Ch8 Hedge Funds: Past, Present, and Future

1. Hedge Funds & Mutual Funds
1-1. Mutual Funds
- active(managed) funds: most funds are actively managed
- passive (index or unmanaged) funds: tracking a benchmark
- short & borrow: prohibited, derivatives: limited
- operate on a larger scale than hedge funds

1-2. Hedge Funds
- deliver complex strategies
- short position allowed
- avoid registering with SEC by having fewer than 15 clients

**open-end vs. close-end
- open-end: share price = NAV
- close-end: share price by secondary market
***Net Asset Value(NAV) = (Asset - Liability) / (# of shares)



2. Hedge Fund Incentive Structures
2-1. Mutual Fund Managers
- Strict regulations
- Symmetric Compensation Method: % of assets under management

2-2. Hedge Fund
- Asymmetric Compensation
- 1~2% fixed base management fee (operating expenses) of asset base
- 15~25% incentive fees (portfolio management incentive) of total profits
* profits measured above a risk free rate
- high water mark: need to recover previous losses first

3. Withdrawing Capital
Hedge Fund investors can only withdraw funds at certain times during the year and only after having given some notice
e.g.) Withdraw at the end of the quater given 30 days notice

4. Disclosure Requirements
4-1. Mutual Funds
Required to audit all financial statement & to disclose holdings to the SEC

4-2. Hedge Funds
- not required to disclose holdings to investors
- transparency might compromise investor returns for a hedge fund with an information-sensitive strategy
- high frequency transparency not efficient for a strategy characterized by illiquid investments

5. Hedge Fund Diversification
- concentrated, unique risk exposures, large investment -> diversification is important
- past: low correlation, present: increasingly becoming correlated with overall market moves
- diversification with the lack of transparency require costly due diligence

- fund of funds hedge fund: a diversified portfolio with risk management service


6. Market Efficiency
- arbitrage opportunities
- activity of hedge fund managers may be increasing market efficiency using short sales and derivatives (but, no real direct evidence)

7. Hedge Fund Strategies
- Equity long/short
- Event-driven hedge
- Global macro hedge
- Fixed income arbitrage

8. Hedge Fund Considerations
- from 1994 to 2006: slightly higher average return with a much smaller standard deviation
- hedge funds growth: $1 trillion in 2005 whereas mutual funds $8.5 trillion, dramatical growth after 2000

8-1. Gauging Hedge Fund Performance
**difficult to gauge performance because of the following reasons:
- biased data can result from the low level of regulations: survivorship bias
- adjusting returns for risk exposures is difficult given the complicated strategies: complicated strategies over a given time period & risks/returns are non linear
- past performance may give a very selective view of risk
- nature of the investments make computing the value and return of a hedge fund difficult

- serially correlated rates: evidence of managers massaging their reported returns in that they are probably trying to reduce the period-to-period variability of the returns -> downward bias in the measures of risk associated with the fund
- December Effect: average return of hedge funds in December is much higher than that of the average monthly return for the rest of the year

9. Hedge Fund Performance
- non-negative alpha on average and after fees
- alphas for individual funds are persistent: a hedge fund with a high alpha in the first period has a greater probability of a high alpha in the second period

10. Risk Concerns
- relatively high mortality rate (about 10% annum)
- regulators need not be concerned about investors and financial institutions
- no evidence that liquidity risks have produced disastrous outcomes
- no clear proof that hedge funds have created volatility risk

11. Futures of Hedge Funds
11-1. Institutionalization
- increasing proportion of investments are from pensions and endowments -> requires more transparent & institutionalized

11-2. Regulation
- more hedge fund regulations

11-3. Trends in Hedge Funds & Mutual Funds

12. Hedge Fund Legal Structure
12-1. Types
- limited partnership
- limited liability corp.
- offshore corp.

12-2. Allowed
- taking short & long positions in any asset
- use all kinds of derivatives
- leverage without restrictions

12-3. Section 3(c)(1) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 100 partners (accredited investors)
- individual: greater than $1M or income greater than $200K
- entity: greater than $5M
- prohibited from advertising

12-4. Section 3(c)(7) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 500 partners (qualified purchasers)
- individual: greater than $5M
- entity: greater than $25M
- prohibited from adversing