The history and track record of hedge funds; 3) all of the basic fundamentals of investing. One investor's risk is another's opportunity. Hedge funds may represent a paradigm shift or it may be a bubble. GetAbstract maintains complete editorial responsibility for all parts of this abstract.
The history and track record of hedge funds; 3) all of the basic fundamentals of investing. One investor's risk is another's opportunity. Hedge funds may represent a paradigm shift or it may be a bubble. GetAbstract maintains complete editorial responsibility for all parts of this abstract.
The history and track record of hedge funds; 3) all of the basic fundamentals of investing. One investor's risk is another's opportunity. Hedge funds may represent a paradigm shift or it may be a bubble. GetAbstract maintains complete editorial responsibility for all parts of this abstract.
The Risk and Opportunities of Hedge Fund Investing
by Alexander M. Ineichen John Wiley & Sons 2002 514 pages
Focus Take-Aways Leadership & Mgt. Strategy Sales & Marketing Corporate Finance Human Resources Technology & Production Small Business Economics & Politics Industries & Regions Career Development Personal Finance Concepts & Trends Sociologist Alfred Winslow Jones set up the rst hedge fund in 1949. Warren Buffett set up a fund that ts todays perception of a hedge fund in the 1950s. Absolute return money managers play both the long and short side of the market. Good hedge fund managers specialize. Analyzing their motivation and performance is difcult. Markets are never completely efcient, and active managers can beat them sometimes. Arbitrage traders take offsetting positions in related instruments whose performance is fairly predictable. Market neutral strategies are a form of arbitrage that seeks to exploit market inefciencies by holding roughly equivalent long and short positions. These strategies have been quite protable. One investors risk is anothers opportunity. Hedge fund investing may represent a paradigm shift or it may be a bubble.
Rating (10 is best)
Overall Applicability Innovation Style 8 8 8 7
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This summary is restricted to the personal use of Hugo A. Gonzales (hugoaguilar7@googlemail.com) Copyright 2004 getAbstract Absolute Returns 2 of 5
Relevance What You Will Learn In this Abstract, you will learn: 1) The history and track record of hedge funds; 2) All of the basic investment questions about hedge funds; and 3) Numerous possible answers to each one. Recommendation Hedge funds burst into the headlines in the early 1990s, when George Soros became a household name at least in Europe, where many people blamed him and his hedge fund for wrecking the European exchange rate mechanism. Similarly, a U.S. hedge fund called Long Term Capital Management (LTCM) began with an aura of investing invincibility, only to fail dramatically. Hedge fund investing is sometimes, but not always, high risk and high return. Once limited to a privileged elite group of investors, hedge funds are now opening their rosters to less sophisticated, less wealthy speculators. But hedge funds are not just like any other funds, and anyone contemplating an investment needs a solid, comprehensive guide, such as this book. Author Alexander M. Ineichen, neither a salesman nor an alarmist, pulls no punches when discussing the risks of hedge funds. He is quite straightforward about the sometimes astonishing success of some hedge fund managers, but careful to point out the common misconceptions about them. Without hedging our bets, getAbstract.com nds this book a valuable addition to every investors library.
Abstract
Dont lose money. If you dont know the facts, dont play. I just wait until there is money around the corner, and all I have to do is go over there and pick it up. A Half Century of Hedge Fund History The rst hedge fund made its debut in 1949, when sociologist Alfred Winslow Jones started a general partnership, later changed to a limited partnership, to trade equities. In his stock trades, Jones sometimes went long and sometimes sold short. Short sellers borrow a stock and sell it, expecting to buy it back at a lower price and then return it to the lender. Traders who go long expect the price to go up; those who sell short expect the price to fall. Joness ability to prot both ways was extraordinary. Other hedge funds followed. In 1956, Warren Buffett established a partnership which resembled a hedge fund in most ways; the difference was that Buffett did not sell short. From 1956 to 1969, his returns were 29.5% compounded. Buffetts compensation depended on the funds performance. His investors received a 6% return plus 75% of any prots above a 6% hurdle rate. Buffett himself received 25% of prots above the 6% rate. Buffett was a contrarian, and specialized in nding and buying stocks that he thought were undervalued. When the market soared in the late 1960s, he couldnt nd enough undervalued stocks to practice his traditional approach and he dissolved the partnership instead of changing his approach. George Soros, another renowned hedge fund investor, may be even greater at it than Buffett. His compound annual return from 1969 to 2001, after deducting fees, was 31.6%. During the rst decade of that period, the 1970s, only a few other, mostly small, hedge funds were in the market. A handful of prominent money managers set up funds during the 1980s, but hedge funds proliferated in the 1990s, as money managers left big nancial institutions and set up shop on their own. Not only did hedge funds multiply during this period, but a wide range of investment approaches appeared. Copyright 2004 getAbstract Absolute Returns 3 of 5
Irrespective of the history of hedge funds or whether hedge funds are leading or lagging the establishment, the pursuit of absolute returns is probably as old as civilization and trade itself. How- ever, so is lem- ming-like trend following.
Capitalism is the astounding belief that the most wick- edest of men will do the most wick- edest of things for the greatest good of everyone.
Risk control and capital preserva- tion are among the main areas where the best hedge funds consistently excel. Absolute Return Most investment managers have some sort of benchmark. Many measure themselves against the S&P 500 index, for example. If the index goes down, but their funds go down less, they have succeeded. If their funds earn more value than the index, they have succeeded. Absolute return managers do not measure themselves against an index. They aim to make money no matter what the overall market is doing. They may use derivatives and other tools or techniques to exploit a downward trend. They may go long or short. Contrary to popular misconception, these managers are not cowboys. They tend to be extremely conservative, and they often use sophisticated nancial instruments, not to speculate, but to hedge. Their Ten Commandments are ten iterations of: Thou shalt not lose. Absolute return managers are more sensitive to risk and more apt to manage it than long-only investors. The Hedge Fund Industry Reliable information about the hedge fund industry is hard to get. Some observers say that there are as few as 2,500 hedge funds in the world, others estimate there are as many as 6,000. Numbers uctuate as new funds form and old ones dissolve. Hedge funds, collectively, probably manage between $500 and $600 billion in assets. This is minuscule compared to the $15.9 trillion 1999 asset base of pension funds. European hedge funds account for about 11% of total managed assets for the industry. Hedge funds achieved an important landmark in 1999 when the California Public Employees Retirement System (CalPERS) announced that it would invest in such funds, among other hybrid investments. Funds of funds, corporations, pension funds and individuals all invest in hedge funds now. The success of hedge funds in attracting new investors is rather surprising given their generally negative press. Hedge funds are open to some justied criticism on several counts: Magnitude Once hedge funds get really big, they have trouble delivering superior, or even positive, returns. Leverage Highly leveraged hedge funds have sometimes threatened the stability of the entire nancial system. The most notable example was Long Term Capital Management (LTCM). Transparency Transparency allows third parties to monitor risk, but hedge funds are quite secretive and it is difcult to know exactly what they are doing. Stability of funding A run on the bank scenario can cause serious market disrup- tion. Hedge funds need stable fund sources. Many LTCM trades were actually good trades and might have scored if investors had not rushed to pull out their capital. Pride As the proverb has it, pride goeth before a fall. Hedge fund managers need a great deal of self-condence, because they receive rich compensation when they are right. Being right made them managers in the rst place, and betting on their convictions is a sine qua non of further success. Such condence can easily evolve into arrogance and lead to disastrous missteps. The top three hedge fund investment styles, measured by their outcomes in the third quarter of 2001, were: Equity Long/Short $228 billion in assets, roughly 46% of total hedge fund assets. Event $108 billion, roughly 22% of total. Macro, global $40 billion, 8% of total. Copyright 2004 getAbstract Absolute Returns 4 of 5
Either the con- vertible was too cheap or equity was too expen- sively valued by the market. To exploit this inef- ciency, convertible arbitrageurs sold expensive equity and bought the comparably cheap convertible bonds.
Buy and sell deci- sions are based on expectations about future prices, and future prices, in turn, are contin- gent on present buy and sell deci- sions.
Hedge fund man- agers, especially in the relative- value arena, make money by ex- ploiting objective market inefcien- cies. The average age of hedge funds has declined as more and more new hedge funds have emerged. This means, of course, that evaluating and selecting good managers is getting more difcult. The eld is so crowded that you may easily confuse luck with skill. Even so, several myths about hedge funds should be debunked, including: Hedge funds are high-risk investments In fact, any investment may be high-risk when it is not diversied. Hedge funds are inherently no riskier than technology or transportation stocks. Diversication is important in every case. Hedge funds are gambles Although hedge funds speculate, they are not necessar- ily speculative. Every investment is a speculation, but hedge funds may be more pro- tective of principal than other types of funds, precisely because they often hedge. Hedge funds do great regardless of market moves In fact, like other investments, hedge funds have good years and bad years. Hedge funds always hedge Hedge fund managers choose when to hedge and when not to, and take risks when they judge the risks to be good investments. Short and long are opposites In fact, in an investing context, short and long are not the mirror image of each other. Short positions have a different risk prole than long positions and need to be handled with greater caution. However, most long/short investors consider a pure long strategy to be quite speculative compared to a strategy that balances long and short positions. Hedge funds usually, but not always, outperform mutual funds in the aggregate. This makes sense since most mutual funds cannot exploit a down market or defend against one effectively. Hedge funds do not aim at a benchmark; by and large, the only measure of hedge fund success is cash won in the markets. A good benchmark of hedge fund performance is unlikely to be developed because such a metric would have to be: Reective of the range of hedge fund styles and approaches. Clear and subject to measurement. Capable of being replicated passively. Hedge fund styles are too diverse and idiosyncratic to t a benchmark. The best funds do well because they are run by superlative risk managers. Investing in hedge funds has disadvantages, most notably the relative absence of transparency. But fees seem to be money well spent hedge funds are no costlier than other investments when the costs are viewed in the context of performance. To some extent, hedge fund success ies in the face of efcient market theory, but efcient market theory itself often ies in the face of plainly observable facts. Styles Some of the main hedge fund styles include: Convertible arbitrage Most managers in this area buy bonds, warrants or convert- ible bonds and hedge away the market exposure. A formula allows them to calculate a fair value relationship between the stock and the convertible. When the convertible is under-priced relative to the stock, they buy. Fixed income arbitrage This school applies a similar arbitrage approach to bonds and other xed income investments. Market-neutral equity These funds aim to exploit inefciencies in the equity market by holding roughly equivalent long and short positions. Managers take a sta- tistical approach to historical price analysis to discern good potential trades. Copyright 2004 getAbstract Absolute Returns 5 of 5
A small, well- performing fund attracts assets. Unlike mutual funds, many abso- lute return strate- gies have limited capacity.
Active funds underperform passive funds because active money manage- ment is more costly than pas- sive money man- agement. Risk arbitrage Risk arbitrageurs essentially bet on a merger, acquisition or spin-off, usually buying the stock of the target and shorting the acquirer to capture the spread. Robert Rubin, former U.S. Treasury Secretary, was one of the best risk arbitrageurs. Distress Managers in the distressed securities business take positions in bankrupt or otherwise troubled companies. These securities often trade at a discount off of their fundamental value because so many investors avoid them. This leads to oppor- tunities since the various classes of securities that these companies issue generally dont follow rational pricing relationships. Equity long/short This approach has many variations but, in general, managers take a directional view on securities, buying the ones they expect will appreciate and selling short the ones they expect will depreciate. This is not quite the same thing as market neutral. Market neutral players do not take a general market view; in fact, they seek to eliminate any suggestion of such a view from their portfolios. Sector specialization Managers apply a long/short approach to a particular sub- class of securities, for example, technology stocks, health care stocks and so on. Macro These funds are utterly unrestrained and completely exible. Short Short managers aim to nd overvalued securities, borrow them, sell them for what the market thinks theyre worth, buy them back when the market recognizes what theyre really worth and make money doing it. Emerging markets Emerging market managers trade the securities of less devel- oped countries or markets, for instance, Latin America, Africa, Southeast Asia and Eastern Europe. Fund of funds This is not precisely an investment style but rather is a way of invest- ing in hedge funds. A fund of funds invests in funds managed by a number of manag- ers, mixing and matching to achieve a certain overall balance of risk and return.
Some say hedge funds represent a paradigm shift in investing. Others suggest that hedge funds are a bubble waiting to pop. The truth is probably somewhere between these extremes. Hedge funds are neither extremely risky nor sure things. The most important advice to prospective investors is to know what risk you are taking before you take it, and if you arent sure, dont.
About The Author Alexander M. Ineichen, CFA, is Managing Director and Head of Equity Derivatives Research at UBS Warburg in London.