How it all started....
Hedge funds started first appearing in the US in the 1950s and were also called "managed futures accounts" or "futures funds". "Hedging" was originally used in the commodities markets as a means of directly securing positions in the futures market.
Hedge funds derived their name from the fact that they were often long and short, thus "hedged" or protected to some degree against market uncertainties. Today, hedge funds encompass not just long, short, and leveraged securities, but also futures, forwards, options, and even physicals. Often they are structured not as single-strategy funds but rather as fund-of-funds encompassing a multitude of strategies. But the essential is always the same.
You are long something because you believe the price will rise and short something because you believe the price will decline. And if you're really certain, you will borrow money to do either or both.
Who traditionally invests?
The term "Hedge Fund" includes a multitude of skill-based investment strategies with a broad range of risk and return objectives. A common element is the use of investment and risk management skills to seek positive returns regardless of market direction.
In recent years, hedge funds have become an increasingly prominent part of investments. The universe of hedge funds encompasses some 3000 funds. At the end of 1999, funds investing primarily in stocks accounted for 46% of the $275 billion invested in hedge funds (Hedge Fund Research, Chicago).
Hedge funds have become part of the growing universe of alternative investment possibilities such as Private Equity, Venture Capital or funds with an ecological or even ethical concept. Hedge funds have long been the province of high net worth individuals and wealthy families. The client base has now widened to endowments, foundations, banks and insurers and a small-but-growing retail investors base that takes advantage of vehicles invested in fund of funds, but offer units at lower entry levels.
How they operate...
Most typically one finds hedge funds in the form of private partnerships located in offshore financial centres, for tax and regulatory reasons. Despite the fact that hedge funds are a quickly growing industry (many managers who used to work for Robertson, Soros or Fidelity have started their own funds) their modus operandi is still through private placements rather than public offerings. Ownership is often restricted to rich individuals and selected institutions. The "advantage": less stringent disclosures and regulations. "The disadvantage": less transparency. Sharing information with their clients has not always been popular with hedge fund managers. They promised top returns and as long as they delivered, investors accepted "proprietary strategy" arguments. But the tide is changing: last year even John Meriwether, who ran LTCM, promised potential investors that he'd share more information with investors in his new fund. However, the less stringent requirements can also be an advantage, despite the loss of transparency. Since hedge funds are not bound by their prospectuses as much as their "Mutual Fund colleagues", they retain a higher grade of flexibility. In a falling market environment, mutual funds are often required to liquidate positions under internal controls or reduce holdings due to investor withdrawals. Hedge funds can sit out such downturns, draw on credit lines to put on more margin and don't have to worry about withdrawals as much; clients are locked in much longer.
What about leverage....
Alternative investment funds tend to leverage at least part of their capital by buying securities on margin and engaging in collateralized borrowing. In addition, more established funds might be able to buy structured derivative products without up-front payment. They pay premiums when the market trades in either one direction in these securities. Some funds can also obtain credit lines that allows the managers to finance calls for more margin if the market moves against them. These practices allow hedge funds to achieve higher leverage ratios. They can then aim for return objectives often targeted around 20+% (if a guarantee is wrapped around returns of around 12%-15% are more realistic).
.... And Risk Management
The fallout of LTCM and also the alleged involvement of the industry in the Asian crisis have taught many lessons. One of the more important ones, however, was the need for better risk controls in conjunction with hedge funds. Banks involved in lending to such funds as well as those holding clients investments in hedge funds want to quantify their positions at daily mark-to-market prices, test them and perform Monte Carlo simulations, request information on the funds strategies, their monthly returns and in and out flows. Despite "improved information flow", the use of derivative instruments, however, poses still a formidable challenge in evaluating positions for all involved. And last but not least, with the global investment reach of most of these funds and the leverage used through credit lines with various banks, the true extent of some of those hedge fund exposures is very difficult to assess. A complete database, with the characteristic of every security involved is not yet in place.
There is currently a broad discussion going on as to the extent of "official" control over hedge funds. Topics such as "regular public disclosure of portfolio positions", "international clearing" and "limitations on short positions" are actively debated. We would expect quite some time to pass until we see concrete governmental measures. The most important step until then, however, is to enhance transparency from hedge funds and about hedge funds. This will broaden the investor base as well as soften the public image of this industry in the coming years.
They are worth considering; but be selective
Despite all the shortcomings mentioned above, funds using a multi-manager approach often enhance diversification by virtue of low correlation to traditional asset classes. And they allow for the ability to create profit regardless of the direction of financial markets. After the exit of Soros and Robertson, investors seem to switch out of broader-based macro funds, that are basing their investment decisions on trends in interest rates and currency fluctuations. Stock picking and the ability to go long and short at the same time, are back in favor. And it seems that leverage is used less extensively. Seasoned investors have a broad range of larger and smaller specialized managers available to them. Newcomers, however, are often faced with the dilemma in picking the right managers. Funds of funds offer the best alternative to gain experience and do not require very large initial investments ($25,000-$50,000).
ED&F Man Investment Products has recently closed a guaranteed multi-strategy fund aiming to achieve 18% p.a. for an annualized volatility of 13%. The bank guarantee is issued by Bank of America. ED&F employs four distinct strategies: Securities selection (long/short), Event Driven, Managed Futures, Market Neutral & Arbitrage.
Credit Suisse Asset Management has a range of open-ended hedge funds under their umbrella CS Prime Select. "Equity Alpha" extracts stock picking skills, "G7 Equity Long/Short" invests long/short in the world's most liquid equity markets, "European Strategies" does the same in Europe and "Technology Long/Short" focuses on today's most volatile sector.
CS Prime Select G7 Equity Long/Short
These funds come close to the original idea of "hedging ones investments against market uncertainties". Focus is on absolute returns and broad diversification. And established investment houses are a "guarantee" for continuous monitoring and analysis of investments, managers and the global market place not only at the time of investment into the fund manager but throughout the course of the investments life. This improves transparency for investors, traders, researchers, and risk managers alike.
Fidelis M. Goetz is Head of Investment Consulting for Credit Suisse Private Banking Singapore.
The author has used the following sources: B. Eichengreen/D. Mathieson: "Hedge Funds: What do We Really Know?". In: Economic Issues No. 19, IMF, Sept. 99. W.J. Crerend: "Fundamentals of Hedge Fund Investing" McGraw-Hill, 1998.
