Hedge fund
A hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments.[1] In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.
Hedge funds are considered alternative investments. Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, commonly known as mutual funds and ETFs. They are also considered distinct from private equity funds and other similar closed-end funds as hedge funds generally invest in relatively liquid assets and are usually open-ended. This means they typically allow investors to invest and withdraw capital periodically based on the fund's net asset value, whereas private-equity funds generally invest in illiquid assets and return capital only after a number of years.[2][3] Other than a fund's regulatory status, there are no formal or fixed definitions of fund types, and so there are different views of what can constitute a "hedge fund".
Although hedge funds are not subject to the many restrictions applicable to regulated funds, regulations were passed in the United States and Europe following the financial crisis of 2007–2008 with the intention of increasing government oversight of hedge funds and eliminating certain regulatory gaps.[4] While most modern hedge funds are able to employ a wide variety of financial instruments and risk management techniques,[5] they can be very different from each other with respect to their strategies, risks, volatility and expected return profile. It is common for hedge fund investment strategies to aim to achieve a positive return on investment regardless of whether markets are rising or falling ("absolute return"). Hedge funds can be considered risky investments; the expected returns of some hedge fund strategies are less volatile than those of retail funds with high exposure to stock markets because of the use of hedging techniques.
A hedge fund usually pays its investment manager a management fee (typically, 2% per annum of the net asset value of the fund) and a performance fee (typically, 20% of the increase in the fund's net asset value during a year).[1] Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial portion of the asset management industry,[6] with assets totaling around $3.8 trillion as of 2021.[7] Hedge fund managers can have several billion dollars of assets under management (AUM).
Etymology[edit]
The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk.[8] Early hedge funds sought to hedge specific investments against general market fluctuations by shorting other, similar assets.[9]: 4 Nowadays, however, many different investment strategies are used, many of which do not "hedge" risk.[9]: 16–34 [10]
Fees and remuneration[edit]
Fees paid to hedge funds[edit]
Hedge fund management firms typically charge their funds both a management fee and a performance fee.
Management fees are calculated as a percentage of the fund's net asset value and typically range from 1% to 4% per annum, with 2% being standard.[99][100][101] They are usually expressed as an annual percentage, but calculated and paid monthly or quarterly. Management fees for hedge funds are designed to cover the operating costs of the manager, whereas the performance fee provides the manager's profits. However, due to economies of scale the management fee from larger funds can generate a significant part of a manager's profits, and as a result some fees have been criticized by some public pension funds, such as CalPERS, for being too high.[102]
The performance fee is typically 20% of the fund's profits during any year, though performance fees range between 10% and 50%. Performance fees are intended to provide an incentive for a manager to generate profits.[103][104] Performance fees have been criticized by Warren Buffett, who believes that because hedge funds share only the profits and not the losses, such fees create an incentive for high-risk investment management. Performance fee rates have fallen since the start of the credit crunch.[105]
Almost all hedge fund performance fees include a "high water mark" (or "loss carryforward provision"), which means that the performance fee only applies to net profits (i.e., profits after losses in previous years have been recovered). This prevents managers from receiving fees for volatile performance, though a manager will sometimes close a fund that has suffered serious losses and start a new fund, rather than attempt to recover the losses over a number of years without a performance fee.[106]
Some performance fees include a "hurdle", so that a fee is only paid on the fund's performance in excess of a benchmark rate (e.g., LIBOR) or a fixed percentage.[107] The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread.[108] A "soft" hurdle means the performance fee is calculated on all the fund's returns if the hurdle rate is cleared. A "hard" hurdle is calculated only on returns above the hurdle rate.[109] By example the manager sets a hurdle rate equal to 5%, and the fund return 15%, incentive fees would only apply to the 10% above the hurdle rate.[108] A hurdle is intended to ensure that a manager is only rewarded if the fund generates returns in excess of the returns that the investor would have received if they had invested their money elsewhere.
Some hedge funds charge a redemption fee (or withdrawal fee) for early withdrawals during a specified period of time (typically a year), or when withdrawals exceed a predetermined percentage of the original investment.[110] The purpose of the fee is to discourage short-term investing, reduce turnover, and deter withdrawals after periods of poor performance. Unlike management fees and performance fees, redemption fees are usually kept by the fund and redistributed to all investors.
Remuneration of portfolio managers[edit]
Hedge fund management firms are often owned by their portfolio managers, who are therefore entitled to any profits that the business makes. As management fees are intended to cover the firm's operating costs, performance fees (and any excess management fees) are generally distributed to the firm's owners as profits. Funds do not tend to report compensation, and so published lists of the amounts earned by top managers tend to be estimates based on factors such as the fees charged by their funds and the capital they are thought to have invested in them.[111] Many managers have accumulated large stakes in their own funds and so top hedge fund managers can earn extraordinary amounts of money, perhaps up to $4 billion in a good year.[112][113]
Earnings at the very top are higher than in any other sector of the financial industry,[114] and collectively the top 25 hedge fund managers regularly earn more than all 500 of the chief executives in the S&P 500.[115] Most hedge fund managers are remunerated much less, however, and if performance fees are not earned then small managers at least are unlikely to be paid significant amounts.[114]
In 2011, the top manager earned $3 billion, the tenth earned $210 million, and the 30th earned $80 million.[116] In 2011, the average earnings for the 25 highest-compensated hedge fund managers in the United States was $576 million[117] while the mean total compensation for all hedge fund investment professionals was $690,786 and the median was $312,329. The same figures for hedge fund CEOs were $1,037,151 and $600,000, and for chief investment officers were $1,039,974 and $300,000, respectively.[118]
Of the 1,226 people on the Forbes World's Billionaires List for 2012,[119] 36 of the financiers listed "derived significant chunks" of their wealth from hedge fund management.[120] Among the richest 1,000 people in the United Kingdom, 54 were hedge fund managers, according to the Sunday Times Rich List for 2012.[121]
A portfolio manager risks losing his past compensation if he engages in insider trading. In Morgan Stanley v. Skowron, 989 F. Supp. 2d 356 (S.D.N.Y. 2013), applying New York's faithless servant doctrine, the court held that a hedge fund's portfolio manager engaging in insider trading in violation of his company's code of conduct, which also required him to report his misconduct, must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness.[122][123][124][125] The court called the insider trading the "ultimate abuse of a portfolio manager's position".[123] The judge also wrote: "In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron's behavior damaged the firm's reputation, a valuable corporate asset."[123]
Performance[edit]
Measurement[edit]
Performance statistics for individual hedge funds are difficult to obtain, as the funds have historically not been required to report their performance to a central repository, and restrictions against public offerings and advertisement have led many managers to refuse to provide performance information publicly. However, summaries of individual hedge fund performance are occasionally available in industry journals[225][226] and databases.[227]
One estimate is that the average hedge fund returned 11.4% per year,[228] representing a 6.7% return above overall market performance before fees, based on performance data from 8,400 hedge funds.[68] Another estimate is that between January 2000 and December 2009 hedge funds outperformed other investments and were substantially less volatile, with stocks falling an average of 2.62% per year over the decade and hedge funds rising an average of 6.54% per year; this was an unusually volatile period with both the 2001-2002 dot-com bubble and a recession beginning mid 2007.[229] However, more recent data show that hedge fund performance declined and underperformed the market from about 2009 to 2016.[230]
Hedge funds performance is measured by comparing their returns to an estimate of their risk.[231] Common measures are the Sharpe ratio,[232] Treynor measure and Jensen's alpha.[233] These measures work best when returns follow normal distributions without autocorrelation, and these assumptions are often not met in practice.[234]
New performance measures have been introduced that attempt to address some of theoretical concerns with traditional indicators, including: modified Sharpe ratios;[234][235] the Omega ratio introduced by Keating and Shadwick in 2002;[236] Alternative Investments Risk Adjusted Performance (AIRAP) published by Sharma in 2004;[237] and Kappa developed by Kaplan and Knowles in 2004.[238]
Sector-size effect[edit]
There is a debate over whether alpha (the manager's skill element in performance) has been diluted by the expansion of the hedge fund industry. Two reasons are given. First, the increase in traded volume may have been reducing the market anomalies that are a source of hedge fund performance. Second, the remuneration model is attracting more managers, which may dilute the talent available in the industry.[239][240]
Hedge fund indices[edit]
Indices play a central and unambiguous role in traditional asset markets, where they are widely accepted as representative of their underlying portfolios. Equity and debt index fund products provide investable access to most developed markets in these asset classes.
Hedge fund indices are more problematic. The typical hedge fund is not traded on exchange, will accept investments only at the discretion of the manager, and does not have an obligation to publish returns. Despite these challenges, Non-investable, Investable, and Clone indices have been developed.
Debates and controversies[edit]
Systemic risk[edit]
Systemic risk refers to the risk of instability across the entire financial system, as opposed to within a single company. Such risk may arise following a destabilizing event or events affecting a group of financial institutions linked through investment activity.[242] Organizations such as the European Central Bank have charged that hedge funds pose systemic risks to the financial sector,[243][244] and following the failure of hedge fund Long-Term Capital Management (LTCM) in 1998 there was widespread concern about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties. (As it happens, no financial assistance was provided to LTCM by the US Federal Reserve, so there was no direct cost to US taxpayers,[245] but a large bailout had to be mounted by a number of financial institutions.)
However, these claims are widely disputed by the financial industry,[246] who typically regard hedge funds as "small enough to fail", since most are relatively small in terms of the assets they manage and operate with low leverage, thereby limiting the potential harm to the economic system should one of them fail.[228][247] Formal analysis of hedge fund leverage before and during the financial crisis of 2007–2008 suggests that hedge fund leverage is both fairly modest and counter-cyclical to the market leverage of investment banks and the larger financial sector.[98] Hedge fund leverage decreased prior to the financial crisis, even while the leverage of other financial intermediaries continued to increase.[98] Hedge funds fail regularly, and numerous hedge funds failed during the financial crisis.[248] In testimony to the US House Financial Services Committee in 2009, Ben Bernanke, the Federal Reserve Board Chairman said he "would not think that any hedge fund or private-equity fund would become a systemically critical firm individually".[249]
This does leave the possibility that hedge funds collectively might contribute to systemic risk if they exhibit herd or self-coordinating behavior,[250] perhaps because many hedge funds make losses in similar trades. This coupled with the extensive use of leverage could lead to forced liquidations in a crisis.
Hedge funds are also closely connected to their prime brokers, typically investment banks, which could contribute to their instability in a crisis, though this works both ways and failing counterparty banks can freeze hedge funds assets, as Lehman brothers did in 2008.[251]
An August 2012 survey by the Financial Services Authority concluded that risks were limited and had reduced as a result, inter alia, of larger margins being required by counterparty banks, but might change rapidly according to market conditions. In stressed market conditions, investors might suddenly withdraw large sums, resulting in forced asset sales. This might cause liquidity and pricing problems if it occurred across a number of funds or in one large highly leveraged fund.[252]
Transparency[edit]
Hedge funds are structured to avoid most direct regulation (although their managers may be regulated), and are not required to publicly disclose their investment activities, except to the extent that investors generally are subject to disclosure requirements. This is in contrast to a regulated mutual fund or exchange-traded fund, which will typically have to meet regulatory requirements for disclosure. An investor in a hedge fund usually has direct access to the investment adviser of the fund, and may enjoy more personalized reporting than investors in retail investment funds. This may include detailed discussions of risks assumed and significant positions. However, this high level of disclosure is not available to non-investors, contributing to hedge funds' reputation for secrecy, while some hedge funds have very limited transparency even to investors.[253]
Funds may choose to report some information in the interest of recruiting additional investors. Much of the data available in consolidated databases is self-reported and unverified.[254] A study was done on two major databases containing hedge fund data. The study noted that 465 common funds had significant differences in reported information (e.g., returns, inception date, net assets value, incentive fee, management fee, investment styles, etc.) and that 5% of return numbers and 5% of NAV numbers were dramatically different.[255] With these limitations, investors have to do their own research, which may cost on the scale of US$50,000 for a fund that is not well-established.[256]
A lack of verification of financial documents by investors or by independent auditors has, in some cases, assisted in fraud.[257] In the mid-2000s, Kirk Wright of International Management Associates was accused of mail fraud and other securities violations[258][259] which allegedly defrauded clients of close to US$180 million.[260] In December 2008, Bernard Madoff was arrested for running a US$50 billion Ponzi scheme[261] that closely resembled a hedge fund and was incorrectly[262] described as one.[263][264][265] Several feeder hedge funds, of which the largest was Fairfield Sentry, channeled money to it. Following the Madoff case, the SEC adopted reforms in December 2009 that subjected hedge funds to an audit requirement.[266]
The process of matching hedge funds to investors has traditionally been fairly opaque, with investments often driven by personal connections or recommendations of portfolio managers.[267] Many funds disclose their holdings, strategy, and historic performance relative to market indices, giving investors some idea of how their money is being allocated, although individual holdings are often not disclosed.[268] Investors are often drawn to hedge funds by the possibility of realizing significant returns, or hedging against volatility in the market. The complexity and fees associated with hedge funds are causing some to exit the market – CalPERS, the largest pension fund in the US, announced plans to completely divest from hedge funds in 2014.[269] Some services are attempting to improve matching between hedge funds and investors: HedgeZ is designed to allow investors to easily search and sort through funds;[270] iMatchative aims to match investors to funds through algorithms that factor in an investor's goals and behavioral profile, in hopes of helping funds and investors understand the how their perceptions and motivations drive investment decisions.[271]
Links with analysts[edit]
In June 2006, prompted by a letter from Gary J. Aguirre, the U.S. Senate Judiciary Committee began an investigation into the links between hedge funds and independent analysts. Aguirre was fired from his job with the SEC when, as lead investigator of insider trading allegations against Pequot Capital Management, he tried to interview John Mack, then being considered for chief executive officer at Morgan Stanley.[272] The Judiciary Committee and the US Senate Finance Committee issued a scathing report in 2007, which found that Aguirre had been illegally fired in reprisal[273] for his pursuit of Mack, and in 2009 the SEC was forced to re-open its case against Pequot. Pequot settled with the SEC for US$28 million, and Arthur J. Samberg, chief investment officer of Pequot, was barred from working as an investment advisor.[274] Pequot closed its doors under the pressure of investigations.[275]
The systemic practice of hedge funds submitting periodic electronic questionnaires to stock analysts as a part of market research was reported by The New York Times in July 2012. According to the report, one motivation for the questionnaires was to obtain subjective information not available to the public and possible early notice of trading recommendations that could produce short-term market movements.[276]
Value in a mean/variance efficient portfolio[edit]
According to modern portfolio theory, rational investors will seek to hold portfolios that are mean/variance efficient (that is, portfolios that offer the highest level of return per unit of risk). One of the attractive features of hedge funds (in particular market neutral and similar funds) is that they sometimes have a modest correlation with traditional assets such as equities. This means that hedge funds have a potentially quite valuable role in investment portfolios as diversifiers, reducing overall portfolio risk.[107]
However, there are at least three reasons why one might not wish to allocate a high proportion of assets into hedge funds. These reasons are:
Several studies have suggested that hedge funds are sufficiently diversifying to merit inclusion in investor portfolios, but this is disputed for example by Mark Kritzman who performed a mean-variance optimization calculation on an opportunity set that consisted of a stock index fund, a bond index fund, and ten hypothetical hedge funds.[277][278] The optimizer found that a mean-variance efficient portfolio did not contain any allocation to hedge funds, largely because of the impact of performance fees. To demonstrate this, Kritzman repeated the optimization using an assumption that the hedge funds took no performance fees. The result from this second optimization was an allocation of 74% to hedge funds.
Hedge funds tend to perform poorly during equity bear markets, just when an investor needs part of their portfolio to add value.[107] For example, in January–September 2008, the Credit Suisse/Tremont Hedge Fund Index returned -9.87%.[279] According to the same index series, even "dedicated short bias" funds returned −6.08% in September 2008, when Lehman Brothers collapsed.