Hedge Funds

Investor should be aware of the following issues in selecting and using hedge fund indices. 1. Biases in Index Creation

A primary concern is that most databases are self-reported; that is, the hedge fund manager chooses which databases to report to and provides the return data the correlations among hedge fund indices based on similar strategies are generally moderately high in the period covered by Exhibit 26 (e.g., above 0.80), in certain cases, the correlations fall below 0.20

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An appropriate benchmark reflects the particular style of an investment manager and can serve as a surrogate for the manager in studies of risk and return performance and asset allocation. Of great concern for investors is whether an index reflects the actual relative sensitivity of hedge funds to various market conditions, such that each index provides information on the true diversification benefits of the underlying hedge fund strategies. Many studies have used both single-factor and multifactor models in identifying market factors and option-like payoffs that describe the sources of hedge fund returns. However, the SENSITIVITY OF VARIOUS HEDGE FUND INDICES to these economic factors may change over time, so the changing styles and changing assets under management (if asset-weighted) in an index may make historical results relative to that index conditional at best.

The compensation structure of hedge funds

Comprises a percentage of net asset value (NAV) as a MANAGEMENT FEE (or AUM fee) plus an INCENTIVE FEE. The management fee generally ranges from 1% to 2% The incentive fee is a percentage of profits as specified by the terms of the investment. It has traditionally been 20% but has recently averaged approximately 17.5%

Here are several possible explanations for low correlations between "similar strategy" indices. One is the size and age restrictions some indices impose. Another may be the weighting schemes.

Equal-weighted indices may reflect potential diversification of hedge funds better than value-weighted indices. For funds designed to track equal-weighted indices, however, the costs of rebalancing to index weights make it difficult to create an investable form

Comparison of Major Manager-Based Hedge Fund Indices: MONTHLY SERIES

For the Monthly return series, the EACM Advisors, CISDM, HFR, and MSCI indices have many different classifications and subclassifications, whereas the Credit Suisse/Tremont and Standard & Poor's have relatively few classifications. The CISDM indices do not report a "hedge fund composite" return each month.

6.2.2. Historical Performance

For the entire period, the HFCI had the superior return performance relative to other traditional asset classes. The minimum monthly return for the HFCI for the entire period, at -6.92 percent, represents a smaller loss than that of the worst monthly return for either US or world equities. For the five-year period ending in 2004, the HFCI outperformed US and world equities but not bonds. In 1990-2004, there was considerable variation in the risk and return characteristics among styles Because equity hedge funds load on similar return factors as the S&P 500, they offer less diversification than many relative-value strategies and can be more rightly considered return enhancers. The different sensitivities of various hedge fund strategies to various market factors result in different correlations among hedge fund strategies themselves. Diversification among hedge fund strategies should therefore also reduce the volatility of hedge fund-based investment portfolios.

6.2.1. Benchmarks

Hedge fund benchmarks include both MONTHLY and DAILY series. In alphabetical order, a sample of monthly hedge fund indices includes the following: • CISDM of the University of Massachusetts • Credit Suisse/Tremont • EACM Advisors • Hedge Fund Intelligence Ltd • HedgeFund.net. • HFR • MSCI A sample of available daily indices includes the following: • Dow Jones Hedge Fund Strategy benchmarks • HFR hedge fund indices. • MSCI Hedge Invest Index • Standard & Poor's Hedge Fund Indices

6.2.3. Interpretation Issues

Hedge fund indices often have meaningfully different performance within a given time period. This raises the challenging question of WHICH INDEX is most appropriate for the investor's purposes. Despite the differences in returns, comparable hedge fund indices appear to be SENSITIVE to the SAME SET OF RISK FACTORS. The return differences among indices often reflect differences in the WEIGHTS OF DIFFERENT STRATEGY groups.

Solution

Hedge fund strategies within a particular style often trade similar assets with similar methodologies and are sensitive to similar market factors. Two principal means of establishing comparable portfolios are 1) using a single-factor or multifactor methodology and 2) using optimization to create tracking portfolios with similar risk and return characteristics.

LOCK UP PERIOD

Hedge funds also prescribe a minimum initial holding or LOCK-UP PERIOD for investments during which no part of the investment can be withdrawn. Lock-up periods of ONE TO THREE YEARS are common Thereafter, the fund will redeem the investments of investors only within specified exit windows—for example, quarterly after the lock-up period has ended. The rationale for these provisions is that the hedge fund manager needs to be insulated to avoid unwinding positions unfavorably. FOFs usually do not impose lock-up periods and may permit more frequent investor exits.

6.1.2. Size of the Hedge Fund Market

It is estimated that money under management for hedge funds grew from less than US$50 billion in 1990 to approximately US$600 billion in 2002; the number of hedge funds increased to more than 6,000.

6.2. Benchmarks and Historical Performance

Many investors are concerned that hedge funds DO NOT PROVIDE a means for monitoring and tracking these investments that are available for other, more traditional investments. In the ALTERNATIVE INVESTMENT INDUSTRY, Center for International Securities and Derivatives Markets, Hedge Fund Research (HFR), Dow Jones, Standard & Poor's, and Morgan Stanley provide MONTHLY or DAILY indices that track the performance of active manager-based benchmarks of HEDGE FUND performance. research has also focused on developing indices for STRATEGIES (e.g., tracking portfolios) that try to separate the contribution to performance of the strategy from the contribution to performance of the manager's specific talent. Investors should be cautioned that abnormal returns simply reflect that the reference benchmark is not a complete tracking portfolio for the hedge fund so the abnormal returns are simply the result of additional, NONMEASURED RISKS.

Much DEBATE has surrounded the fee structures of hedge funds.

ONE PERSPECTIVE is that to the extent a hedge fund investor is not paying for "beta" (exposure to systematic risk), as the investor might do with a traditional long-only mutual fund, a higher fee structure is warranted. ANOTHER RATIONALE is that to the extent a hedge fund contributes to controlling a portfolio's downside risk, somewhat like a protective put, the fund manager should earn a premium, somewhat like an insurance premium.

Comparison of Major Manager-Based Hedge Fund Indices: DAILY SERIES

Of the current indices, only Dow Jones, Standard & Poor's, MSCI, and HFR provide a daily return series. Of these daily indices, only Dow Jones and Standard & Poor's publicly list the funds in the indices. Another important feature of the daily indices is that they are generally constructed from managed accounts of an asset manager rather than from the funds themselves.

Alpha Determination and Absolute-Return Investing

Performance appraisal has emerged as a major issue in the hedge fund industry. Hedge funds have often been promoted as absolute-return vehicles ABSOLUTE-RETURN VEHICLES have been defined as investments that have no direct benchmark portfolios. Estimates of alpha, however, must be made relative to a benchmark portfolio.

Investor should be aware of the following issues in selecting and using hedge fund indices. 3. Survivorship Bias

Survivorship bias results when managers with poor track records exit the business and are dropped from the database whereas managers with good records remain. If survivorship bias is large, then the historical return record of the average surviving manager is higher than the average return of all managers over the test period Studying only survivors results in OVERESTIMATION of historical returns Survivorship bias is minor for EVENT-DRIVEN STRATEGIES, is higher for HEDGED EQUITY (1%-2%), and is CONSIDERABLE FOR CURRENCY FUNDS & the bias may be concentrated in certain periods. The problem of survivorship bias may be reduced by conducting superior due diligence (reason for FOF existence)

HWM (2) and FOF fees

The PURPOSE of a HWM provision is to ensure that the hedge fund manager earns an incentive fee only once for the same gain. For the HEDGE FUND MANAGER, the HWM is like a CALL OPTION on a fraction of the increase in the value of the fund's NAV. Many hedge fund managers depend on earning the incentive fee. Given a 15 percent gain, a 1 and 20 fund would earn about 4 percent of the asset versus 1 percent if no incentive fee were earned. FOFs impose management fees and incentive fees. A "1.5 plus 10" structure would not be uncommon.

Comparison of Major Manager-Based Hedge Fund Indices

The general distinguishing FEATURE of various hedge fund series is whether they report MONTHLY or DAILY series, are INVESTABLE or NONINVESTABLE, and list the actual funds used in benchmark construction.

High Water Mark (HWM)

The great majority of funds have a HWM provision that applies to the payment of the incentive fee. HIGH-WATER MARK (HWM) is a SPECIFIED NET ASSET VALUE LEVEL that a fund must exceed before performance fees are paid to the hedge fund manager Once the first incentive fee has been paid, the highest month-end NAV establishes a high-water mark. If the NAV then falls below the HWM, no incentive fee is paid until the fund's NAV exceeds the HWM; then the incentive fee for a "1 plus 20" structure (a 1 percent management fee plus a 20 percent incentive fee) is 20 percent of the positive difference between the ending NAV and the HWM NAV The new, higher NAV establishes a new HWM. A minority of funds also specify that no incentive fee is earned until a specified minimum rate of return (hurdle rate) is earned.

6.1. The Hedge Fund Market

The hedge fund market has experienced tremendous growth in the past 15 years Although many hedge funds maintain that their strategies seek "ABSOLUTE RETURNS" that require no benchmark, some INSTITUTIONAL INVESTORS who invest in hedge funds are asking for relative performance evaluation, which requires some benchmarking.

Here are several possible explanations for low correlations between "similar strategy" indices. One is the size and age restrictions some indices impose. Another may be the weighting schemes.

Value weighting may result in a particular index taking on the return characteristics of the best-performing hedge funds in a particular time period: As top-performing funds grow from new inflows and high returns and poorly performing funds are closed, the top-performing funds represent an increasing share of the index (dices that are value weighted may reflect current popularity with investors because the asset values of the various funds change as a result of asset purchases and price) Popularity may reflect the most recent results, creating a momentum effect in returns. The ability of an investor to track an index subject to momentum is problematic.

Problems in alpha determination

differences in the selected benchmark can result in large differences in reported alpha. - One perspective is that all active management is about performance relative to some investable benchmark. Another important issue in evaluating claims of alpha is whether account is being taken of all sources of systematic risk the fund may be exposed to

Investor should be aware of the following issues in selecting and using hedge fund indices. 2. Relevance of Past Data on Performance

hedge funds with similar investment styles generate similar returns, and there is little evidence of superior individual manager skill within a particular style group. The volatility of returns is more persistent through time than the level of returns. Best forecast of future returns is one that is consistent with prior volatility, not one that is consistent with prior returns The composition of hedge fund indices also changes greatly, so the past returns of an index reflect the performance of a different set of managers from today's or tomorrow's managers. This may be a more severe problem for value-weighted indices than for equal-weighted indices because VALUE-WEIGHTED INDICES are MORE HEAVILY WEIGHTED in the recent BEST-PERFORMING fund(s).

6.1.1. Types of Hedge Fund Investments 2.

• Convertible arbitrage: Convertible arbitrage strategies attempt to exploit anomalies in the prices of corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds' risk by shorting the associated stock. The cash proceeds from the short sale remain with the hedge fund's prime broker but earn interest, and the hedge fund may earn an extra margin through leverage when the bonds' current yield exceeds the borrowing rate of money from the prime broker. The risks include changes in the price of the underlying stock, changes in expected volatility of the stock, changes in the level of interest rates, and changes in the credit standing of the issuer. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies typically make money if the expected volatility of the underlying asset increases or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves.

6.1.1. Types of Hedge Fund Investments 4.

• Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Distressed debt and equity securities are fundamentally different from nondistressed securities. Most investors are unprepared for the legal difficulties and negotiations with creditors and other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented by charter from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity, short sales are difficult, so most funds are long.

6.1.1. Types of Hedge Fund Investments 8.

• Emerging markets: These funds focus on the emerging and less mature markets. Because short selling is not permitted in most emerging markets and because futures and options are not available, these funds tend to be long.

6.1.1. Types of Hedge Fund Investments The following classification of hedge fund STYLE will be the basis for most of our discussion. Keep in mind that industry usage applies the term "ARBITRAGE" somewhat loosely to mean, roughly, a "LOW-RISK" rather than a "NO-RISK" investment operation. 1. Equity Market Neutral

• Equity market neutral: Equity market-neutral managers attempt to identify overvalued and undervalued equity securities while neutralizing the portfolio's exposure to market risk by combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. The market opportunity for equity market-neutral programs comes from 1) their flexibility to take short as well as long positions in securities without regard to the securities' weights in a benchmark and 2) the existence of pockets of inefficiencies (i.e., mispricing relative to intrinsic value) in equity markets, particularly as related to overvalued securities. Because many investors face constraints relative to shorting stocks, situations of overvaluation may be slower to correct than those of undervaluation.

6.1.1. Types of Hedge Fund Investments 3.

• Fixed-income arbitrage: Managers dealing in fixed-income arbitrage attempt to identify overvalued and undervalued fixed-income securities primarily on the basis of expectations of changes in the term structure of interest rates or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements because the portfolios combine long and short positions.

6.1.1. Types of Hedge Fund Investments 9.

• Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10-30 hedge funds, and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees—one to the hedge fund manager, and the other to the manager of the FOF.

6.1.1. Types of Hedge Fund Investments 7.

• Global macro: Global macro strategies primarily attempt to take advantage of systematic moves in major financial and nonfinancial markets through trading in currencies, futures, and option contracts, although they may also take major positions in traditional equity and bond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many global macro managers use derivatives, such as futures and options, in their strategies. Managed futures are sometimes classified under global macro as a result.

6.1.1. Types of Hedge Fund Investments 6.

• Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value of long positions and the portfolio may have a net long exposure to the equity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management.80

6.1.1. Types of Hedge Fund Investments 5.

• Merger arbitrage: Merger arbitrage, also called "deal arbitrage," seeks to capture the price spread between current market prices of corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company's stock.

There is no single standard classification system or set of labels for hedge fund STRATEGIES. One provider of hedge fund benchmarks classifies STRATEGIES into the following FIVE broad groups:

• Relative value, in which the manager seeks to exploit valuation discrepancies through long and short positions. This label may be used as a supercategory for, for example, equity market neutral, convertible arbitrage, and hedged equity.

differences in the construction of the major MANAGER-BASED HEDGE FUND INDICES

• Selection criteria. Decision rules determine which hedge funds are included in the index. Examples of selection criteria include length of track record, AUM, and restrictions on new investment. For example, MSCI, Dow Jones, and Standard & Poor's have specific rule-based processes for manager selection. • Style classification. Indices have various approaches to how each hedge fund is assigned to a style-specific index and whether or not a fund that fails to satisfy the style classification methodology is excluded from the index. • Weighting scheme. Indices have different schemes to determine how much weight a particular fund's return is given in the index. Common weighting schemes are equally weighting and dollar weighting on the basis of AUM. Many indices report both equal-weighted and asset-weighted versions. • Rebalancing scheme. Rebalancing rules determine when assets are reallocated among the funds in an equally weighted index. For example, some funds are rebalanced monthly; others use annual rebalancing. • Investability. An index may be directly or only indirectly investable. The majority of monthly manager-based hedge fund indices are not investable, whereas most of the daily hedge fund indices are investable but often in association with other financial firms.