rt G lo b a l S E q uity G ro up Hedge funds can deliver superior risk Ja nua r y 1990 - Ma r c h 1999 17 adjusted returns. Figure D shows the 16 1 performance of a typical US pension 15 fund index 8 compared with the same 14 7 index that includes hedge funds9 added 13 654 3 12 at different levels, 5%, 10% 15% and 11 2 20%. The hedge funds have been 10 added uniformly and no discretion has 6 7 8 9 10 11 12 13 14 15 Vola t ilit y ( A nnua liz e d S t a nda r d De v ia t ion) been used to either over or Figure E underweight the allocation. 1. Long/Short Global Equity Group 2. MSCI $ Global Return Index 5%11 PFI 10% 15% 20% 3. Pension Fund Index 10 12 13 14 4. Pension Fund Plus 5% Hedge Funds Average 5. Pension Fund Plus 10% Hedge Funds Annual 13.1 13.2 13.3 13.3 13.5 6. Pension Fund Plus 15% Hedge Funds Return (%) Drawdown 7. Pension Fund Plus 20% Hedge Funds (%) 9.41 8.90 8.28 7.99 7.86 P e ns io n Fund Ind e x L o ng / ho rt U S E q uity S Standard G ro up Deviation 8.96 8.66 8.27 7.98 7.71 Ja nua r y 1990 - Ma r c h 1999 (Annualized) 24 1 Semi 22 Deviation 6.92 6.52 6.12 5.74 5.54 20 (Annualized) 18 2 Sharpe Ratio 16 (Annualized) 0.90 0.95 1.00 1.05 1.10 14 8 76 5 4 12 3 Figure D 10 6 8 10 12 14 16 18 Vola t ilit y ( A nnua liz e d S t a nda r d De v ia t ion) What is interesting to note is that as hedge funds are added the index return Figure F increases and the volatility is reduced. 1. Long/Short US Equity Group 2. SP 500 Return Index 7 3. Russell 2000 Return Index All data that has been used in this analysis 4. Pension Fund Index is available from TASS 8 5. Pension Fund Plus 5% Hedge Funds Source: Tremont Partners, Inc. 9 6. Pension Fund Plus 10% Hedge Funds TASS Fund Universe Average 10 7. Pension Fund Plus 15% Hedge Funds Pension Fund Index 11 8. Pension Fund Plus 20% Hedge Funds Pension Fund Index Plus 5% Hedge Funds 12 Pension Fund Index Plus 10% Hedge Funds 13 Pension Fund Index Plus 15% Hedge Funds 14 Pension Fund Index Plus 20% Hedge Funds Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 19 understanding that it is read subject to the notice on Page 3 to which readers are referred.
  21. 21. 1. Long/Short Global Equity Group P ension Fund Indices Long/ hort European S Equity G roup 2. MSCI $ World Return Index Ja nua r y 1990 - Ma r c h 1999 16 3. Pension Fund Index 1 4. Pension Fund Plus 5% Hedge Funds 15 5. Pension Fund Plus 10% Hedge Funds 2 6. Pension Fund Plus 15% Hedge Funds 14 7 7. Pension Fund Plus 20% Hedge Funds 6 13 54 3 12 6 8 10 12 14 16 18 20 S P 500 Ind e x Rus s e ll 2000 Ind e x vs Vola t ilit y ( A nnua liz e d S t a nda r d De v ia t ion) L o ng / ho rt U S E q uity G ro up P e ns io n Fund S Ind ic e s 7800 Figure G Ja nua r y 1990 - Ma r c h 1999 1 6800 2 3 5800 1. Long/Short European Equity Group 4 4800 5 2. MSCI Europe Return Index 3800 6 3. Pension Fund Index 7 2800 8 4. Pension Fund Plus 5% Hedge Funds 1800 5. Pension Fund Plus 10% Hedge Funds 800 6. Pension Fund Plus 15% Hedge Funds 7. Pension Fund Plus 20% Hedge Funds Time ( Da t e ) Figure J MS CI Europe Inde x vs Long /S hort Europe a n 1. Long/Short US Equity Group Equity G roup P e nsion Fund Indic e s 4300 Ja nua r y 1990 - Ma r c h 1999 1 2. SP 500 Return Index 3800 2 3. Russell 2000 Return Index 3 3300 4 4. Pension Fund Index 2800 5 5. Pension Fund Plus 5% Hedge Funds 2300 6 7 6. Pension Fund Plus 10% Hedge Funds 1800 1300 7. Pension Fund Plus 15% Hedge Funds 800 8. Pension Fund Plus 20% Hedge Funds Time ( Da t e ) Figure H Figure K shows the net performance in all negative months of the SP 500 1. Long/Short European Equity Group return index, between January 1990 2. MSCI Europe Return Index and March 1999, and the 3. Pension Fund Index corresponding performance of the US 4. Pension Fund Plus 5% Hedge Funds 5. Pension Fund Plus 10% Hedge Funds Pension Fund Index, and the 6. Pension Fund Plus 15% Hedge Funds performance of the US Pension Fund 7. Pension Fund Plus 20% Hedge Funds Index with hedge fund inclusion varying from 5 to 20 percent. MS CI $ World Index vs Long/ hort G lobal Equity S G roup P ension Fund Indices Ja nua r y 1990 - Ma r c h 1999 1 4300 2 3800 3 3300 4 2800 5 6 2300 7 1800 1300 800 Time (Da te ) Figure I Copyright Tremont Partners, Inc. and TASS Investment Research Ltd. The above information is given on the strict 20 understanding that it is read subject to the notice on Page 3 to which readers are referred.