Hedge Funds: Examining the Potential Benefits and Risks of Hedge Fund Investing

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Hedge FundsExamining the Potential Benefits and
Risks of Hedge Fund Investing

• Robert Howie
• Shalin Bhagwan, Leon Beukes, Harjeet Cheema, Con
  Keating, Khurram Mirza, Ian Morley, Yasmin Saltuk

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Contents

• Introduction
• Literature Review
• Investor Activity
• Expected returns from hedge funds
• Non-Investment Risks
• Benchmarking Hedge Fund Investments

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What are hedge funds?

• Not easy to define concisely
• Large universe
• Some are by no means hedged
• Key characteristics
• Heavily skill-based
• Investment flexibility
• May employ short-selling and use leverage
• Focus on absolute returns or cash plus

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Other (non-defining) characteristics

• Performance related fees
• Less regulated
• Less transparent
• Small fund and organisation size
• High minimum investment
• Relatively illiquid
• Fund manager co-invests with investors
• Many hedge funds do not have these characteristics

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Academic Research

• Several major academic groupings established
• Variable quality of research, focusing on
• Distribution of hedge fund returns
• Biases in hedge fund data
• Understanding and modelling drivers of returns

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Survivorship Bias

• Hedge fund data
• Diverse range of investment techniques, fairly
  large dispersion
• Voluntary submission of data selection bias
• Most index providers only include data for a fund
  after it enters index
• Estimated survivorship bias in hedge fund data
• Ackermann et al. (1999) negligible bias
• Brown et al. (1999) c. 3 p.a.
• Liang (2000) 2-3 p.a.
• Fung et al. (2004) 2-3 p.a.

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Survivorship Bias

• No studies measuring bias of fund of hedge fund
  indices
• Substantially lower given the lower failure rate?
• Similar to mutual fund universes?
• Academic studies on survivorship bias in mutual
  fund data have estimated 0.2 - 1.4 p.a.

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Modelling Hedge Funds

• Academic research confirms, without exception,
  that returns are non-normal
• Standard mean/variance analysis is invalid
• Calculated stability coefficient (1.67) questions
  existence of 2nd moment
• Multivariate regression possibly inappropriate
• Modelling is non-trivial
• Research is in its infancy

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Total Investment in Hedge Funds
Source HFR Industry Reports
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Institutional Allocations to Hedge Funds (2003)
Source HFR Industry Reports
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Institutional Share of Hedge Fund Capital Flows
Source HFR Industry Reports
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Product Offerings

• Standard offerings
• Structured products
• Principal protected products
• Leverage products
• Potential role in alpha transport and
  liability benchmark strategies

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Expected returns from hedge funds

• Simple model for hedge fund returns
• gross return 67 (cash return) 19 (equity
  return) 14 (high yield return) tracking
  error
• Historical standard deviation of tracking error
  is 6.4
• With gross Information Ratio 1.6

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Expected returns from hedge funds

• If gross return is positive
• net return (gross return 1.3 p.a.) (1 -
  19.3)
• If net return is positive
• net fund of fund return (net return 1 p.a.)
  (1 - 5)

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Expected returns from fund of funds
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Impact of fees

• If cash returns are 4.5 and gross IR 1.6
• Fees are 4.1 p.a. for fund 1.5 for fund of
  funds
• If gross IR is zero
• Fees are 2.1 p.a. for fund 1.1 for fund of
  funds
• High gross IR required to generate attractive net
  of fee returns

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Hedge Fund Risks

• Investment risks fairly well documented
• Non-investment risks can be significant
• Operational failings
• At worst, fraud
• Operational risks occur in
• Manager
• Fund
• Third parties

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Evaluation of Operational Risk

• Necessarily qualitative, covering
• Background checks
• Conflicts
• Administration and trading
• Pricing
• Third parties
• Legal structure and documentation
• Reporting
• Special skills needed

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Benchmarking

• Measurement of value added should not constrain
  manager
• Benchmark must represent neutral position of
  manager
• Stated objectives
• Composite of market indices
• Hedge fund indices

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Questions?